Bennett Stewart, the author of the Quest for Value and co-founder of Stern Stewart & Co. - the EVA Company, writes a short essay (here) at HBR Now about the meaning of the bankruptcy of General Motors. He explains how any company can become a ward of the state or go into liquidation if the financial management system bows at the alter of the accounting based EPS metric. Accounting does not charge for equity capital, only debt capital, so the mandate for the operating managers and the board too, is SPEND, SPEND & SPEND. Spend until the company fails.
He begins by recounting the last time GM almost went under before the Great Depression, and how DuPont, not the government, stepped in with cash and one Alfred Sloan:
GM was at death's door, and only a healthy infusion of cash and financial restructuring saved it. Actually, not just saved GM — made it great.
But unlike this time around, when the heavy hand of the government is at the wheel, it was an investment from DuPont, whose chairman was instrumental in bringing in the legendary Alfred Sloan to run GM, and a financial restructuring orchestrated by J.P Morgan, that saved the day.
By 1923, Sloan had arranged for the GM management team to acquire a large block of the company's stock from DuPont, financed with a non-recourse loan that would be repaid by diverting bonuses. GM's management effectively participated in the incentives of a leveraged buyout of the firm, but without imposing a like financial risk on the company itself. As for the bonuses, they were based on simply allocating a sizable portion of GM's operating profit above a 6% cost of capital hurdle rate, which gave the managers unlimited upside for achieving income efficiency and balance sheet asset management. There was no calibration of the bonuses to a market pay scale, which only tends to institutionalize a guaranteed level of pay irrespective of performance. There was the risk and the return of the owner on the shoulders of management.
And that, coupled with excellent management, set the stage for greatness.
Basically, Sloan's magic formula was to incentivize operating managers of semi-autonomous divisions by paying them some pre-determined fixed share of operating profits above a 6% hurdle rate - low, but much higher than the after-tax cost of debt - the hurdle rate in an accounting-based system even today.
A fixed-share of "excess operating profits" is the same thing as a fixed share of the Economic Value Added or "EVA" of the divisions. The best part was that it was a pre-determined formula which meant the operating managers could shoot for the moon as long as they figured they could get an excess return on their investments/spending. It was as though Sloan had created a way to give a fixed share of the intrinsic value growth of their specific operating units.
What happened?, you may be asking. Well Stewart says:
Over the years, GM moved away from the incentives and value focus of an owner to the incentives of a bureaucrat. Bonuses were hitched to growth in earnings-per-share, and a raft of situational metrics that obscured responsibility for delivering real value.
Spend, spend, spend is the mantra of the EPS-addled manager. And so they did, and now, it's time to pay the piper.
Indeed.
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