Tuesday, April 22, 2008

Incenting execs: they're very good at gaming the system

Harvard's Philip Greenspun does a great job describing how EBITDA and other compensation schemes are readily gamed ....
Philip Greenspun’s Weblog Statins, cholesterol, health; fancy employee compensation, EBITDA, and company value:

... Conspiracy of Fools chronicles one of the discussions about EBITDA among Enron senior managers. One guy pointed out to Rebecca Mark, a Harvard Business School graduate star of the company, that EBITDA was meaningless because one could improve EBITDA simply by borrowing money at 10 percent and investing it in T-Bills at 5 percent and that was essentially what Mark was doing. She was borrowing money at X% to purchase businesses that would return no more than (X-4)% in a best-case scenario. This fattened her paycheck, but led the company towards bankruptcy....

.... if you’re on a Board and you decide to compensate a manager with anything other than cash or a long-term stock option, make sure that you’re not granting compensation based on a number that the manager can easily manipulate. Keep in mind that managers are often a lot more clever in doing things that will benefit themselves than things that will benefit the company.
Senior executives in large corporations may not be particularly honest, honorable, or bright -- but they are always good at playing the game. Greenspun's key observation is that only long term share price is difficult to game for a CEO. All other incentive plans will lead to undesireable choices.

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