Let's look at some of the delicious compensation practices at Kraft.
I'm hesitant to invest in companies that think bigger is better. Too many times CEO's and the Board of Directors benefit from a larger company while shareholders suffer.
Of course CEO's and Boards never come out and say directly they will benefit from these acquisitions. No, what they do is frame this in terms of how shareholders win.
Shareholders put too much blind-faith in the Board to do the right thing and underestimate the impact of incentives.
Since Kraft's largest shareholder and arguably the worlds best investor came out against the Cadbury acquisition as proposed, I've been particularly interested in what the incentives behind Cadbury acquisition looked like. Now that Kraft has released their proxy statement we can get some insight into who really walked away better-off. Regardless of how the acquisition turns out, management rarely walks away a loser in an acquisition.
The first thing that strikes you reading the Kraft proxy is that post-Cadbury, retainers for Board members went up 57%. It seems odd they would have any financial incentive to approve an acquisition. I wonder if the board would have supported KRAFT CEO Irene Rosenfeld's Cadbury acquisition had their retainers gone down 57%. I'm positive Irene didn't walk into a board meeting and say, "Hey I know our largest investor and the world's best investor doesn't agree with this deal but I think he's wrong. If you approve this deal I'll bump your retainer and put 57% more cash in your pocket." No, she didn't have to do that. The board knew she'd do that. After all, she picked them all.
Putting "effort" into an acquisition should never be part of compensation. Yet at Kraft it was. In 2009 "The Committee heavily weighted the significant effort and the ultimate acquisition of Cadbury in assessing individual performance used to determine the value of the annual incentives paid to Ms. Rosenfeld and the other named executive officers." Wow! Really? Irene actually got paid for "significant effort"?
Now given that a portion of Irene's salary is tied to profits you'd think that it would be in her best interest to make sure the acquisition was profitable. You wouldn't expect Kraft's board to actually de-emphasize profits and free cash flow after the acquisition but that is exactly what they did. Knowing the acquisition wouldn't be profitable to shareholders, they actually changed the compensation policy to emphasize revenue and de-empathize free cash flow.
Annual Incentive Design – We changed the weighting of our Annual Incentive Plan metrics as follows:
|2009 Weighting||2010 Weighting|
Free Cash Flow
And going forward Free Cash Flow will "Not (be) used as a performance measure." Of course not, because after the acquisition free cash flow per share went down.
It's sad to see companies manipulate the system to their advantage. But after all, that is their incentive.
Setting compensation is not that difficult. Pay people well for things they control, don't reward them for things they don't. Think on a per-share basis. Avoid tying compensation to share performance. Avoid stock options. Pay very well for operating performance and return on incremental invested capital. These formulas and such as nothing but a smokescreen to distract shareholders and reward management. As the Kraft examples shows, too often management paints the bullseye around the dart.
More thoughts on compensation later.