Buffett's approach to designing a compensation package for directors

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An important reason for the exceptional high returns on capital at Berkshire Hathaway’s subsidiary Scott Fetzer is that Ralph Schey, CEO, was incentivised through his compensation deal to focus on returns on capital rather than total profits. As always, Buffett drew up a simple contract, but it hit the nail on the head when aligning the interests of the manager with those of Berkshire’s shareholders.

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  • The first logical step, is to ensure that compensation is based on the results at Scott Fetzer rather than those at Berkshire. He wrote in his 1994 letter to BH shareholders:

“What could make more sense, since he’s responsible for one operation but not the other?  A cash bonus or a stock option tied to the fortunes of Berkshire would provide totally capricious rewards to Ralph.  He could, for example, be hitting home runs at Scott Fetzer while Charlie and I rang up mistakes at Berkshire, thereby negating his efforts many times over.  Conversely, why should option profits or bonuses be heaped upon Ralph if good things are occurring in other parts of Berkshire but Scott Fetzer is lagging?”

  • Secondmake sure the rewards are great for great performance, “In setting compensation, we like to hold out the promise of large carrots, and make sure their delivery is tied directly to results in the area that a manager controls.”
  • Thirdpenalise low rates of return on capital through a charge on use of capital, reward high rates of return and pay a bonus to managers handing over capital to head office:

“When capital invested in an operation is significant, we also both charge managers a high rate for incremental capital they employ and credit them at an equally high rate for capital they release. The product of this money’s-not-free approach is definitely visible at Scott Fetzer.  If Ralph can employ incremental funds at good returns, it pays him to do so:  His bonus increases when earnings on additional capital exceed a meaningful hurdle charge. But our bonus calculation is symmetrical:  If incremental investment yields sub-standard returns, the shortfall is costly to Ralph as well as to Berkshire.  The consequence o

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