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Jeff Ubben: How to Revive Animal Spirits in CEOs


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From 2012. Via Planmaestro.


Corporate America is stuck in a rut, and it is holding back economic growth. Despite record-low financing costs, capital-expenditure plans at large firms are down, R&D is being cut, and mergers and acquisitions are at a virtual standstill. This corporate age of austerity is a failure of governance—not just in Washington but in public company boardrooms.


In the name of risk management, corporate boards have lost the "owner" mentality they need in designing management compensation. Too many CEOs are now better off being caretakers instead of value creators. Surprisingly, the solution may entail more compensation for CEOs, not less—but only if CEOs create long-term, sustainable value for shareholders. There is a "better mousetrap" for long-term incentives that is simple and can help bring back growth. [...]


There is a simple solution: Boards can reorient management to maximize value for stockholders by paying CEOs a percentage of the equity value they create above a minimum rate of shareholder return, or "hurdle." Traditional stock options, it is said, both encourage risky behavior and reward CEOs for stock-price increases even if caused by temporary market volatility rather than long-term value creation. But if hurdles are set high enough and required holding periods are long enough, CEOs won't be rewarded for temporary stock-price increases. They will "own" the long-term outcome of risky investments.


This simple concept—sharing the gains with managers once the gains exceed a hurdle rate of return—exists in many private companies. It is the "better mousetrap" of compensation design.


[...] In 2009, this newspaper published an article praising a public company's CEO-compensation plan that incorporated the "better mousetrap" model ("Valeant CEO's Pay Package Draws Praise as a Model," Aug. 24). One of our firm's partners, Mason Morfit, chaired the compensation committee that designed CEO Michael Pearson's incentive plan when he joined Valeant in February 2008.


Since then, Valeant has taken advantage of low interest rates to invest over $8 billion in M&A, R&D and capital spending. The company has introduced an innovative and efficient operating model in the pharmaceutical industry while driving sales growth (excluding the impact of acquisitions) to 9%, or more than double the growth rate of global GDP.


Credit some of Valeant's success to the design of the CEO's compensation. During Mr. Pearson's tenure, shareholder value has increased tenfold, the annualized return to shareholders has been 60%, and Valeant's market value has grown to $17 billion.


For their gains, stockholders have rewarded Mr. Pearson with more than 3% of the value created—but, crucially, had he not achieved his hurdle rate, he would have shared the pain of stockholders and earned far less than his peers.

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