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.
