Share options: The law of unintended consequences; When bosses take the short view

Share options: The law of unintended consequences; When bosses take the short view

Feb 8th 2014 | From the print edition

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EXECUTIVE share options were created in an attempt to align the interests ofmanagers and shareholders. In the 1970s and 1980s many investors had feared that executives were more interested in empire-building (in order to justify higher salaries and lavish expenses) than in generating returns for shareholders. Granting options was supposed to allow executives to benefit alongside investors from rises in the share price.

In recent years, however, a new fear has arisen: that options have prompted executives to focus on the short-term performance of the shares rather than the long-term health of the business. A firm’s share price can often suffer a big fall if it misses its quarterly earnings target, something that would dent an executive’s pay-off from his options. Spending money on research and development (R&D), for example, may hit profits in the short term but is vital for a firm’s survival.

A new academic paper examines this issue by focusing on the period when options “vest”—that is, when it becomes possible for executives to cash them in. It shows that spending on R&D does indeed decelerate slightly at vesting time, as do outlays on other things that bring results in the longer term, such as capital expenditure and advertising. It seems unlikely that the period of vesting would routinely come at times when the need for such spending had fallen. The study also finds that firms are more likely to top their earnings targets in quarters when options are about to vest than at other times, suggesting that bosses are massaging profits up at the critical moment.

This may help to explain why corporate investment has been slow to pick up of late, even though many firms have big cash piles which are earning next-to-nothing in interest. The incentives for executives are still not working perfectly.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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