Posted by Yaron Nili,
Co-editor, HLS Forum on Corporate Governance and Financial Regulation,
on Wednesday December 3, 2014 at
The following post comes to us from
Jon Lukomnik of the IRRC Institute and is based on the summary
of a report commissioned by the IRRC Institute and authored by
Mark Van Clieaf and
Karel Leeflang of Organizational Capital Partners and
Stephen O’Byrne of Shareholder Value Advisors; the full report
Investors, directors and
corporate executive management share common interests when it comes to
company performance and economic value creation.
Yet, whilst this commonality is
laudable, a review of performance measurement and long-term incentive plan
design for USA public companies identifies that current practice is less
than clear in measuring and aligning these interests in a manner that is
robust and meaningful.
Existing approaches do
not deliver a clear line of sight by which to manage or measure a
This report began by seeking to
answer the degree of alignment that currently exists between company
economic performance, shareholder return and executive compensation for
the S&P 1500 companies.
The expectation was that the
analysis could usefully serve as a marker in the ground and yet what it
uncovered was unexpected.
The most common measurement
tools and metrics used in enterprise performance measurement and the
design of long-term incentives do not necessarily directly align with
underlying sustainable value creation for shareholders.
» Some 75% of companies have
no balance sheet or capital efficiency metrics in their long-term
incentive plan design,
» Total shareholder return is,
by far, the most dominant performance metric in long-term incentive
plans, present in over 50% all plans,
» Only about 17% of companies
specifically disclose the use of return on invested capital or economic
profit as a long-term performance measure for long-term executive
» More than 85% of the S&P
1500 have no disclosed ‘line of sight’ process metrics aligned to future
value, such as innovation, and related drivers.
» On the positive side, the
use of performance-based incentive vehicles in long-term incentive plan
design has increased every year since 2009—from 52% in 2009 to 76% in
Amongst the most problematic of
the findings is the lack of use of any balance sheet and
capital-efficiency performance metrics in over 75% of listed companies.
Also, the focus on share price
appreciation through total shareholder return (TSR) obscures more than it
reveals with share price as a capital markets performance metric. Factors
which impact TSR such as fund flows, central bank policies,
macroeconomics, geo-political risks and regulatory changes are all beyond
the control of executive management.
Economic performance explains
only 12% of variance in CEO pay. The remainder is based on other factors
largely beyond management control, for example:
» Over 44% of CEO pay variance
was explained by the size of the company based on revenues, the industry
itself, and inflation.
» Another 19% of CEO pay
variance is explained by the consistency of corporate-specific
compensation policy; that is, how much did the company pay in previous
plan designs are, at best, “medium-term”
» Only 10% of all long-term
incentives have their disclosed longest performance period for named
officers greater than three years.
» Nearly a quarter of
companies have no long-term performance based awards, relying instead
stock options and time-based restricted stock in their long-term
» Fewer than 15% of long-term
plans include operating metrics such as innovation, new products,
customer loyalty, environment and employee engagement; which drive
future value creation.
» Nearly 60% of companies
changed their performance metrics for incentive design in 2013. The lack
of stability of performance metrics, as well as frequent changes in the
composition of the peer groups used for relative performance
benchmarking—one-third of companies changed 25% or more of their peer
group in 2013—further reinforces a short-term focus despite the
ostensible long-term nature of these incentive plans.
The short-term focus in most
companies is further reinforced by long-term incentive plans with the
longest performance period of three years or less.
A new performance lens
This report details how a
reliance on traditional accounting metrics obscures a line of sight to the
underlying drivers of current value and future value, which in turn drives
total shareholder return.
That said, there are, of course,
factors that executive teams can directly control and this report reveals
that across all industry sectors, there are leadership teams that are
forging ahead, consistently driving and building value creating growth and
enterprise value over a five- to ten-year performance cycle. What also
emerged from the analysis was a stark indication of the factors necessary
to drive sustainable shareholder value and economic value creation over
The report suggests that
companies have distinct life cycles characteristics. These life cycle
stages of development or value quadrants directly correlate to performance
and future prospects. Companies were segmented into four value quadrants:
» Only 35% of S&P 1500
companies generated both five-year positive relative TSR and five-year
(2008–2012) positive cumulative economic profit (ROIC exceeding cost of
» 18% of companies over five
years (2008-2012) had a negative relative TSR, while at the same time
achieving a positive cumulative five-year economic profit (ROIC
exceeding cost of capital).
» 17% of companies over five
years (2008-2012) had a positive relative TSR, but a negative five-year
cumulative economic profit (ROIC less than cost of capital).
» 30% of companies over five
years (2008-2012) had negative relative TSR and negative five-year
cumulative economic profit (ROIC less than cost of capital).
By utilizing this analytical
framework, or value quadrants, it is possible to identify consistently
negative economic performance. Conversely, it is possible to identify
value-creating growth and sustainable performance.
This framework is not industry
sector specific. Every sector had both challenged companies, and companies
whose leadership, strategy and execution allowed them to excel, as
evidenced by the dispersion in results. On average, the performance spread
between the 20th and 80th percentile for revenue growth was eleven times.
The ROIC performance spread between the 80th percentile and 20th
percentile was in the 300 to 400 basis point range. In other words, high
performers are high performers no matter the sector. The high performers
in almost every sector boasted both annual revenue growth greater than
15%, and also a ROIC greater than 15%.
» There is no single, silver
bullet performance measure. Traditional accounting metrics such as
EBITDA, earnings, and EPS have correlations to five-year shareholder
returns in the 29% to 38% range. By including sales, growth in NOPAT,
economic profit growth, and ROIC, the alignment between these operating
drivers and shareholder returns on average rises to the 45% to 48%
range, depending on the industry sector.
» Median future value,
as a percentage of enterprise value for the S&P 1500 has declined from
50% of enterprise value in 2001 to 27% in 2013. One reason may be that
research and development investment and net, new capital expenditure
investment, as a percentage of revenues, at the median, has also
declined from 2.9% at its peak in 1998, to 1.7% in 2012. This is a 41%
or 116 basis point decline in investment to create future enterprise
The full report is available
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