Executive Pay with Equity Awards: It Takes a Buffett to Push This Agenda

buffett_and_cokeI recently pointed out the absurdity of certain executive pay packages which result from stock or stock option awards. Rather than matching “pay to performance” as proponents claim, the equity awards to executives often create absurd payouts for bad performance, or substitute lucky timing for skill. If the stock goes up during an executive’s tenure, or even ordinary compound growth occurs coincidental with generous stock option awards, the benefits turn into windfalls for executives.

Equity or stock option awards involve disguised generosity, since they do not drain the cash in the bank account of a corporation, as would a non-equity bonus.  Instead, the awards dilute existing shareholders, who barely notice the dilution. Compensation is compensation, and is taxed as such, but it probably seems less expensive.

Warren Buffett made the paper today for opposing certain awards like this at Coca Cola, of which Berkshire Hathaway owns 9%.

This seems like a victimless crime, in that only shareholders suffer, and they can theoretically protest at an annual meeting (they never do) or ‘vote with their feet’ by selling shares if they disagree with board-approved compensation or executive recruitment/incentive packages.

The reality is that shareholders have virtually no power when it comes to executive compensation. Corporate boards and compensation consultants – the decision makers in this scenario – have a perverse set of self-interested incentives on this issue. Executive cross-sit on each others’ board, so nobody wants to be the turd in the punchbowl when it comes to doling out generous packages. Compensation consultants, for their part, want to be invited to do work for subsequent compensation committees, so they always aim high with what ‘seems fair’ as a recruitment or compensation package.

Buffett, who sits on a number of corporate boards, has written in the past about how he’s (curiously!) never been invited to sit on the compensation committee of corporate boards, for this very reason: his well-known opposition to overpaying CEOs via stock-option awards

Buffett has a long and honorable track record when it comes to opposing executive pay through equity awards, having written and spoken in the past on the issue. He also has an ironic “Nixon Goes to China” credibility on the issue.  Almost nobody on the planet has earned more from their own equity ownership in a large corporate enterprise, so he deeply understands the extraordinary compounding magic that comes from being an equity owner of a profitable enterprise. I suspect he would be the first to slyly wink and admit that it’s better to be lucky than good when it comes to getting wealthy as the executive of a public company with a large ownership stake.

See Related Post: Absurd Executive Pay: The Latest Example from Yahoo

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Ask An Ex-Banker: Is the Finance Game Rigged Against Outsiders?

Q: A question for debate:

We all seem to get mad that the financial-industrial complex is repeatedly rigged for the Big Boys.  I’d suggest to you that the public should just give up on the wall street-banker/big bank/mutual fund industry as having any possibility of being fair to you or me.  Thus, it makes no sense to be mad at it.  Instead, people should invest the way their grandparents did: bonds, cash savings in a local bank or a hole in your backyard, real property, and (if they’re savvy enough) businesses or stocks that they understand.  –Michael G., San Antonio, TX

 

This is a really good question for debate, Michael, and I agree with some of the spirit of it.  I suspect millions of people have had a version of this thought, wondering if they’re the suckers at a rigged game and whether it’s time to take their marbles and go home – to bury their savings in the back yard or the local bank.  But while I’m sympathetic with the question, I disagree on the actionable consequences of your view.

I particularly like your suggestion, paralleling Michael Pollan’s food movement of the last few years,[1] to do only what your grandparents would recognize as investing.  There’s virtue in simplicity, and you could not go too far wrong that way.  Many of us have an imaginary Amish pastoral scene in mind as a balm on a particularly confusing day.  The horse-drawn buggy approach to financial life could be a good financial life.

I’m not willing to actually go along with the Amish pastoral investing life, however, either in my own life or for people who ask me my opinion on what they should do.

Mutual funds, to pick the most beautiful of the babies you’ve tossed out with the bathwater, are just like some of the other totally awesome things we love to complain about.  If you’ve got money to invest, with a few clicks or a simple phone call, you can own a piece of a wide swath of the world’s most successful companies.  At any point in your lifetime, should you choose, you can get your investment back with a similar amount of effort, with a day’s notice.  Real property investing doesn’t work that way.  CDs don’t work that way.  Private business investing doesn’t work that way.  Our grandparents had to wait for the end of their 6 months (or whatever time) period to get their cash out of CDs, or possibly years to liquidate their real estate or private businesses.

