Moody's Links CEO Compensation To Credit Risk

Investors should be wary of companies with big fat paychecks being cut at the ceo level because credit risk can be related to ceo compensation, according to a report from Moody's Investors Service.

  • 26 Aug 2005
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Investors should be wary of companies with big fat paychecks being cut at the ceo level because credit risk can be related to ceo compensation, according to a report from Moody's Investors Service. In a study of executive pay, stock options and bonuses in relation to credit defaults, Moody's found that there is a correlation between higher than average pay and increased credit risk. The study did not include ceos brought in to turn around already troubled companies.

Following the situations at companies such as Enron and WorldCom, the ratings agency wanted quantitative research to go along with studies it had been conducting on corporate governance. Chris Mann, v.p. and senior analyst at the ratings agency, authored the report.

The agency looked at specific measures, such as bonus and salary and what the risk of default or large rating downgrades was for the 10 years between 1993 and 2003. It controlled for a number of characteristics, including industry effects and long term ratings and found "large, positive, unexplained bonus and option awards are predictive of both default and large rating downgrades." Specifically, it calculated that out of 865 firms, about 43 defaulted during the sample period and 214 incurred "large downgrades," which Moody's characterized as a change in three or more refined rating notches within any 12-month period. "There is some correlation between companies paying quite a bit above the average and increased credit risk," said Ken Bertsche, managing director corporate governance analysis at Moody's. "It does not mean that all companies that pay that much are a problem, but a higher proportion of them might be."

The results might partially reflect that some executives have been encouraged to take a lot of risk, Bertsche said. "From a shareholder perspective that is not necessarily bad,' he said. "You have a lot of companies taking a lot of risk, some are going to fail and some are [going to do well.] Creditors don't have the upside, shareholders do."

One portfolio manager said he doesn't know if the report will impact the way his firm looks at companies. When deciding on a credit, they do not look at direct compensation, but do look at what kind of incentives are in place. This firm happens to like incentive systems that are directly linked with the company's performance. Whether that could lead to default, he said, could always be a risk. "But you are going to have it no matter what. It is one of the things you always evaluate as part of the due diligence process," he said.

Another investor said that historically, ceo compensation does not effect the types of credits his firm invests in, although it can be a red flag. Still, he thinks that following the Enrons and WorldComs, board control has gotten stricter and there is greater regulation on public companies. Private companies that are controlled by private equity groups such as Kohlberg, Kravis, Roberts & Co., are also good investment choices for his fund because they are sophisticated and tightly regulated.

  • 26 Aug 2005

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