23 February 2022

Cut-price CEOs can come with hidden costs

In September 2019 Smith & Nephew announced that Namal Nawana was to leave his position as CEO. Hired in May 2018 from US diagnostics company Alere, it was reported that the board of Smith & Nephew were looking for ways to align his pay more closely to the US market from which he was recruited. Unlike many UK CEOs, they considered the US market to be a relevant comparator, given the realistic prospect that he would one day return there (as indeed he now has).

In the 2019 annual report, the Chair of the Remuneration Committee said of their shareholder consultation on a new remuneration policy: “We listened to, and discussed all feedback received, and as a result made some changes to the initial proposals, including around the pace of pension reduction and the maximum opportunity under the Performance Share Programme.” This is almost certainly code for: “You told us to cut pensions quicker and scale back our proposed incentive plan awards, so we did”. It was widely reported that the failure to enhance his pay package was a significant factor in Nawana’s departure.

We don’t know whether the board had made commitments to Nawana when he was recruited that they would try to increase his pay when the time was right. Or whether Nawana saw a chance to push for an increase following an impressive first 12 months in charge that saw the leadership overhauled and the share price rise 40%. 

What we do know is the share price rapidly fell by around 9% on the announcement, amounting to £1.4bn of lost share value. The share prices doesn’t always fall when a CEO departs unexpectedly. Indeed research shows that often it rises, when investors think they’ve got a below average CEO. That same research suggests that investors attribute a value of up to around 10% of the value of the company to having a good versus bad CEO. That’s quite a lot, and consistent with this specific case.

We don’t know what Nawana would’ve considered to be acceptable pay or what the board was asking shareholders to support. But by standing up to Nawana’s demands on pay, shareholders quite likely saved themselves no more than £1m to £2m a year. While that sounds a lot, it’s perhaps not so much when put in the context of what’s happened since. Yesterday, Smith & Nephew announced that Nawana’s replacement of just a couple of years ago, Roland Diggelmann, was also leaving. The company’s share price immediately rose around 3% on the news and at the time of writing is trading about 10% above the pre-announcement price. However, that is still over 25% below its level the day before Nawana resigned.

Correlation does not mean causation. Smith & Nephew was significantly affected by delays in elective surgery and supply chain disruption due to COVID-19. Hidden problems under Nawana’s reign may just have come to light under Diggelmann’s. We don’t know whether Nawana would’ve dealt with the COVID-19 crisis any better. We will never know the counterfactual. But the contrasting share price reactions on Nawana’s and then Diggelmann’s departures surely tell a story.

It is, at least, a reminder that CEOs matter. And not just for shareholders. Smith & Nephew’s performance affects the security of employees’ jobs, health outcomes for customers, and investment in innovation that benefits the UK economy.

We’re in a strange place with CEO pay in the UK. My research with Professors Alex Edmans of LBS and Dirk Jenter of the LSE highlights the extent of disagreement between UK investors and boards on this topic. More than three quarters (77%) of investors think that pay is too high or far too high, with 86% agreeing that boards are ineffective at lowering it even though they should. Only 18% believe that a company would recruit a lower quality CEO if pay were cut by as much as a third - an extraordinary finding. By contrast, directors believe cutting pay would result in the company recruiting a lower quality CEO and only 10% believe there would be no adverse consequences. Indeed our research revealed that directors are increasingly concerned not just about the UK’s competitiveness compared with overseas markets, but also the attractiveness of listed versus private companies.

Executive pay has changed enormously over the last decade in the UK. It’s got lower, harder to earn, easier to reclaim when things go wrong, and longer term. Yet still people are unhappy. UK listed company CEO pay levels have been flat or declining and so have dropped materially relative to other countries and private-equity backed businesses (Nawana is now at a venture fund backed by KKR). With a reducing gap between CEO pay and the next level of executives, there’s a risk of the top job becoming less attractive.

In this context, it’s worth noting that problems with CEO pay tend not to show up in CEOs leaving - the case of Smith & Nephew was an exception - but rather in the candidates you can’t get interested in the job in the first place. So it’s a hidden cost, and in my view an increasing one.

Restraining CEO pay is all very well, and of course there have to be limits. But it doesn’t always come for free, either for shareholders or society.