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Need to align management incentives with long term business performance instead of stock price

 

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Source: The Harvard Law School Forum on Corporate Governance and Financial Regulation, December 3, 2014 posting

Posted by Yaron Nili, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday December 3, 2014 at 9:02 am

Editor’s Note: 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 is available here.

 

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 company’s performance.

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 compensation,

» 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 2013

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.

Compensation alignment

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 time periods.

“Long-term” incentive 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 compensation plans.

» 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 longer-term.

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 capital).

» 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%.

Other observations

» 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 value.

The full report is available here.

 

 

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