ETFs, the ADHD sufferer’s version of mutual funds, are similarly awesome, if used correctly.  You can even invest in a wider variety of instruments than mutual funds, including currencies, commodities, real estate, in addition to the opportunity to short markets and take on leverage.

As a recovering hedge fund manager, I also obviously maintain a soft spot in my heart for hedge funds as a way to access a still wider variety of investing strategies.  As a former mortgage bond salesman as well, I could similarly wax poetic about a whole universe of investment vehicles with an alphabet soup of acronyms that, like an Elizabethan sonneteer declaring his undying devotion, would make you long to  possess a super-senior CDO linked to a basket of credit default swap positions.  Ah, financial innovation…But I digress.  Where was I?

In sum, I’m actually a fan of financial technology, albeit with one important caveat that I think will link back to your original question, about whether the financial game is incorrigibly rigged for the Big Boys.

Not to be too John Kerry about it, but my answer is No, and Yes.

I infer that what you mean by “rigged” is the idea that insiders cheat in sufficient numbers to leave outsiders at a severe disadvantage when it comes to earning a fair and worthwhile return on capital.

I disagree.  In my fifteen years in the financial industry I saw no evidence of widespread cheating.  On the contrary, I can honestly say I trust “the system” in our country to treat outsiders far more fairly than any other industry I’m aware of.  I would also trust our system in the US better than any other country’s financial system, based on quite a bit of anecdotal and experiential evidence across borders.

Where I would blanket-statement agree on the rigged part for your average outside investor, however, is in costs.  The insiders depend on your ignorance of the cost of their product.

Most investment products designed in the past 50 years are compensation schemes for insiders.

Hedge funds are the most egregious example, of course, as knowledgeable insiders correctly and dismissively refer to hedge funds as ‘compensation schemes masking as investment vehicles.”

Products like retail ETFs, primary designed to encourage high-frequency day-trading, wrap up a casino-like product in an investing package, for the benefit of the house casino.

Even the mutual fund industry typically charges far more than is necessary to accomplish what are really simple tasks with minimal value-added.

Fees to insiders in all of these areas remain stubbornly high and extremely difficult to track down for the average outsider.  In no other area of life do we willingly purchase a product costing many thousands of dollars without asking about the price of the product or attempting to price-shop the product.

I can’t emphasize enough how much of the inside game is devoted to convincing outsiders of the ‘special sauce’ of a particular investment vehicle.  Contrary to what the insiders want you to believe, simple would generally be better and low cost would be best of all.

I linked to this page before, but it bears repeating.  I have no link to this investment advisor, I’ve never met him, and I just found his stuff a month ago.  Do yourself a favor, print out pages 9-12, post them on your bulletin board, and refer to them frequently when considering where and how to invest.



[1] He famously advised people to avoid eating anything your great-great-grandmother wouldn’t recognize as food.  Incidentally, my great-great-grandmother ate a lot of Nutella.  In my own mind.

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Interview: What the %#@! is a Fund of Funds?

Please click above to listen to full interview.

I spoke with an old friend Trevor, a former Director of Research at a Hedge Fund of Funds.  In college, a mutual friend of ours imaged a radio show named “What the Fuck Do you Do?” in which he interviewed people in jobs that nobody else understood the name of, or the function of.  This interview is in that spirit.  He spoke about the business, lucking into one of the best bosses in finance, and then leaving it all.  This interview is also in the spirit of Trevor himself, a recovering banker trying to figure out what’s next for him.

What is a Fund of Funds?

Trevor:  Hi my name is Trevor and I used to be the director of research for a fund of funds.

Michael:   Trevor, thank you for agreeing to be part of Bankers Anonymous. I’m wondering when you said you’re a fund of funds manager, what percentage of people that you ever talk to, who you identify yourself as a fund of funds manager say, “Oh, I know exactly what that is,” or do people have no idea what you’re talking about?

Trevor: People have no idea what I’m talking about.

Michael: What do you usually say?

Trevor:  And it’s usually a stultifying opener when I say – people say what do you do and I say, “I work for a fund of funds, fund of hedge funds.” Three-quarters of the time there’s a blank stare and then one-quarter of the time people actually ask a follow-up question about what it is. But the topic of finance generally sends people running away from the conversation. So I usually lie now when I tell people what I do.

Michael:  What’s your backup answer now, zoo keeper?

