Friday, May 4, 2012

Can financial markets measure management performance?



According to an interesting article written by Mihir Desai in the Harvard Business Review, the answer to this question is no. More specifically, the author argues that “[financial markets] can't easily disentangle skill from luck”.

To align the interests of managers with those of shareholders better, Mihir Desai suggests to identify the company's performance attributable to the manager's specific skills and strategic decision-making and to separate it from the company's performance that is due simply to luck. This should be done using the risk measure beta (which explains the risk profile of the company and, therefore, captures the normal performance of the company) and adjust it using alpha (which explains any superior performance of the company).

I was wondering whether and how this can work in practice.

Calculation of Alpha

Alpha is calculated using the following formula:

Alpha= (Rc - RF) - Beta * (Rm - RF)

whereas:

Alpha = the alpha for the company

Rc = the rate of return for the company (probably best captured by Total Shareholder Return)

RF = the average risk free rate of return during the period measured

Beta = the beta for the company = Cov (rJ,rM) / V (rM)

Cov (rJ,rM) = the covariance of the return of the specific security J with that of the market

V (rM) = the variance of the market return

Rm = the required rate of return for the market = the expected return of the market portfolio

Structure of a bonus compensation clause

In practice, you could structure the bonus compensation clause as follows:

Variable compensation

(1) The variable compensation depends on the company's performance as measured by [EBITDA / ROCE / etc.]. The variable compensation shall be [Formula depending on the chosen performance measure].

(2) The parties agree that the above defined variable compensation shall only be paid if alpha (as defined below) is above [positive threshold].


To conclude, I would guess that the practical application of such a clause should not cause major problems. Any of the above named financial ratios is widely reported in the financial press.


Resources:

  • Mihir Desai, “The Incentive Bubble” in Harvard Business Review 2012, 124 et seq.