Incentivize!

I'll keep this post short, as the message is pretty simple (but hard to implement in real life).
We had a guest speaker in my finance class who was a private equity manager. Of all things, he chose to focus his talk on incentive alignment. As a private equity firm buys an existing company, they need to incentivize either the current or replacement management to achieve the company turnaround or growth goals that are planned from the beginning.

He taught us that the status of incentive alignment explains performance. No matter what, people will be driven by the incentives placed before them and work to optimize the incentive formula, not necessarily the company's long-term value.

He also pointed out that incentives may be good per individual but bad when mixed together. For example, sales people may get commissions on sales; marketing may get bonuses based on brand surveys; the CEO may get bonuses based on stock price. When looking at each individually, it seems like the incentive makes sense based on the individual's role and department. However, when combined into one organization, the incentives can often be at odds with each other and not have a lot of cohesion. Tying everyone to one incentive system also doesn't work that well because of different people's limited control over parts of the business that are not their own and the problem of free-riding, where some may benefit at the hard work of others.

Finally, our guest taught us why it's hard to align incentives for the long term: things are changing all the time for a company, and it's hard to constantly revise incentive plans accordingly. Because incentive plans are forward-looking by nature (whereas company plans are drawn up based on past performance and the present outlook), there is always a lag in responding to a changing market environment when updating incentive systems. In addition, there's a sense of stickiness to incentives once put in place; if people got hired with a specific incentive scheme promised to them, it may be hard to renegotiate this. However, it's probably the right thing to do in the long run, and many companies probably are better off anyways without people who focus on incentives and compensation over learning and producing results.

I've always been interested in the subject of incentives and compensation and am simultaneously frustrated and curious about the issues at play because there is clearly no right answer or optimal solution. I hope to learn more about this topic next quarter in my Pay & Rewards class.

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