Trevor: I raise bees, African honey bees which produce a very spicy variety of honey.

Michael: Awesome. I know what a fund of funds business is more or less, although I’ve not worked at one, but is it easy to describe what that means?

Trevor: It is. It is a collection of funds run by other people managed by the fund of funds operator. Usually I give people the analogy of mutual funds because most people know what mutual funds are. The business model is if I was going to create a fund of mutual funds, so instead of you investing in mutual funds directly and picking ten mutual funds, you could invest in Trevor’s fund of mutual funds and by investing in my one fund you get exposure to however many underlying mutual funds I choose to put in the portfolio.

The fund of hedge funds is the same idea but instead of underlying investments being in mutual funds, the investments are in hedge funds. That’s usually when people freak out because they’re like “Oh my god, hedge funds; now you’ve lost me. Aren’t those all terrible?”

Michael: Are you part of the evil hedge-fund world?

Trevor: Yeah.

Michael: I’m familiar with that, where people hear fund of funds and suddenly there’s a blank stare and everybody’s like “Oh my God look shiny object over there.”

Trevor: And, to interrupt you, then the smart people say, “Oh, so that’s an extra layer of fees, so basically you pay fees to the hedge funds and then I pay fees to you, and then there’s multiple layers of fees. So it’s not really a business, it’s just a set of fees.” That’s what the savvy, cynical, smart people usually observe right away.

Michael: The classic criticism of hedge funds themselves is they’re not really an asset class but a compensation scheme.  As a derivative of a hedge fund you could be a compensation scheme on top of a compensation scheme.

Trevor: Yes.

Michael: But having been in the world, do you think the added expense is worth it?

Trevor: The firm that I worked at launched multiple products going back over the last twenty years and their long-term results easily beat the S&P500 with better performance characteristics, as net of all fees.

Michael:  Performance characteristics: Volatility, Return, what else am I worried about – draw down I guess; how much did you lose in a bad year?

Trevor:  Yup, and then one more which is correlation to the index.  If the index is going one way the fund of funds is not necessarily having the same pattern. So there are fund of funds which have been able to outperform the broad-based market net of all fees over a five, ten, fifteen, twenty-year time frame.

Michael: And your fund did that?

Trevor:   Yes.

Michael:  So post-credit crisis in 2012 is the world different for fund of funds?

Trevor:    I think there will always be a need for fund of funds because institutional investors want access to alternative investments and part of that is access to hedge funds. A lot of those programs don’t have the resources to research hedge funds, and invest in them, and monitor them. So if you’re a 200 million dollar endowment for a secondary school or small university,

Michael:  Basically, tiny.

Trevor:  And you allocate twenty percent to hedge funds, so you have 40 million dollars going into hedge funds. And of that, you have half of that going into long/short equity hedge funds, you can’t hire the staff to adequately research and monitor it. So middle-sized endowments will always have a need for a gatekeeper to help them.

Then a lot of larger institutions often hire funds of funds to create a starter kit and they will put together fund of funds for the larger college endowment, and then the endowment will eventually take it over once they’ve learned the ropes.

And the last category that’s probably never going away is if you’re a high net-worth individual but you’re not super, ultra-rich, you can’t afford to create your own diversified portfolio hedge fund because they generally have a one million dollar to five million dollar minimum, so if you, say, only have ten million dollars to invest and you put twenty percent in hedge funds which is two million dollars, you can invest in two hedge funds, maybe, which as everyone knows you don’t want to take on concentration risk in really any asset class. So the high-net individual but not ultra high-net will always need a fund of funds to create a diversified pool.

Michael:  Is that essentially the customer base of your business, medium-size endowments and high but not ultra high-net worth individuals?

Trevor:  When the firm first launched it was mostly high net-worth individuals, which I think is if you go around to your friends and say, “Hey I’m starting this business, will you invest?” And then over time they generate the track record and credibility, their shift was towards institutional clients. The current composition is ninety-five percent institutional and five percent individuals.

Michael: I’m sorry, ninety-five percent institutional and five percent individuals?

Trevor:  Right, so the shift over time was dramatically towards institutional money meaning pension plans, charities, endowments, foundations as opposed to individual investors.

Michael: I obviously know you quite well and I know you have a mathematical background but can you describe what it’s like to work for a fund of funds? What’s the main skill set that’s useful?

