Highwater marking

I wanted to talk to you about an executive pay concept that was introduced into my thinking by a former colleague, who is still a good friend, named Chandler Spears. Chan is the Portfolio Manager of the Davis Real Estate Fund and he has served in that capacity for many years now. Chandler introduced me to the concept of “high-water marking” executive pay packages.

So what exactly is “high-water marking?” It means that executive pay packages are tied to the incremental performance of the businesses that they manage. In other words, if the CEO of the made-up-by-me XYZ Corporation were to deliver net earnings (i.e. profits) of $100 million in 2008 then she would only be eligible to receive a bonus based on the incremental profit growth. So if profits in 2007 had been $90.91 million then the CEO would only be eligible to receive bonus monies in 2008 based on the 10% incremental performance from 2007.

In 2009 however, in order to achieve a bonus the CEO would have to exceed the performance of 2008 in order to receive a bonus. So if profits fell from $100 million down to $99.99 million, the CEO would not be eligible for a bonus. In other words, the peak performance of the Company becomes the new hurdle that the executive has to exceed in order to receive a bonus.

The genius behind this form of compensation scheme is that executives only get rewarded if they are improving the business. As it stands currently many executives get large, ridiculously-sized bonuses regardless of performance. The other nice thing about this form of incentivizing executives is that it encourages executives to be innovative in their thinking. The executive team needs to think of new ways of making money and improving business performance in order to improve the business each year.

There are several prospective drawbacks to this form of executive compensation. The first is that not many other businesses have in place schemes such as this one. What that means is that executives are naturally going to be attracted to work at businesses where tremendous pay is offered for mediocre performance. It will be the rare executive that will desire to work at a firm where there is a higher standard of excellence. The second drawback is that if the business is close, but short of the high-water mark then executives have a suddenly outsized incentive for “cheating” in order to achieve the incremental performance necessary for scoring the big bonus bucks. Consequently, there has to be in place so stellar mechanism to ensure that no accounting manipulation takes place. Fortunately, there are many such ways of diminishing the chances that executives are able to get away with false performance. But this is outside the scope of what I wanted to talk about today. Quickly though, one of the ways to do this is to reward executives based on a rolling time period, say of five years. That way, no one year’s performance is going to sully the record of the executives, thus removing the incentive to cheat.

I hope that all of you had good weekends and that you are getting geared up for Thanksgiving!

Jason