McDonalds and Agency Fee Transparency

McDonalds recently shifted its agency to Omnicom - specifically, DDB (only creative was up for grabs here, the media buying wasn't being reviewed). After working with Publicis' Leo Burnett for the past 35 years, and after growing to roughly $1B in annual media spend, this is important for both Omnicom and Publicis in the obvious ways. The transaction was also important for the agency industry as a whole and may (or may not) serve as a model for future deals.

McDonalds would be a large, tier 1 customer for any agency. It has the heft and cachet to push the bounds on the nature of the terms it uses in agency relationships. But McDonalds also conducted its agency review not long after the ANA released its transparency report. So when it came time to look for an agency, McDonalds wanted to make sure the agency's primary interests were increasing McDonald's sales. McDonalds required that the winning agency handle its business "at cost" - meaning (generally) make no profit whatsoever on the fees charged. All profit would be tied to an explicit incentive structure based on performance.

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Agencies do not operate like this. As discussed in previous lift letter (The ANA Report on Media Transparency), media agencies make money directly and indirectly based on the media. Just like any professional service organization, a creative agency would expect to add its profit margin to the fees charged. One wouldn't expect a law firm to work at cost with outcomes tied to business success. McDonalds, however, is at an interesting point in its history. Nutritional and cultural trends may be working against it, and it may be struggling to rebrand in line with current market forces. Further, unlike a law firm - whose primary interests are protecting against downside risk - ad agencies can be much more closely aligned to overall business success.

The major questions here are whether an incentive structure like this catches on and whether it makes sense. It's to-be-determined if this structure works long term, but the operative questions are whether McDonalds and DDB can sufficiently align on the nature of the incentive structure, and whether the agency doing a good job can, alone, be dispositive of McDonalds - and thus the agency - attaining the performance tiers.

One could imagine that if a company paid their marketing department bonuses based solely on company revenue, that department's questions would be 1) whether the company has a sufficient investment in marketing programs that they will be able to meaningfully impact overall performance, 2) whether the targets for the team are reasonable and whether their good work could be undone by other departments' bad work, 3) what the company's overall plans are, and 4) what prevailing market conditions look like. McDonalds and DDB are making a meaningful investment that they can align on these answers. If not, this may have the opposite impact - DDB could be demotivated by unreasonable or otherwise unattainable performance targets such that they wouldn't do great work. If they are aligned, this could be incredibly powerful. The thresholds, however, are both very difficult and very important.

The question of whether this catches on could extend beyond creative and into media buying. In a world of rebates and undisclosed margins as discussed in the ANA report, advertisers might be forgiven for growing wary of a complex media world. Instead, a system that simply says "do what you want with my media dollars, but your profits have to come only from overall performance" could create incredible or terrible performance. Ultimately, whether other brands have the stomachs to try to resolve the alignment questions, and the hearts to better align their agencies with their outcomes may determine the compensation system over the years to come. This, in turn, may have dramatic effects on the media ecosystem as a whole.

The ANA Report on Media Transparency

The Association of National Advertisers (ANA) recently released its report “An Independent Study of Media Transparency in the U.S. Advertising Industry.” I've attached the report itself if you're interested. As many pundits and insiders had predicted, it revealed widespread rebates and other non-transparent practices that may or may not be in the best interests of the advertisers themselves.

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The report described a number of tactics that it found misaligned with the ANA's principles. A simple example is a media agency buying media in bulk at a discount and selling it to its customer at market price - without necessarily disclosing the cost for which the media was originally purchased - and keeping the difference. Other examples include partnerships with media companies for rebates (or "service agreements" with no services provided) based on amount spent, without necessarily disclosing the rebates to the advertiser; buying through affiliated intermediaries and allowing the intermediary to markup the media; and dual rate card negotiations - where a holding company negotiates a lower rate for an ATD and a higher rate for the agency, and then purchases through the ATD can be marked up for an internal margin whereas those that bypass that ATD have worse rates (and lower margins for the holding company).

The ANA report describes these practices in a rather unsavory light. Indeed, it's not hard to find unethical interpretations for much of this behavior. That said, it's worth considering what's going on at a deeper level. The majority of the employees at ad agencies are doing actual, productive work in the greater interest of their advertiser customers. And they tend to have a particularly large number of employees doing a significant amount of manual work. With every account review, advertisers push for the agency to take lower margins. This means one of two things - either worse service or the margins come down. No one wants to offer worse service (and they'll lose the business if they do), and the agencies are generally public companies that have to deliver certain margins to their investors. So things happen and eventually you get an ANA report on transparency in the media industry.

This is actually a very complex principal-agent problem. If an agency is paid as a percent of media spend and it could achieve the same results with half the media spend, the incentives aren't aligned. If an agency were completely transparent about its fees in this case, it would choose to buy the same media at the highest price it could to net the greatest fees. If the fees were completely opaque, it might negotiate a discount and pass along some - but not all - of the savings to its customer. One could argue that it would obligated to get the best discount for its client and pass on all the savings to its customer, but this isn't exactly a realistic portrayal of human nature in the aggregate, nor of publicly traded companies. Similarly, an agency trade desk might design algorithms to drive conversions at a lower price. The more effective the algorithm, the less money the agency would make. Finally, it's really quite hard to tell how effective an agency actually is. Did it buy the "right" media? Did it get the "best" prices? An advertiser has basically no way of knowing.

So it's an interesting question: if the ANA report results in advertisers demanding full transparency, what will happen to the agency world? Will the agencies refuse? The report details at least some agencies refusing, with justifications including the fact that the ATDs have costs that are spread among all the clients, so you can't allocate costs or transparency to a particular client. But beyond that, if there were transparency - would that simply mean decreased margins or lower service levels? Is that actually what the advertisers want? It's very possible (and ironic!) that, by demanding and obtaining a lower and transparent margin from the agencies, advertisers might actually be hurting their overall media performance.