A key tenet of economics is that you get what you incent. That basic rule of economic law seems to be lost on American Capital Agency (AGNC -0.32%), however.
At a recent conference, the mortgage REIT’s CEO, Gary Kain, explained the benefits of buying out its management contract with American Capital Ltd. (ACAS).
He highlighted one of the biggest benefits was the elimination of a conflict of interest between management and shareholders, stating that “not having to be burdened with the worrying about the economics for the management company and the REIT” would be a much easier situation that “will benefit shareholders over the long run.”
I agree. Externally-managed companies, wherein the people who manage a publicly-traded company are actually employed by an outside firm, create conflicts that threaten shareholder returns. In American Capital Agency’s case, it previously paid its external manager a fee equal to 1.25% of its shareholders’ equity.
Thus, those who managed American Capital Agency had an incentive to grow at all costs, and never shrink, often leading to situations where the manager was at odds with shareholders. Shareholder returns are determined by earnings and book value per share. The external manager was paid based on the size of the company's balance sheet equity.
For several years now, American Capital Agency has traded below book value. In this situation, it makes sense for the company to divert excess capital to repurchase its own stock. For example, if American Capital Agency can pay just $20 per share to buy back stock with a book value of $25 per share, it can essentially buy $1 bills for $0.80.
Shareholders benefit directly from share buybacks below book value because the value of each share increases with every share repurchased. However, management companies lose from repurchases, because shrinking assets leads to shrinking management fees.
Conflicts persist
By buying out its contract with the external management company, American Capital Agency should theoretically be free to run the business as it sees fit. It will no longer have to consider the objectives of an external management company, which favored growing the balance sheet vs. shrinking it with repurchases.
Unfortunately, some of the conflicts persist, particularly as it relates to Kain’s compensation. His base salary, which is also a key component to his bonus compensation, is tied to the amount of equity capital managed by American Capital Agency and American Capital Mortgage (NASDAQ: MTGE). Thus, Kain stands to benefit from a bigger American Capital Agency, just as American Capital Ltd. did before American Capital Agency bought out the management contract.
It makes little sense to me that the company would leave this relic after buying out the management contract. If one of the goals is to remove conflicts of interest in a transformative acquisition of its external management company, why leave such a glaringly obvious conflict behind?
This year, Kain stands to earn a base salary of about $4.4 million as the result of the calculus that determines his compensation, a tiny fraction of the company’s $62 billion of assets. If he can generate spectacular returns for American Capital Agency shareholders, I believe he deserves every bit of it, if not more.
The issue isn’t what the mortgage REIT’s managers earn, but how they earn it. Compensating management on per-share metrics would truly remove any and all conflict between the C-suite and everyday investors. It’s a shame that it wasn’t done right the first time.
