Thursday, 27 November 2008

Why aren't there more films like this [sigh...]?

Ever wondered why there are so few films you really like? It has to do with an old choice in strategy: do you focus on a narrow, specific audience and really satisfy their needs or do you try to appeal to a broader audience, having a larger base of customers but risking to not really satisfy anyone? It appears that – perhaps a bit unfortunately – in the film industry, it often pays to do the latter.

Professor Greta Hsu, from the University of California Davis, examined 949 movies in the US film industry and showed that films that fit more clearly into one specific genre (action, romance, comedy, drama, horror, etc.) generally are appreciated more by the audience. However, films that span various genres attract a larger audience, and that pays off at the box office.

Of course it’s a trade-off – do you go for a broad or a specific set of customers? – and one that most firms in most industries face. It depends very much on the characteristics of the industry where the balance lies; towards specialisation or towards being a generalist.

The fact that in the film industry many firms & films come out as quite general can partly be blamed on the role of marketing. You only really know what a film brings you once you’ve gone to see it (and paid for it). Smart marketers can make multi-genre films appeal to a variety of people, without them realising beforehand that it is going to be a bit of a mish-mash.

For example, the film Cocktail was marketed in four different ways by Touchstone Pictures, including different television commercials, each pertaining to a different genre. Similarly, Miramax produced two different ad campaigns to promote their film The English Patient, one emphasizing the film’s action and war components, and the other one emphasizing the romantic elements of the movie. It turned the film into a product that was purchased by a mass audience.

Altman, in his book Film/Genre, describes this Hollywood strategy as “tell [audiences] nothing about the film, but make sure that everyone can imagine something that will bring them to the theatre”.

Thus, although on average multi-genre films are less appreciated by customers than genre-specific films, it is the former that usually bring in the big audiences, and with it the big bucks. As a consequence, genre-specific films are much more of a rarity, although we love them. Once we see one, we may sigh “why aren’t there more films like this…?” but we really only have ourselves to blame: it is because we do let ourselves be tricked into seeing all this other (multi-genre) crap that it becomes relatively unattractive for film makers to make anything specific.

Tuesday, 25 November 2008

Advice or influence? Why firms ask government officials as directors

Let’s face it; outside directors are just a very strange phenomenon in our global economy. They form a business elite that operates as a self-governing clique. Moreover, these people are amateurs. Literally. The supervision of the management of a globally diversified company is just something they do on the side – a couple of days per year or so. Often they are CEOs of other companies – so that might help a bit (or harm a bit…) – but typically they have about half a dozen of these gigs. So, they can’t let any single one of them distract them too much.

It is a bit like we manage our own personal finances – paying bills and filing bank statements etc. In the evening, after a hard day’s work, while watching the X-factor, we quickly glance over the financials and put our signature on the most necessary evils before making a cup of coffee and turning our attention to the newspaper. Bills, bank statements, the accounts of a multinational; what’s the difference really?

But not all outside directors are (ex) CEOs. Quite often, companies also invite ex government officials to serve on their boards. The reasons for that, as research has indicated, are not too hard to fathom: They can provide advice, but they can also provide influence. I guess there’s nothing wrong with buying advice, but the idea of buying influence may be a bit more morally challenged…

Government officials can provide specific advice on how to deal with government-related issues. They have specific knowledge and experiences and can therefore provide valuable advice. But ex officials can also offer contacts for communication which are not accessible to other companies. Then, directorships start to become the currency used to buy influence, which makes it a bit more dubious. It certainly gets dubious if they provide for a direct way to influence political decisions. Some people have even suggested that board memberships for ex government officials are rewards for “services” rendered while they were in government… which would certainly be in the “barely legal” category.

It’s hard to examine which of the aforementioned reasons motivate firms to invite ex government officials onto their board. However, by analysing exactly which individuals get offered the job, we can get a bit of a sense of what’s going on. Professor Richard Lester from Texas A&M University and some his colleagues analysed this question – which government officials are most likely to be approached to serve on a board? – using data from the United States. They tracked all senators, congressmen and presidential cabinet ministers who left office between 1988 and 2003 and figured out which of them got offered directorships.

