Rewarding risky business

Short-termism of incentive system favours recklessness

If you think about it, given the reward system in place, it’s amazing that our supposedly super-efficient market system hasn’t generated much more value destruction. The R7bn write-down at Woolworths’ Australian venture looks like small change in the wake of the untold billions that seem to have gone up in smoke at acquisition-driven Steinhoff. Far from being shocked by last week’s news, some in the market merely shrugged and suggested Woolworths may have to take a second similarsized hit in the not-too-distant future.

But here’s the thing: the people working on these sorts of transactions are driven by one overwhelming consideration — that they will only get paid serious money if the deal is done. The funders, corporate advisers and top executives stand to score handsomely if a mega-merger is closed. If no deal is done, the advisers might not even have their costs covered, and the executives will have to get used to the idea of not leading a really big firm.

At last year’s Woolworths AGM, remuneration committee chairman Tom Boardman explained to Asief Mohamed, the only fund manager concerned enough to attend, that the generous retention bonus paid to CEO Ian Moir was “fair and appropriate” according to the committee’s benchmarking exercises. Moir’s remuneration had to make provision for higher levels of remuneration in Australia.

A Woolworths circular released in May 2014 refers to the R23.3bn price tag on the David Jones acquisition, noting that it included transaction costs of just under R1bn. The section above the funding note outlines the rationale for the deal, explaining why the combination of Woolworths and David Jones “provides significant advantages that will benefit both companies and their customers”. Given the subsequent surge in the share price, it’s safe to assume there was strong belief in this rationale being realised.

But there were also many voices urging caution, arguing that the steep price made it a high-risk gamble. Unfortunately, none of those voices seem to have been represented on the board, or at least were not heard by it.

So who should be looking after the long-term interests of shareholders when executives and board members are smitten with the prospect of their company becoming the largest retailer in the southern hemisphere? Or, in the case of Steinhoff, the secondlargest furniture retailer in the world?

In terms of experience and skill, the Woolworths board is impressive, possibly even more so than Steinhoff’s. No doubt its backing for the deal — the board unanimously recommended the transaction — encouraged shareholder support, just as so many Steinhoff investors were comforted by the assumed calibre of its board.

It’s a difficult situation. Business is about taking risk; shunning all risk would cause as much damage as recklessly embracing it. But the reward system favours reckless embrace. Surely a longer-term perspective is needed — one that defines “successful completion” of a deal over a 10-year time frame, with rewards paid out over that period. It might help improve the dismal record acquisitions have for enhancing profit.

The people working on mergers are driven by the overwhelming consideration that they will only be paid serious money if the deal is done