CEO Compensation - Using Complex Derivatives

In our FIT class, our group presentation project was to look at CEO compensation (with deliberately vague instructions to give the teams flexibility to take the initiative on how to approach the topic: allowing us to think about our thinking). Our group was one of the teams that presented today (and we got generous feedback from our peers), however, it's another group's presentation I wanted to discuss in more detail.

Nick Kerhoulas' team, composed of Amanda, Nik, Mark and Nick K, mentioned in their presentation the unique idea of compensating a CEO with stock options against a benchmark. I thought this was a brilliant (yet generally overlooked) idea and I wanted to explore it further.

First, you will probably notice a trend (and skeptics and critics in the market have always highlighted this) that when a company has done well, it is touted as because of good management (alpha). However, when the company is doing poorly, it is pitched as being because the market (beta) is in recession.

In using Kerhoulas' idea which he presented in class, I think it would be interesting to see if CEO compensation could be restructured to include more complex derivatives rather than just stock options. Although stock options are a form of derivatives, deriving their value based on the underlying stock (in this case the firm's equity), I think Kerhoulas' idea can be adopted with more complex derivatives. My proposal is to use a sort of net neutral strategy similar to the market leader growth strategy I mentioned at the end of this previous post. The assumption here is that you believe your company should outperform competitors.

How would this work? Well rather than compensate your CEO with either pure equity or call options to buy the equity at a given exercise price, the CEO should be compensated with a mix of these options as well as a short position against an industry index. What does this mean?

The short position against the industry index means that if the industry as a whole succeeds because the market rises (beta), the compensation of the CEO goes down (the firm is succeeding because of the industry). However, if the CEO's decision making allows his/her firm to outperform the industry, then (s)he will be compensated based on the performance in excess of what the market is providing (alpha).

Similarly, if a market is in recession (beta), the short position gains value as the market declines, but if the CEO can manage the company to outperform (or 'do less bad' than the market as a whole), (s)he gets compensation accordingly (based on alpha).

How about poorly performing CEOs? If management ability (alpha) ever underperforms the market (beta), the CEO's compensation will always be negative. Now rather than qualitatively make statements against the causes of your firm's performance, you can use the market index as a benchmark to have a context in which to describe management (CEO) performance as suggested by Nick.

I think another interesting result is what happens if this compensation structure is adopted in a system (say, the industry at large) versus in isolation (at one company). I intuitively believe that the game theory grid that would represent this scenario describing a system would resemble the prisoner's dilemma, in that as CEO's are incented to "outperform" the market becomes more competitive and the market index rises (which reduces overall compensation within the system due to all the short positions) because each of its individual components rise. It could even potentially be framed as a zero-sum game (as shown below) if the CEOs are forced to trade stocks with each other to create the required short positions in the market index.

This actually even acts as a natural cap for CEO compensation, but still motivates CEO's to fight over the same pool of compensation. The maximum compensation available will be determined by the increase in the short position of the market (how the market moves as a whole), but CEO's can essentially earn more compensation against their competitors.

Example:
Assume 3 CEO's managing equal companies. Each company's stock is valued at $100.
Market index is composed of one of each stock and the compensation derivative is described as:

• Long three shares of the company's stock
• Short one unit of the market index

Assuming that companies 2 and 3 have stable performance (no change in stock price), but company 1's performs and stock price goes up by $10.

Total compensation would be:

• Long three shares: Increase in value $30
• Short Market: Decrease in value $10
• Total compensation change:+ $20

Now try a new (industry wide / systems based) scenario:

Firm 1's stock: +$50

Firm 2's stock: +$20

Firm 3's stock: -$10

Market index: +$60

CEO 1's compensation: 3*(+$50) - (+$60) = +$90

CEO 2's compensation: 3*(+$20) - (+$60) = $0

CEO 3's compensation: 3*(-$10) - (+$60) = -$30

Note that the sum of the CEO's compensation is $60 (CEO compensation 1 + 2 + 3 which is the Market index). This is because the market index compensates 3 CEO's with 3 shares of each company, and the CEO's each hold three shares of their own company. It's as if each CEO shorts competitors' stocks to the other CEOs respectively. In this way, there is a natural cap on the CEO compensation (which is directly reflected to the value they bring to the market) yet, CEO's are still incented to overperform because they can capture the bonuses of their competitors if they outperform them.

Would this work in practice? Well the only people who would actually adopt this form of compensation are the executives who actually believe they can outperform the market. Once this gains legitimacy as a compensation structure by those who want their performance bonuses to have high credibility, it provides companies with a quantitative answer (and a nearly indisputable answer) to the question: Is your company performing well because of you or the market you are in?