They found that the longer officials had served in government, the more likely they were to be approached for a directorship. I guess that could be because more experience gives them more influence but also because experience made them better advisors. Presidential cabinet ministers were more likely to receive board invites than senators, who were more likely to be approached than congressmen. I think this starts to lean towards an “influence” explanation for board invites rather than an “advice” one, but I guess one could still argue that cabinet ministers are simply the better advisors.

However, another clear finding was that these people would either get asked for a board very shortly after leaving their government position or not at all. Senators and former cabinet officers would usually be snapped up in the first year after leaving office. This could hardly be because after a year they all of a sudden would make for lousy advisors; it’s much more consistent with the fact that their ability to influence government decisions quickly deteriorates after leaving office. And it seems consistent with the idea that they get offered the job in return for services already delivered…

Finally, Richard and colleagues examined what happened in the case of a government change; that is, if the party in power (in the House, the Senate, or the White House) shifted from Democrat to Republican or vice versa. The effect of this was clear; the ex government official, associated with the party no longer in power, would lose much of his attraction as a potential board member. Because if the wrong party comes to power, you just lost much of your power to influence and with it your value as a potential board member. Clearly this points at an “influence” argument; companies ask ex government officials on their boards to bend political decisions in their favour. And I'm afraid this puts these officials firmly in the barely legal category.

Thursday, 20 November 2008

How to tame an analyst

Let’s face it; analysts are just a very strange phenomenon in our global economy. These people advise us to buy, sell or hold particular companies’ stock but we also all know that the banks that employ them make money if we buy. More importantly, we know that these very same companies that they advise us on are the banks’ customers (e.g. for their M&A deals), which makes it a rather hefty conflict of interest (especially when the real advice should be “sell, now!”). Moreover, on what information do these analysts base their recommendations? 1) The same o-so-reliable numbers as the rest of us have too, and 2) talking to the company’s sweet-talking CEO. Ooo… that’s comforting…

That is of course a nice, glamorous perk for the average analyst; being invited to personal audiences with a real-life CEO. Mind you though, if you subsequently don’t write nicely about their company, they won’t invite you back! That’ll teach you!

Or do you think I am exaggerating now, and really starting to create a gimmicky parody of what really is a very serious financial business? Well, let me tell you a story. And it is a story about facts.

Professor Jim Westphal from the University of Michigan and Michael Clement from the University of Texas Austin examined exactly this issue: the relationship between CEOs and analysts. They surveyed a total of 4595 American analysts and examined the strategies and performance of the companies they made recommendations on.

In the surveys, they asked the analysts to what extent they had been given the privilege of personal access to certain top executives, in the form of private meetings, returned phone calls or conference calls, and so on. And how often this form of individual access was denied. They also asked them about personal favours that these CEOs might have done for them, such as putting them in contact with the manager of another company, recommending them for a position or giving advice on personal or career matters. Then Jim and Mike ran some numbers.

First of all, their statistical models showed that the CEOs of companies that had to announce relatively low corporate earnings started to significantly increase the number of favours they handed out to analysts, by granting them personal meetings, jovially returning their phone calls and making some much-appreciated introductions. Similarly, CEOs of companies that were about to engage in diversifying acquisitions – a rather controversial if not dubious strategy that the stock market invariably hates – engaged in much the same thing. Clearly, these CEOs were trying to sweet-talk the analysts and mellow the mood ahead of some rather disappointing announcements they were about to make. The question is: did it work…?

What do you think? Is the pope catholic? Is Steve Jobs whizzier than MacGyver? Did Neutron Jack eat all his meat?! Is Bill Clinton heterosexual…?!?! Sorry, let me not get carried away in analogy here, the answer is yes.

Of course it’s yes. It works. Analysts who received more personal favours from a CEO would rate a company’s stock more positively when he announced disappointing results or engaged in questionable strategies. And if they didn’t? Yep, you guessed it: those analysts who in spite of the favours had the indignity of downgrading the company’s stock all of a sudden ceased to see their phone calls returned, would be denied any further personal meetings and sure as hell were not given the phone number of the CEO’s golfing buddies. And the only remaining advice they ever received was to get a life and bend their bodies in ways that would enable self-fertilisation.

