Ep48 “Are CEOs Underpaid?” with Dirk Jenter

Introduction: The CEO Overpay Debate

• The topic of CEO compensation is discussed, with many news outlets suggesting that CEOs are overpaid due to their high salaries, often in the millions of dollars (52s).
• The argument that CEOs are overpaid is mainly based on the high numbers and ratios of CEO pay compared to other employees, but this perspective may not consider the value that CEOs add to their companies (59s).
• In contrast to other high-earning professionals like Michael Jordan and film stars, CEOs are often singled out for their high salaries, despite the significant value they may bring to their companies (1m41s).

CEO Pay Compared to Other High Earners

• Research on money managers has shown that they capture the benefits of the value they create, but it is unclear if this is also true for CEOs (2m7s).
• The example of the new Starbucks CEO is cited, where the stock price increased by billions of dollars after their hiring, while the CEO's salary was significantly lower, suggesting that the CEO is not capturing the full value they are adding to the company (2m30s).
• The average CEO of an S&P 500 company makes around a couple of million dollars, or up to 10 or 20 million dollars, which is a significant amount compared to other employees, but may not be relative to the value they add and the responsibility they hold (3m7s).

The Responsibilities and Risks of Being a CEO

• The responsibility of a CEO is significant, as a few bad decisions can lead to the downfall of the entire company, as seen in the example of Nokia's failure to enter the smartphone market (3m31s).
• Dirk Jenter, Professor of Finance at the London School of Economics, is a leading expert on CEOs' compensation and job aspects, and has previously discussed how to become a CEO. (4m32s)

Expert Opinion: Dirk Jenter on CEO Compensation

• The current topic of discussion is CEOs' salaries, whether they are overpaid, underpaid, or receiving the right amount, and how to measure this. (5m7s)
• Dirk Jenter claims there is no evidence that CEOs are overpaid, citing the example of S&P 500 CEOs in the US, who are paid an average of $18-20 million per year. (6m10s)
• Shareholders seem to be happy to pay these amounts, and there is no evidence of coercion or malice in how CEO pay is set in large public companies in the US. (6m37s)
• The theory that high CEO pay is due to bad corporate governance does not fit the data, as corporate governance has improved over the last 40 years, and companies are more focused on shareholder value creation. (7m22s)
• Dirk Jenter's answers on CEO pay are likely to annoy everyone participating in the discussion, as he believes CEOs are not overpaid. (5m41s)

Case Study: Elon Musk's Compensation Package

• Elon Musk received a large pay package in 2018, estimated to be around $2.3 billion over 10 years, which was extremely risky due to numerous performance hurdles that needed to be met (7m50s).
• By 2024, Musk had passed all the performance hurdles, which included significant increases in stock price, revenue, and profits, resulting in the package being worth around $55-56 billion (8m32s).
• The Delaware Court initially rejected the pay package due to governance issues, but it was later approved by a vast majority of shareholders in a vote (9m8s).

Shareholder Perspective on CEO Pay

• A survey of UK investors and board members found that directors believe lowering CEO pay would be detrimental to shareholder value, indicating that they voluntarily pay high amounts to maximize value (9m33s).
• The contribution of CEOs to large publicly traded firms can be very large, and having the right CEO can create significant value, with even a 1% increase in firm value resulting in substantial monetary gains (10m16s).

The Value Creation of CEOs

• The hiring of a new CEO, such as Brian Niccol by Starbucks, can result in significant market value movements, with Starbucks' stock price increasing by around 25% and the previous employer's stock price decreasing by around 8% (11m4s).
• The levels of CEO pay are considered minuscule compared to the significant market value movements that can result from a CEO's performance (11m39s).
• CEOs may not be overpaid, as their compensation is a small fraction of the value they create for their companies, with an example being Brian Nickel's $85 million sign-on bonus being a tiny fraction of the value creation assigned to him by investors (11m53s).

CEOs: Underpaid or Fairly Compensated?

• A comparison can be made between CEOs and mutual fund managers, with both adding enormous value, but mutual fund managers retain all the economic rents, while CEOs do not (12m57s).
• CEOs are vastly underpaid in the sense that they add a lot of value, but their pay is a small fraction of that value, unlike mutual fund managers (13m14s).

