GM's Second Great Crisis

General Motors is back in trouble, again. The last time it faced a crisis so severe was in the stretch from 1917 to 1922, when World War I precipitated a collapse in the demand for automobiles and Ford's mass market model had started producing cars at prices GM couldn't match. 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.

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. Responding to these incentives Roger Smith, GM's CEO in the 1980s, made a series of decisions that precipitated GM's current woes. The easiest way for him to buy labor peace and keep EPS on a roll was to offer overgenerous retirement benefits in exchange for keeping wages lower than they might otherwise have been because, at the time, accounting rules allowed companies to ignore the eventual costs of meeting retirement obligations.

But accounting is not reality, and companies that let accounting numbers govern how they see the world will inevitably make big mistakes.

A second problem with EPS is that it places a woefully inadequate charge on investing capital. It effectively ignores the cost of equity. A mature, surplus generating company like the 1980s GM that does this will invest its cash in ill-advised and ultimately value-destroying investments while keeping its EPS on the rise. Let's count the ways: Saturn; investments in robots that can't be made to work; global expansion and the acquisition of luxury badges.

Spend, spend, spend is the mantra of the EPS-addled manager. And so they did, and now, it's time to pay the piper.

Will GM be able to repeat history and emerge from the ashes? It's not likely. Rather than a passionately interested and committed investor like DuPont, we have the Feds in charge. Will they put in place the incentives of the owner and not the bureaucrat? This is the government, right? And will they find the equivalent of George S. Patton to pound through the cultural thicket and entangling contracts and legacy issues and union commitments and restore economic logic and value? I fear not.

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Bennett Stewart is founding partner of Stern Stewart & Co. and CEO of EVA Dimensions. He is the author of The Quest for Value, which is regarded as the definitive guide to the EVA ("economic value added") financial management and incentive compensation framework now employed at over 350 companies worldwide.