Why trade investors collude with managers to vote for star-like compensation

The star-like compensation of CEOs and other senior managers is undermining the trust of people in the fairness of capitalism. The spiraling of shocking compensation packages continues because the market system does not have built-in self-interest incentives that prevent collusive behavior between trade investors and managers. The problem is more acute in listed companies with high levels of float and with significant shareholdings by trade investors that do not compete to supply or finance the company.

A simple numeric example is enough to illustrate the problem. Consider the case of an investor who is contemplating investing in two almost identical companies—Companies A and B—trading at the same multiple of earnings, with the same expected risk and a rate of return on equity of 20%. Company B is a potential major supplier or financier of A, but is not currently trading with Company A. Both companies have the same asset turnover and leverage. After paying the current market rate of 1% of profits as management compensation, they each generate a net profit of 10%.

Prudence dictates that the investor should diversify by investing in both companies. However, given that A and B have the same expected return and risk, regardless of how the investor chooses to split his investment (whether 50/50, 10/90, or any other way), his expected return will be always 20%.

Imagine now that the CEO of Company A only needs 10% to control the board of directors and approve a pay raise that triples his compensation to 3% of profits. Management approaches the trade investor and asks him to invest 10% in company A and vote for the proposed pay rise in exchange for A giving B 10% in new business, provided that B matches the price of the suppliers replaced.

As long as the investor is able to lead a majority of shareholders in Company B, they will keep the Company B managers’ pay at 1%, so that his total return from both companies will now increase by 8.81% to an average return of 21.76%. Since there is no new value creation, the gains obtained by management and the new insider investor are made partly at the expense of the remaining shareholders in Company A, but mostly at the expense of the replaced vendor. The reduction in return incurred by the shareholders in A would be just 0.39 percentage points (i.e. 1.94%). This small loss could be either concealed or compensated if the other 40% of insiders supporting management protest.

It remains to be shown if there are any self-interest market mechanisms to prevent this predatory behavior. There are three candidates to oppose the insider investor’s actions in the above example: the managers of company B, the suppliers displaced, and the other investors in Company A—but none will be able to prevent such behavior. Here’s why:

The managers of B could try to get a similar pay raise by threatening to leave and bid for the job of A’s managers. If they were to get a similar raise, this would offset a large share of the investor’s gain. However, as a controlling shareholder, the investor can easily collude with A’s managers and other insider shareholders to stop such a bid. Thus, the managers of Company B can only threaten to shirk on their increased workload and ask for a modest raise. For instance, if they manage to get a 20% raise, this would only reduce the trade investor’s return to 21.72%.

The suppliers replaced may or may not be among the current group of insider shareholders. In the first case, they would try to fight the managers, but unless they can attract other shareholders to their cause, the only way they can retaliate is to sell their position to hurt the stock price. However, this would mean the supplier’s adding a self-inflicted capital loss on top of his business loss as a supplier, while simultaneously lowering the entry price for the new rival investor.

Next, imagine that the non-insider investors of Company A wished to retaliate against the managers’ pay raise by selling their stock. This would result in a self-inflicted loss for the late sellers. This loss could only be prevented if the insiders stepped in to buy the shares, or if management acted to offset a possible decline in the stock’s price by promising to pay an increased dividend or by introducing a share buy-back program. Forced to choose between certain loss and a promise, they will be more inclined to bet on the manager’s ability to avoid a decline in the stock price.

Finally, if the replaced suppliers were not yet shareholders, they might try to keep the business by outbidding the investor and invest the same amount while supporting A’s management in a bid to get an even higher pay raise. However, they could not outbid the rival investor. The pay incentive would only work if they could compensate the other insider investors, and their investment in A would have a lower return than that of the new investor since they would not gain from increased sales to their business.

The numeric example given above can be replaced by a model to work out the optimal investment allocation between A and B, including the more common situation where Companies A and B are different, but it is easy to see that the optimal outcome will also depend on the possibilities to switch suppliers and the greed of Company A’s management. It is nevertheless unquestionable that there is a large incentive for collusion between management and trade investors against other investors in A and its current suppliers.

Are the costs of this market failure large enough to damage the working of market capitalism? If so, then the question now is to assess if it is possible to correct this inefficiency through regulation.

The simplest way to regulate is to impose limits on the ownership of major suppliers, to limit their rights, or a combination of both. The first could be easily defined, but it can be easily evaded. In particular, in the case of shareholdings by suppliers of financial services, such limits could be easily circumvented by investing through investment funds managed by those financial institutions.

Limiting the voting rights of trade investors who are major suppliers of Company A is probably the best solution. It does not disrupt arms’-length trading relations, and it is more easily enforced. The only debatable issues would be about the qualification of trade investors and the voting restrictions. These should cover voting for the election of management and their remuneration, but they could also extend to voting in the Governance and Auditing Committees.

Regulation always has its own costs, which should not be disregarded lightly in a full assessment of this proposition. In particular, the possibility of discouraging trade investing may have its costs in terms of business intelligence and synergies. However, overall, limiting the voting rights of trade investors would be a market-perfecting policy that would contribute to achieving the ideal of true market capitalism.