The alignment illusion of shareholder value

13th July 2015

Julia Hanna

Are LTI metrics up to the job?

In their recent paper ‘No routine Riches: Reforms to Performance-Related Pay’ the High Pay Centre think tank recently called for the abolition of Long Term Incentives (LTIs) on the basis that executive pay has risen 5 fold since the 1990’s but company performance has not.

There’s plenty of evidence to support this – Median earnings of FTSE 350 directors increased more than twice as fast as median pre-tax profits since 2000, and four times as fast as the median market value of FTSE 350 companies.

LTIs are designed to align executive pay with shareholder value. But is shareholder value the same as company performance?

The alignment illusion:
A study by Investor Responsibility Research Center Institute (IRRCi) and Organizational Capital Partners shows that shareholders and executives share common interests on company performance and economic value creation. But often the measures used in LTI plan design don’t reflect these.

Not all LTIs incorporate performance measures but when they do the most common metrics are Total Shareholder Return (TSR) and Earnings per Share (EPS). It can be argued that neither adequately reflects company performance. The IRRCi contend that this is because;

TSR is driven by current performance and expectations for future growth based on disclosed company strategy. It can therefore reflect investor sentiment and be largely impacted by factors such as central bank policy, macro-economics or geo-political risks – all outside the control of executives.

Executives can however use business tactics such as share buy-backs to prop up the share price which influences the TSR equation.

Not all TSR results are equal in terms of company performance. For example; a company can have a positive TSR but negative Return on Invested Capital (ROIC) and Economic Profit (EP) perhaps in the case of start-ups when heavy capital investment is required or conversely a negative TSR as a result of the recent global financial crisis but where underlying company business fundamentals are strong.

Often TSR is measured on a relative basis in order to negate some of the external factors but relative TSR outcomes are heavily influenced by peer groups and the method of calculation.

EPS is the second most common measure. But doesn’t take into account levels of invested capital, Return on Capital or Future Value and is therefore purely an income measure.

Share price is primarily a capital markets metric not a business operating measure. It therefore doesn’t create alignment between value creation and executive accountability. But, it can encourage value destroying action for example through some merger and acquisition activity or a strong focus on value extraction.

So the standard accounting measures used as LTI performance metrics do not define company performance or value creation and therefore when used as a metric for LTIs they:

Emphasise past performance not sustainability
Focus on the medium term (3 years)
Penalise for investing in new technology, markets and products as it negatively impacts EPS
Reward for capital market growth rather than company performance

So, is the High Pay Centre right in concluding that we should abolish LTIs? Or should we retain LTIs but take a different view on the measures used?

What should we measure and how should we reward?

If we are looking to reward executives for increasing company value and long term sustainability we should be rewarding them for the actions that they take in order to achieve this. This means a decoupling of the concept of rewarding for shareholder value in its current form. We can do this by:

Using value-based measures: The IRRCi asserts that executives can be held accountable for the measures that are inputs to TSR; the value creation drivers such as Economic Profit (EP), Return on Invested Capital (ROIC) and sales growth.

Both take account of the cost of capital which equity-based measures do not. ROIC shows how efficiently a company is using its capital – whether its market positioning, growth or R&D strategies will generate profit. EP assesses the effectiveness of a business strategy to create value.

Taking a broader view: There is a growing expectation that Environmental, Social and Governance (ESG) factors are incorporated into executive pay. Factors such as customer satisfaction, engagement, safety and increasing public trust give an indication of how well a company is run.

Principles for Responsible Investment (PRI) found that 83% of organisations incorporated some kind of ESG issue in to pay decisions, but they are still often linked to short-term incentive plans. Incorporating ESG measures into LTIs gives a much better assessment as the impact of ESG factors take much longer to work through to the balance sheet.

Used together with financial metrics such as ROIC or EP that evaluate competitive advantage, they give a better picture of long-term value creation. Using these measures incentive plans more directly aligns executive pay to sustainable value creation for shareholders.

Making LTIs longer term: The average tenure of a CEO in the UK is 5 years. With most LTI plans having a timeframe of 3 years, time horizons of decision making remain at best medium-term. Increasing LTI timeframes focuses executives on the sustainability of the company beyond their custodianship.
Creating stability: There needs to be greater stability in the make-up of peer groups and consistency of metrics used. There has been a tendency to tinker with peer groups, metrics and targets on a regular basis (nearly 60% of companies changed their performance metrics 2013) further reinforcing a short-term focus.

A greater prevalence of the use of ESG factors will enable the creation of valid peer groups and consistent measures. The challenge here is to establish measures that are relevant to a specific organisation yet consistent across a peer group.

We are all in violent agreement that executive pay and company performance do not align well. And it is likely that this has contributed to pay escalation for executives.

But does this mean we should abolish the use of LTIs? Or perhaps it’s a matter of re-thinking the measures the LTIs are built upon.

Image courtesy of Frankieleon

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