And this worked too. Not the self-fertilisation but the social punishment of the degrading analyst; other analysts aware of their colleagues' loss of status would be significantly influenced by their plight when making their own recommendations: they made sure not to follow them into the social abyss and were unlikely to downgrade the firm of such a CEO.

Thus, sweet-talking works. But mostly if followed by a good dose of old-fashioned bullying.

Sunday, 16 November 2008

What really caused the 2008 banking crisis?

When you compare the 2008 banking crisis with the Enron debacle, with Ahold’s demise or even with the Union Carbide disaster in Bhopal in 1984 some surprisingly clear parallels emerge. Various explanations have been offered for each of these crises, ranging from top management greed, failing watchdogs to insufficient government regulation and inappropriate accounting and governance structures. Yet, there is one common cause underlying all these symptoms and triggers, and that is the structural failure of management.

One central element in each of these disasters, including the banking crisis, is caused by the division of labour and specialisation within and across organisations. In the case of investment banks, financial engineers drew up increasingly complex financial instruments that, among others, incorporated assets based on the American housing market. Yet, the financial engineers didn’t quite understand the situation in the housing market, the people in divisions and banks participating in the instruments didn’t quite understand the financial constructions or the American housing market, and when it all added up to the level of departments, groups, divisions and whole corporations, top managers certainly had no clue what they were exposed to and in what degree.

Similarly, in Enron, managers did not quite understand what its energy traders were up to, Ahold’s executives had long lost track of the dealings of its various subsidiaries scattered all over the world, and also Union Carbide’s administrators had little knowledge of the workings of the chemical plant in faraway Bhopal. The complexity of the organisation, both within and across participating corporations, had outgrown any individual’s comprehension and surpassed the capacity of any of the traditional control systems in place.

Another crucial role was played by the myopia of success. Initially, the approach used by the companies involved was limited and careful, while there were often countervailing voices that expressed doubts and hesitation when gradually less care was taken – there certainly is evidence of all of this in the case of Enron, Ahold and also Union Carbide. However, when things started to work and bring in financial returns, as in the case of the banks, the usage of the instruments increased, sometimes dramatically, and they became bolder and more far-reaching. Iconoclasts and countervailing voices were dismissed or ceased to be raised at all. For example, in Ahold and Enron, the financial success of the firms’ approaches suppressed all hesitation towards their business strategies.

This caused a third element to emerge: it actually became improper not to follow the approach that brought so much success to many. In the case of investment banks, other banks and financial institutions that did not participate to the same extent as others, received criticism for being “too conservative” and “old-fashioned”. Investors, analysts and other stakeholders joined in the criticism, and watchdogs and other regulatory institutions came under increasing pressure to get out of the way and not hamper innovation and progress.

Similarly, Enron was hailed as an example of the modern way of doing business, while analysts (whose investment banks were greatly profiteering from Enron’s success) recommended “buy” till days before its fall. Similarly, Ahold’s CEO Cees van der Hoeven continued to receive awards when the company had already started its freefall. All of these organisations’ courses of action had been further spurned and turned into an irreversible trend by the various parties and stakeholders in its business environment.

This relates to a fourth management factor that contributes to the formation of a crisis. It’s the factor that is related to what was on everyone’s lips in the immediate aftermath of each of the aforementioned crises: greed. Somehow, all organisations and individuals involved seemed to have let short-term financial gain prevail over common sense and good stewardship. But in all these cases, greed was not restricted to the few top managers who ended up in jail or covered in tar and feathers. Ahold’s shareholders initially profited as much as its executives. Investors, politicians and even customers shared in equal measures the early windfalls of Enron; likewise for the investments banks. Even the Church of England made big bucks on the financial practices they so heavily criticized in the days following the collapse of the system.

