Undercover Economist

To profit, plump for an also-ran at the helm

Team titles might be what matter to them most, but football fans are also generally pleased if a player in their team wins an award. Publishers rarely object when their authors win Booker or Nobel prizes for literature. So how should shareholders in a company feel when the company’s chief executive wins an accolade such as “Best Manager” from Business Week or “Best Performing CEO” from Forbes? New research from two California-based economists suggests that the correct response would be to feel sick.

Economists have long been intrigued by the prospect that chief executives might use their position to pursue wealth, status and perks to the detriment of shareholders. Shareholders, widely dispersed and sometimes protected by flimsy governance, often have little sway over what managers get up to.

This view has unsavoury implications, such as the idea that corporate social responsibility and philanthropy might in fact mean shareholders paying for their chief executive’s golden halo. It has also been prescient: it was in studying economics that I first discovered that managers might be willing to overpay for merger targets because mergers brought them wealth and status, or that they would arrange to receive some of their pay in the form of a large pension because deferred compensation often only causes outrage once it is too late to do anything about it. If only Sir Fred Goodwin’s board at Royal Bank of Scotland had encountered the same lessons.

Ulrike Malmendier of UC Berkeley and Geoffrey Tate of UCLA wondered if awards for chief executives might shift the balance of power further towards the chief executive. That seems likely: it turns out that award-winning chief executives are paid more and deliver less following their award.

Top performers will tend to have been lucky in the past, and luck rarely lasts. If an award from Forbes celebrates a man who has made a few lucky calls, small wonder if he goes on to disappoint. Yet Malmendier and Tate try to adjust for this statistical tendency by identifying a selection of “nearly men” (and occasionally women) who might have been expected to win an award, but didn’t. The nearly-winners, like the winners, tend to run big companies with strong recent shareholder returns. Like the winners, too, they have probably been lucky. Yet in the three years following an award, the share prices of the companies run by winners lag behind the prices of those run by nearly-winners by between 15 and 26 per cent. Nor is their performance reflected in pay: winners enjoy an extra $8m a year compared with nearly-winners.

Winners also seem to enjoy various distracting perks. Although the statistical analysis is less sophisticated here, Malmendier and Tate believe that award-winners are more likely to write books – often self-aggrandising books, let us be honest – and more likely to accept seats on the boards of other companies. The icing on the cake: award-winning chief executives have superior golf handicaps.

In short, awards for chief executives should be about as welcome as the “curse of the pharaoh”. Before the shareholders of the world march on the offices of Business Week, pitchforks in hand, they might bear in mind one final discovery. Malmendier and Tate check their results against an index of bad governance that tots up tricks, such as poisoned pills, designed to protect firms from hostile takeovers. Almost all of the perverse effects of awards to chief executives – including their tendency to spend more time on the golf course – shrink or even disappear in companies which have strong governance. Even superstar chief executives can be kept on a leash, it seems.

Also published at ft.com.