The Premium Paid for Outside CEOs – Sane or Insane?

Two news items this week illustrate the rational and irrational sides of executive compensation.
The first was a published report that CEOs recruited from outside a company earn an average of 65% more than those promoted from within. The discrepancy was greatest in smaller companies. The writer reporting on the study spun the results as conclusive evidence that organizations of all sizes must get their succession planning acts together.

Such studies appear regularly in the press, seemingly always with the same conclusions. But it does not take a major study to argue that in an ideal world, CEO salary costs are best managed by promoting from within. Unfortunately, and inconveniently, conditions are not always ideal. Contextual changes of all sorts regularly impact businesses, sometimes traumatically, driving them to seek perspectives or skills different from those developed in-house. Smaller companies lack the resources and critical mass to develop business leaders for futures which have yet to be charted let alone lived. And let’s face it, except in the most stable of businesses, risk-mitigating boards will almost always favor seasoned CEOs over up-and-comers with no experience in the corner office.

When firms recruit from outside, higher compensation is often required to offset the risks and costs of the new executives leaving one company for another including lost benefits and equity. The smaller the firm or the greater the challenges facing the executive, the bigger the risk and the higher the premium attached to the move.

Though such arguments may be reasonably rational and defensible, it is the less rational decisions regarding executive compensation that catch the attention of the press and infuriate so many observers. Take the hiring last week of Thomas Montag as head of sales and trading at Merrill Lynch. Before retiring in December of 2007, Montag spent 22 years climbing to the top of Goldman Sachs, a company called ‘the most profitable securities firm in the world’. According to a headhunter interviewed for an article on his hiring, it is very difficult to recruit Goldman executives, so when they retire or leave, a feeding frenzy for their services almost always ensues.

So what does it cost to ‘unretire’ a Goldman Sachs superstar? First, he will receive a base salary of $600,000 per year beginning on his first day of employment which was last week. In addition, Mr. Montag will receive a guaranteed stock and cash bonus of $39.4 million payable in early 2009. Merrill will also buy out what remains of Mr. Montag’s equity in Goldman Sachs, which will boost his entire compensation bundle to at least $50 million in the first year, all guaranteed. The actual offer of employment is available online for those who did not win last week’s 6/49 jackpot of $43mm and want to play a little Fantasy Island cut and paste.

The question of course is whether Mr. Montag is worth $40mm for what amounts to five months of work? Is this an unreasonable ‘boom time deal in a bust market’ as the Wall Street Journal suggests? Why pay such a premium for someone not employed? And with $40 million guaranteed just for showing up, are his interests really aligned with shareholders? On the other hand, perhaps this is simply the going industry rate for someone to fix a company losing billions of dollars? Or maybe Morgan Stanley or someone else was also pursuing Mr. Montag’s services resulting in a bidding war?

Though answers to such questions were not forthcoming in the press releases, the hiring provides a glimpse into another side of executive compensation. On the surface, Mr. Montag is a long-time, single employer executive with little discernible experience in executing turnarounds who is being paid an extraordinary amount of money to see if he is any good at it.

Notwithstanding this, the optics for Merrill Lynch CEO John Thain are very good as he lands a big fish from an unimpeachable firm, demonstrating that he is acting decisively and sparing no cost to fix his company. Sensible or not, it is a politically safe hire, one that placates shareholders and buys time. And it shows that some executive compensation decisions are driven not by rational selection considerations only but by a tapestry of forces such as politics, power, expediency and such powerful emotions as lust and fear.

It is exactly because of the coexistence of the rational and irrational in executive compensation decisions that all of the performance data supporting the premium paid to outsiders is so underwhelming. It is also why the issue frustrates so many.