Understanding Incentives: An Often Overlooked Part of the Investment Decision Making Process

Before I begin, I'd like to thank CNBC for recognizing Distressed Debt Investing as one of today's best alternative financial blogs. For those interested, you can view the entire list here: CNBC's Best Alternative Financial Blogs

On a number of posts in the past, I have tried to discuss how I weigh incentives and motivations of major players in the investment situations I am analyzing.  In essence, if you had to boil down a key determinant of how I view incentives, it goes something like this: People want what best for them, and that often means getting paid.  Whether that be management teams, board of directors, FAs, shareholders, etc, in the end, and as shallow as it sounds: follow the dollars (specifically the ones that can be earned 100% ethically), and you can more often than not, come out with the solution that inevitable plays out.

The example I often point to is that of management team's sizable equity incentive plans granted during the bankruptcy process.  More often than not, a management team will have a SCANT equity holding of the debtor prior to entering Chapter 11.  Then, out of seemingly thin air, management is granted 4, 6, 8, or 10% of the company via options that generally trigger when the company emerges from bankruptcy or hits some makeshift financial goal negotiated with creditors that are driving the process (read: distressed funds / distressed private equity) and the financial advisers.  And because the debtor has the sole right to file its own plan of reorganization, management's incentives are to broker the best deal for themselves financially...i.e. "Well the unsecured creditors are offering us 5% of the equity - if the subs can up that to 10%, we'd be more inclined to support them."  Bankruptcy judges are many times loathe to confirm a plan that is not the debtors own creation, it stands to reason that the management team has just scored an amazing pay day for themselves.

In my opinion, the annual proxy is the most important, yet the least read of companies' SEC filings.  While the entire document is a treasure trove of information (management bio, board bio, shareholder makeup, board makeup, board compensation, etc), the most important nugget of information to me is the report of the compensation committee.  This, in no uncertain terms, will tell you what guideposts and targets a board (almost always directed by a consultant hired by the management team) has set up for its executive management team to maximize their financial compensation.  Not only that, but it lays out items like acceleration of benefits on a change of control which can lend a clue whether a company is preparing itself to be sold to the highest bidder.

Let me take an example.  A specialty metals manufacturer recently changed the make-up of their management compensation to eliminate leverage metrics. Historically, the compensation committee targeted a conservative Debt / EBITDA ratio, management hit that ratio (like clockwork), and got paid.  Last year, after a few more aggressive board members joined the board, that leverage target was removed from the compensation structure.  Since then, the company has added over a full turn of leverage moving spreads out considerably.  No credit analyst reported on this.  No one even talked about it or mentioned it in an 8k or a transcript.  It was subtly removed from the one year's proxy to the next.  And if you had caught it, you may have been out of the bonds before their prices fell.

In addition, I think board compensation and make up is something that is often overlooked by the analyst community. Let's talk about the economics of being a board member:  I'd say the average S&P 500 board member is making between 100k-200k/year for attending 5-8 meetings a year where all their expenses are paid, they are put up in a 5-star, and are wined and dined by management teams that they either have a related business with, or have been friends for a number of years.  These board members have the clout of being on a big-name company board of directors.  They can brag to their friends about that.  People DO NOT give that up easily.  If there is a hostile offer for a company and the target's board will be replaced, AND that same board will not make a windfall on acceleration of stock options, then I doubt that hostile will work out.  Tender offers can work, but a highly incentivized board of directors will pay a highly incentivized law firm to work out defenses that will keep the pay checks coming.

There are other most esoteric incentive structures that analysts need to be cognizant of that are often overlooked. In a bankruptcy for instance, a financial adviser's terms of agreement with the company / equity committee / unsecured committee is often filed publicly with the court.  FAs will take a monthly fee but the real dollars come from incentive fees for selling the company.  These incentive fees are often structured at various tier levels.  Believe me when I tell you that FAs are not setting ultra lofty goals for themselves as to not receive their incentive kickers:  They will set reasonable goals that can be used as a base line for valuation work in terms of recoveries to various constituents.

In the beginning of January, I wrote up, as a long idea, the AMR 2001-1 As and Bs EETC (as a strip) on the Distressed Debt Investors Club. This past Friday, AMR elected to 1110A the collateral backing that deal sending the bonds soaring today.  My thesis rested not only on the large deficiency claim that rejecting these aircraft would bring about, but also on some more qualitative work.  Despite the MD-80 status as uneconomic fuel hog, AMR needs a number of these legacy planes to continue operations in certain routes. And as the planes backing the 2001-1 deal were some of the newest MD-80s, it'd stand to reason they'd accept these.  But for me, an important intangible:  Boeing owned the equity of the planes backing the deal.  (AMR was leasing them from Boeing). If you haven't heard, AMR has purchase commitments for nearly $3 billion of Boeing new build planes over the next five years.  I think it was in AMR's best interest to keep things running smoothly on the new order side with Boeing and as an act of good faith, accepted this collateral, despite the economics that say rejection was the correct choice for AMR.  The leases will probably be re-worked, but in the end, the catalyst, the incentives, and the mis-pricing was there for an fantastic investment opportunity.

Peter Lupoff, founder of Tiburon Capital Management, advocates something called the Rational Actor's Assessment:

Rational Actor’s Assessment is a game theory approach where we identify every rational financial actor and consider their anticipated behaviors if pursuing their own rational self-interest. Rational Actor’s are Management, Bond Holders (perhaps a new, activist bondholder), Bank Debt Holders, Private Equity, Competitors, the Trade, Unions, Biggest Shareholder, etc. Any constituent group whose behaviors can influence outcomes

You lay out what is best for each stakeholder, and then play the game. I've recommended it in the past: Bruce Bueno de Mesquita's The Predictioner's Game is simply the best book on the topic.  The book uses game theory in the lens of international politics.  I think though it is just as relevant to evaluating whether a merger is going to go through, if a company is going to overspend on capex to meet sales incentive targets, if the unions will play ball in a bankruptcy etc.  You will never be able to play out every situation in your head (or an Excel spreadsheet - points to self with two thumbs) with 100% accuracy, but you can improve your ability to gauge how situations will play out and by doing that should vastly improve your investment success.