The greed factor, however, does not stand alone; it is built into the structure of the whole corporate system. Traders are incentivised to concentrate on making money; top managers are supposed to cater to the financial needs of shareholders above anything else – opening themselves up to severe criticism if they don’t – and customers are expected to choose the best deal in town without having to worry where and how the gains were created. However, none of these parties actually see what lies behind the financial benefits, and where they come from. The traders just see the numbers, the investors only see their dividends and earnings per share and the Church of England simply chose the best deal while the archbishops were unaware it amounted to short-selling. The high degree of specialisation and division of labour both within and between the financial institutions may have revealed the result of the process but showed no sign of how these profits were actually produced.

In combination, all these elements create a system that escalates risky short term strategies until it culminates into an irreversible course of action. Consequently, it becomes unseemly to do anything else. As in a pyramid investment scheme, everybody is interlocked and benefits until the whole structure collapses, sometimes with devastating consequences. The 2008 banking crisis is only unique in the sense that it did not concern one organization but a whole global sector of interlocked firms, due to the high degree of similarity between the various corporations and their business strategies and the unprecedented extent of the financial linkages between them.

All these things point to one underlying cause: the structural failure of management. The management systems used to govern these organisations were unable to control the inevitable process towards destruction. Whether analysing Enron, Ahold, Union Carbide in 1984 or banks in 2008, the striking commonality is the sheer inevitability of the disaster; each of them were accidents waiting to happen, given the state of the organisation.

More rules and regulations and more quantitative and financial controls are unlikely to solve the problem, and prevent similar events from happening in the future. All organisations and people involved in these cases, ranging from top managers to traders and customers, were governed and incentivised by means of quantitative and financial controls. However, today’s businesses are too complex to be controlled by rules and financial systems alone.

Instead, organisations will need to tap into the fundamental human inclination to belong to a community (such as an organisation), including people’s desire to do things for the benefit of that community rather than focus on their individual, narrow interests. These are alien concepts in the City today, where incentives are geared towards optimising individual, short-term performance while company loyalty and a sense of community are all but destroyed by the financial incentives and culture in place. Yet, when such human desires to contribute to a community are artificially suppressed through narrow financial incentivation schemes, weird things can happen – and the 2008 banking crisis certainly was one weird thing.

Tuesday, 11 November 2008

Too hot to handle: Explaining excessive top management remuneration

In many countries the topic of “excessive top management compensation” – especially for CEOs – triggers much emotion, social outcry and even calls to arms for politicians to finally regulate the issue and introduce mandatory caps on salaries. And I used to think that this was all nonsense, because the arguably high salaries of CEOs were simply the result of a market mechanism and “the way it is” (and certainly none of politicians’ business). However, the more I learn about academic research on CEO compensation and the workings of boards of directors (who usually determine a CEO’s remuneration package) the more I realise there is more going on than that.

First of all, there has been quite a bit of research that has tried to show that CEO compensation is tied to firm performance. It ain’t. That research has tried, has tried hard and harder, but just could not deliver much evidence that CEO remuneration is determined by firm performance. Admittedly, some studies have uncovered some minor positive relations between pay and performance but it wasn’t much.

The only economic factor that has delivered some consistent results worth mentioning – indicating a positive influence on CEO pay – is firm size: bigger firms pay better. Although this may be an intuitive result, it is actually not that clear why... Why do the CEOs of big firms earn more? Do CEOs of big firms put in more hours? Not that I know. Is managing a firm with 100,000 employees that much harder and more demanding than managing a firm with a tenth of that number on their payroll? Not necessarily. So what is it? I guess one could argue that a top manager of a large firm can do more damage if he messes it up and, since large firms generally have more resources available than smaller firms, they hire (and pay) the best. Yeah... I guess that could be it... Although research has also shown that, on average, large firms are not really more profitable than small ones, so I am not sure these better paid guys actually are better at their jobs. But anyway, we have found one thing that seems to explain top executive pay, so let’s not be too critical about it but accept it with grace.

But, beyond plain size, what then does determine CEO remuneration? Well, let’s start with who determines CEO compensation. In most counties, for public firms, that’ll be the board of directors. And, specifically, the directors that serve on the firm’s remuneration committee (usually 3-5 outside directors). And, yes, there has been some research on these bozos.