Economic Perspective on CEO Compensation

• Basic economics states that no CEO should be paid more than their expected contribution to firm value, and that CEOs cannot be hired or retained if paid less than their outside option (13m52s).
• The contribution of a CEO to a firm and their outside option can be very different, as a CEO's value is often specific to a particular firm and is based on their firm-specific human capital (14m19s).
• A CEO's value added can be significantly lower if they are moved to a different company, as they lose their knowledge and connections specific to their original company (15m19s).
• The gap between a CEO's contribution to a firm and their outside option can be significant, making it difficult to determine their optimal compensation (15m34s).
• A CEO's value is determined by the difference between the value they add to their current company and the value they would add to the next best company they could work for, with the CEO staying in the company where they add the most value (15m40s).
• The board of a company knows they cannot pay the CEO less than the expected value of their future contributions, creating a surplus that is split between the CEO and shareholders through bargaining and psychological factors (15m57s).
• The surplus splitting game is influenced by notions of fairness, social norms, and cultural norms, which can vary significantly between countries such as Japan, Sweden, and the US (16m36s).
• CEOs often get less than their value added, but also get more than their outside option, as they are unhappy when fired and may not find another CEO job, resulting in a significant decrease in earnings (17m0s).
• From an economic efficiency perspective, there is nothing wrong with CEOs getting more than their outside option, as it is just how the pie splitting ended up (17m37s).
• Mutual fund managers, on the other hand, have firm-specific human capital that is highly portable, and their market wage should be driven up to their economic contribution due to competition between mutual fund families (18m28s).

Internal vs. External CEO Hires

• The observation that there is no matching issue with mutual fund managers is correct, but it raises the question of why companies would hire CEOs from the outside instead of promoting from within (18m48s).
• In reality, 80% of new CEO hires are insiders, with the S&P 500 sample showing 81-82% of new hires being internal promotions (19m16s).
• Large firms, which are highly visible and can easily pay search firms, tend to promote internally over 80% of the time, indicating a strong bias towards insiders (19m39s).
• When these firms do go outside, it's often because they're in a crisis situation and need to change, and they don't want to promote anyone from the current leadership team associated with past failures (20m5s).

The Importance of CEO-Firm Matching

• Research on CEO compensation and pay has shown that understanding CEO-firm matching is crucial, and the basic facts indicate a strong bias towards insiders (20m35s).
• When firms do go outside, it often doesn't work out well, but it's difficult to make causal claims due to the circumstances under which they go outside (20m58s).
• Firms tend to go for "superstars" when hiring from outside, such as the case of Starbucks hiring a highly successful and established CEO from another company for a large amount of money (21m14s).

Challenges in Evaluating CEO Performance

• The market for CEOs is not very liquid, making it difficult to prove the value of a CEO, unlike the market for mutual fund managers, which is more liquid (22m11s).
• The lack of a liquid market for CEOs makes it challenging for board members to determine the value of outside options, making it difficult to decide between internal and external candidates (22m41s).
• Insiders have a massive information advantage when it comes to managing a company, as they know who to call and how to get things done, which is difficult for an outsider to replicate (23m0s).
• Knowing who the good people in each division of an S&P 500 company are, whom to promote, whom to ask for help, and how to get information out of different corners is enormously difficult for an outsider to replicate (23m34s).
• There is very little data on how good an outsider would be as a CEO, making it difficult to observe their performance (23m52s).
• In contrast, mutual fund managers' performance is more observable, but still requires a lot of data and understanding of their trading strategies and decisions (24m1s).

Research on CEO and Mutual Fund Manager Performance

• Research by Jules and the speaker has shown that when a mutual fund company promotes a manager within, a tremendous amount of value is added, but when they hire an outside manager, there is no difference in value added (24m48s).
• There is asymmetric information even about the skills of mutual fund managers, and this factor is likely to be much larger for CEOs due to the unique nature of the job (25m8s).

Asymmetric Information and CEO Compensation

• The CEO role requires a combination of people skills, leadership skills, and the ability to make big strategic calls, which are rare and only come with experience as a CEO (25m46s).
• The lack of a liquid market for CEOs makes it difficult to estimate their value and performance, but the speaker's gut feeling is that the asymmetric information factor is much larger for CEOs than for mutual fund managers (25m15s).

Strategic Decision-Making and CEO Evaluation

• Intel missed the opportunity to produce chips for the Apple iPhone 15 years ago, which is considered a wrong strategic call, and the CEO is remembered for this mistake (26m21s).
• Boards struggle to predict such major strategic calls, making it difficult to evaluate a CEO's performance (26m58s).
• It may be easier to hire a good mutual fund manager, but it is still challenging to determine their skill level, similar to CEOs (27m2s).

Conclusion: Addressing the Misconception of CEO Overpay

• Research on CEOs and their performance is crucial, and data-driven analysis can help understand the issue of CEO overpay (27m20s).
• The issue of CEO overpay is not supported by evidence, and more work needs to be done to educate the general public on this topic (27m37s).
• The UK and the US are among the countries where more work is needed to address the misconception of CEO overpay (27m52s).
• The podcast aims to contribute to a better understanding of the issue and encourage listeners to subscribe and follow the show for more information (28m1s).
• The "All Else Equal" podcast is a joint production of the N Institute at the University of Pennsylvania and the Graduate School of Business at Stanford University (28m25s).