SNS Research Brief 5. Remuneration to managing directors – when the owner can make her own choice

REMUNERATION TO MANAGING DIRECTORS is a question that has been subject to much debate, even in the area of research. Are contracts for managing directors the result of a value maximising market solution where the conditions are constructed to create a community of mutual interests between owners and the management? Or do managing directors use their position of power against weak owners to appropriate higher remunerations and benefits than what is optimal from the point of view of owners? This issue of SNS Analys studies how the remuneration contracts for managing directors are designed by strong, professional owners.

HOW STRONG OWNERS ACT We analyse about twenty transactions where leading US risk capital funds have acquired large listed companies which have previously had dispersed ownership, i.e. which have not had any clear principal owner. The study shows the following changes in the remuneration for managing directors after the ownership change:
• The fixed salary increases by about 25 per cent.
• The objectives for flexible remuneration are changed from soft variables (such as colleague satisfaction) to quantitative variables.
• The quantitative goals are changed from profit per share to cash flow.
• The sum for the investment in shares by the managing director is lower, but it corresponds to a larger part of the shares.
• Performance requirements are introduced in share-related remunerations.
• The contracts are rewritten so that the shares and options of the managing director do, in practice, become without any value if the managing director is dismissed.

MONEY TALKS
According to the theory on optimal contracts, contracts must be designed so as to deter managing directors who do not want to make an effort. When risk capitalists set up too high performance requirements, this might, in itself, create a positive selection of candidates since only managing directors who are prepared to work hard will accept the conditions.

AUTHOR
Henrik Cronqvist is Associate Professor of Finance at Claremont McKenna College, Robert Day School of Economics and Finance in the US. E mail: hcronqvist@cmc.edu.
Rüdiger Fahlenbrach is Associate Professor of Finance at École Polytechnique Fédérale de Lausanne (EPFL) in Switzerland. E-mail: ruediger.fahlenbrach@epfl.ch.