Trevor:  I think everybody approaches selecting managers differently and there are places that run Monte Carlo simulations and all sorts of back testing and modeling and then there’s people on the totally other end of the spectrum who just meet with a manager and think, “I like that guy.”

Michael:  More a feel on what’s a good manager or good investor.

Trevor:  Yeah, and both approaches probably work fine, as long as you do the one that makes sense to you. Our firm fell somewhere in the middle where we did a lot of number crunching and we would look at past track records and look at when managers had losses how did they respond to those losses. Hedge funds generally have access to leverage so when the economic environment deteriorates does the manager double down to take on more risk in hopes of making all this money back quickly; or if they have losses and a bad environment do they reduce exposure and risk and crawl back slowly? Looking at quantitative information to assess how a manager responds to risk and how much risk they take on.

Michael:  So it’s a mix. It doesn’t sound like rocket-science math.

Trevor: No, there’s some standard deviation and draw downs but probably high school level math.

How Do You Get a Job at a Fund of Funds?

Michael:  In 2002 you were not in the financial world.  How does one get a job at a fund of funds shop?

Trevor: I think it’s a strange path. Probably very few people coming out of college have heard of this industry. So I happened to get into it by a sequence of events where my uncle had worked for a guy who ran the company and he hired me to do some software programming. Then I joined running operations and gradually made a transition to the investment side while doing the CFA program. It was a very idiosyncratic route.

Michael:  The work environment was somewhat idiosyncratic also?

Trevor:  Yes, I think I worked for one of the nicest people in finance, certainly shocking and refreshing to find someone who is very principled and fair and entertaining. I remember an early conversation where the boss said, “You know, I’d really like to take Fridays off in the summer, but if I take Fridays off what am I going to do about all the employees? Maybe they can work half a day. Oh fuck it, just everybody gets Friday off.” But that was also tempered with if you made a mistake he would come down very hard on you. It was very high expectations but it was a very fair environment.

One great memory which is that my boss used to come into my office and he would say, “You know, when I had my first consulting job, my boss would come in and he would say, ‘I’m going to give you six months to work on this, and if it turns out well you get full credit. And if it goes badly, you’re fired.'” And I’d think ha-ha that’s great, good story.  He told me this anecdote maybe three or four times over the course of two weeks, and the fourth time it dawned on me; those are the rules. If it goes well, I get full credit, and if it goes poorly, I’m fired.

Walking Away From It All

Michael:  Okay, you’re no longer fulltime with the same fund of funds and as I understand it you’re interested in other things. Why would you do that?

Trevor:   Great question. A friend of mine told me he would come up to New York and shoot me if I lived there for more than five years.

Michael:  So it was fear that drove you away.

Trevor: At year eight I was getting worried that would actually happen.

I love spending time out of doors and I love farmers markets and I love a slightly slower pace of life. It’s very hard to achieve that in New York where your apartment can be very small and dark unless you’re extremely successful. People don’t generally host dinner parties or hang out in their apartments which I think is why I think a lot of the public spaces in New York are so great. Peoples’ existence in their own apartments is not a great hosting venue. But all that being said, I wanted to move out West and have access to the out of doors.

Michael: While maintaining your anonymity for this program, we’ll just say you’re in California, somewhere in California. They’ll have to try to find you. I think I’m hearing you say actually when it came down to money versus friendships you found the friendship part more compelling. This sounds very un-banker-like of you.

Trevor: Certainly I would rather have more money than less money. I did have this idea I would work hard and save up money for a while and then leave and do something else. I’m in the process of executing that transition and certainly some days I wake up and I think what an idiot; if I had stayed and followed the traditional succession plans, I’d be a gazillionaire.

Michael:  But even making the choice to leave and get into a different mode of life, it’s still hard to think: “Wow, but I could have had this money!”

Trevor: I think it’s hard to take a path where you’re relatively senior and successful and basically go into another industry or set of interests where you don’t have any credibility or expertise necessarily, but you think it’s a more satisfying and rewarding way to spend your time. I’ve discussed this with my former boss and he wisely wrote back and said, “Money means nothing if you are unhappy.”

Michael: Wise words.

Trevor: If it’s a calling that’s good for you, and there are certainly plenty of people in finance who genuinely enjoy it.  Then I think it’s a great career track. But money corrupts and it’s an industry that can lead people to stay working in it when they don’t get a whole lot of meaning out of it.

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