Deferred share plans ditch 3 year performance measures for longer vesting in tune with business cycle
11/11/2019
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The UK’s “Purposeful Company” is a task force of leading business institutions that was established in 2015 with the support of the Bank of England. Their goal is to transform British business to create value by serving the needs of society.

Recently they released a paper which is having a significant influence on UK institutional acceptance of restricted share plans that have no, or minimal, performance requirements. These plans typically replace all, or part, of long term incentive plans. These plans have particular relevance to Australia, given the stock exchanges and economy’s heavy exposure to long term cyclical industries, such as mining and (dare we say it) banking.

The report by the Purposeful Company explores the potential and risks of using a deferred share plan. Deferred shares are where a company may provide long-term equity, be part of a deferred STI plan or restricted shares.

The report proposes that there is opportunity for a greater adoption of deferred shares. This follows investors advocating for simpler LTI plans and the Council of Institutional Investors in the US encouraging the use of deferred shares in its latest guidelines (see HERE, section 5.5b) and the initial work by the UK Investment Association (see HERE) . It is based on academic evidence, surveyed investors and companies and interviewed other market participants.

Currently, 19 companies in the FTSE 350 offer deferred shares as a replacement for other incentives. A higher level of investors and companies believe that offering deferred shares could be more effective for certain companies. They believe about 25% of companies would be better off adopting deferred shares over an LTI.

Based on the plans, restricted share grants have been discounted by about 50% while performance on grant (subject to a performance condition prior to grant) see discounts between 20%-33%. The reasoning for adopting such plans differs by the industry. Natural resource companies utilise these plans to help control for long term business cycle volatility. Retailers use it because rapid industry change makes it hard to set targets. Financial services employ these plans to encourage prudent risk taking over the long term. Over in the US, technology companies use it to support growth and innovation.

Adoption of deferred shares is also useful in companies that experience highly volatile results or consistent underperformance in their LTI vesting. Deferred shares remove the difficulty in setting and calibrating LTI measures and ensuring it reflects performance.

Academic evidence indicates deferred shares are likely to be a good alternative. A number of market participants also view long term deferred shares as an effective way to integrate ESG considerations into pay. However, studies show executives can take action on share price prior to vesting of LTIs which may undermine future value creation.

Survey respondents see the greater transparency and simplicity as a key benefit of the adoption. They would spend less time on evaluating the executive pay package and more time on the business. Removing incentive targets leads to executives making decisions and executing strategy without too much focus on specific metrics. It removes the volatility involved in LTI outcomes and difficulty in setting appropriate targets.

The main risk identified was the perceived payment for failure. The lack of pay variability has also been highlighted to cause issues in recruiting executives, attracting overly risk-averse executives and executives coasting and avoiding tough decisions. Companies are also hesitant to dip their toes into deferred shares because of perceived pushback and other unintended consequences.

It was commonly cited that the strategic rationale was the key to securing shareholder support. Companies believe that annual incentives with robust targets are needed while confidence is being developed in using deferred shares. Implementation reports get challenged by proxy advisors who judge policy through a conventional lens. In the UK ISS recommended against 40% of the current deferred share plans while Glass Lewis only went against 1 plan. Average votes in favour of the plans have been just under 90% when excluding the adverse votes from ISS. Engagements need to start early in the cycle to prevent being drowned out in reporting season.

Investors would like to see the idea of a deferred share considered within companies. Even if ultimately rejected, the analysis of its effects and outcomes should be part of the consideration towards the final plan. For a restricted share plan, investors would like to see a discount of at least 50% of the LTI plan but companies worry this may not attract the right profile of executive.

Wider package structuring would have to be implemented to maintain the variability in pay package. Increasing and accelerating executive investment would also ensure that there is sufficient skin in the game, especially if the total vesting would be less than usual. Otherwise, introducing a combination of options and deferred shares, there would be less value should the share price not meet the exercise price. However, research suggests options have been known to distort behaviour when approaching the exercise price or date. Granting the shares on previous performance could alleviate some of the concerns over a direct long-term equity grant.

You can read more about the Purposeful Company HERE and read the report HERE .

© Guerdon Associates 2021
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