Three professors who did research on the relation between CEO compensation and boards of directors were Charles O’Reilly and Graef Crystal from the University of California in Berkeley and Brian Main from the University of St. Andrews. They studied 105 large American companies and first computed the relation between a bunch of economic factors (such as firm performance and firm size) and CEO remuneration. The only thing they found was a connection between company sales and CEO pay. In short, on average, if a firm’s sales increased by $100 million during the CEO’s tenure, his salary would go up by $18,000. That’s hardly impressive, now is it...?

Then, Charles, Graef and Brian did something a bit more interesting. You have to realise that the directors on these committees are usually CEOs or ex-CEOs themselves. Therefore, Charles and his colleagues compared the salaries of these director CEOs to the salaries of the CEOs of the companies for which they served on the remuneration committee. There was a strong relationship between them. An increment in the average salary of such an outside director with, say, $100,000 was associated with a jump in salary of $51,000 for the CEO, after statistically correcting for all the results due to the effects of firm size, profitability, etc.!

Charles, Graef and Brian argued that this association could only be the result of some sort of psychological social comparison process. The directors on the remuneration committee who decide on the CEO’s salary simply determine this guy’s pay by looking at what they themselves make at their companies. And thus, doing this, they don’t feel hindered at all by irrelevant issues such as the firm’s actual performance during the tenure of the CEO or any other silly things like it!

And guess what, who do you think determines who gets asked to serve as an outside director for a firm...? Any guesses...? Yep, it’s usually a company’s CEO who generally nominates new outside directors. That does make it rather tempting for a CEO to be rather selective about which peers you nominate to serve as director and determine your compensation packages, doesn’t it...? Since, according to Charles, Graef and Brian’s research, their wealth may nicely domino into your bank account. The last people you want on your board are those guys who are on a meagre package themselves; because they would likely curb your dosh as well. Instead, bring in the rich guys; they’ll make you rich too!

Friday, 7 November 2008

Deciding stuff – that’s the easy bit

Some time ago, my colleague at the London Business School, Phanish Puranam, and I ran a short survey with 111 top managers; all alumni from our School’s senior executive programme. We gave them a list of 35 strategic management topics asking them to rate each of them on a 7-point scale, ranging from unimportant to very important for corporate leaders in today's business environment.

The three things that these senior executives said were the most important issues in their view and experience were:
1. Attract and retain talent
2. Decide on the company’s next avenues of growth
3. Align the organisation towards one common goal

Some further (statistical) analysis showed us that the number one – “attract and retain talent” – pertained to things such as putting together an effective top management team, and managing top management succession. Many business leaders see as their main task to recruit and develop other leaders, and it seems our senior executives were no exception.

The second one – “decide on the company’s next avenues of growth” – reminded me of a survey one of the global consulting firms used to run (I believe it was the then Anderson people). They ran an annual survey asking CEOs “what keeps you awake at night?” It was one of these PR endeavours aimed at getting some free publicity in the business press, bolstering their image as a source of management knowledge & wisdom. However, this survey was not a great success, and they seized to run it, simply because every year the same thing came out on top (which made it rather boring and hardly ideal to get the business press excited…) and that was: “The firm’s next avenue of growth”. Our survey confirmed this result.

The third one – “aligning the organisation towards one common goal” – pertained to this thing that tends to make non-senior executives (including business school professors) smirk: creating a mission and vision statement. These vision things inevitably seem to lead to some generic yet draconian expressions (e.g. “to be the pre-eminent” something) that could only be generated by a de-generated consultant brain. Moreover, inevitably they appear to be highly similar to the terminology on the wall of the firm next door. Nevertheless, our senior executives do seem to take them quite seriously. I guess they’re typical of top managers’ efforts and struggle to “align the organisation towards one common goal”; in their desperation they even turn to hammering a mission or vision statement on the canteen’s wall. Guess it really is a struggle.

What struck me about all these three topics, however, is that none of them are decisions. It seems – also from analysing the remainder of our survey – that top managers are quite unfazed by strategic decisions, no matter how big and far-reaching they are. But things they can’t “decree” – like having an effective team, organic growth, or a common vision – is what keeps them awake.

Indeed, you can’t just declare “I decide that next year our organic growth will be 30 percent”. Instead, you will have to build and nurture an organisation which fosters innovation and motivates people and other stakeholders to achieve autonomous growth. You can’t just decide to have it, like you decide to pursue a particular acquisition, enter a new foreign market, or diversify into a new line of business. Similarly, you can’t just decide to attract and retain talent, or decide that “from now on everybody will believe in the same vision and aspiration”. It simply doesn’t work that way. And apparently top managers are a lot more comfortable with stuff they can decide than with things that are not under their direct control; things they need to foster and carefully build up over a longer period of time. And I don’t blame them: that stuff seems easier said than done.

Tuesday, 4 November 2008

How to justify paying top managers too much

The level of top managers’ compensation is often a contentious topic of much spirited debate. Basically, most people think these buggers get paid too much. The buggers claim it’s simply the result of the market mechanism; supply and demand: Good buggers are scarce and therefore they earn hefty salaries (like movie stars, football players and other half-gods-to-be-worshipped).

Although there is of course a bit of a market at work, it has to be said that the people who determine the pay of a company’s CEO – the board of directors – do face a conflict of interest of sorts. Board memberships are nice jobs to have, in the sense that they are usually rather lucrative gigs and provide a pleasant dosage of power and prestige for those who get them. And – and this is where the conflict of interest arises – it’s mostly the company’s top managers who nominate new board members. In the spirit of “don’t bite the hand that just fed you”, board members may be inclined to nominate their benefactors (i.e. the CEO) handsomely by returning the favour in the form of a nice compensation package.

Moreover, as research has shown, those directors who deviate from this social norm (and for instance vote for a relatively low CEO compensation package) will be frowned upon by the rest of the business elite, spat at and given the cold shoulder until they “come to their senses” and don’t display such ridiculous behaviour any longer.

For this reason, in various countries, boards of directors now have to justify the compensation packages that they give to their CEOs by explicitly comparing the firm and its performance to a “peer group”. The idea is that, due to this forced comparison, it becomes more difficult for boards to step out of line.

The tricky thing is, of course, how do you determine who the company’s peer group is…?

It seems most logical to simply pick a group of firms in the company’s main industry, right? Right… but even firms in one and the same industry are usually not entirely comparable; you have many different types of banks, pharmaceutical companies can be vastly dissimilar, software companies are hardly all alike, and one retailer is not identical to the next one. Therefore, boards have a bit of flexibility regarding who to include in their firm’s “peer group”. And that’s of course a rather inviting opportunity for a bit of old-fashioned manipulation…

Professors Joe Porac, Jim Wade and Tim Pollock analysed the composition of the peer groups chosen by the boards of 280 large American companies. For each peer group, they examined how many firms were in there that were not from the company’s primary industry – thinking that then there just might be something fishy going on. Subsequently, they looked at the financial performance of the peer groups, of the companies in the sample, the performance of each company’s industry and the size of the CEOs’ compensation packages.

They found that boards would usually construct peer groups consisting of firms in the company’s primary industry. On average, there were some 30% of firms in those peer groups that weren’t in a company’s line of business. But, guess what: This figure increased significantly if the firm was performing poorly; then the board would construct a peer group of firms (outside the company’s industry) with quite mediocre performance, to make the firm look better. They did the same thing if everybody in the company’s industry was performing well; then a poorer performing peer group obscured the fact that the good performance of the company was nothing unusual in its industry, again making it look comparatively good.

Finally, boards would compose peer groups that consisted of comparatively poorly performing firms from outside the company’s industry if its CEO received a relatively hefty compensation package; then the seemingly high performance of the firm would come in handy to justify the CEO’s big bucks.

Joe, Jim and Tim concluded “boards selectively define peers in self-protective ways”. Which simply means that they dupe us to pay the buggers too much.