Executive incentives in a falling market
12/11/2018
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It is likely that share markets will continue to correct as quantitative easing is reversed, and asset values regress. In addition, higher yield stocks (i.e. most of the ASX 200) will lose value relative to alternative assets that provide higher yields on a risk adjusted basis. Beyond this late cycle asset price adjustment is the prospect of the next stage when the economy enters a downturn.

This type of market typical in the late economic cycle stage presents a multitude of problems in setting appropriate executive incentive measures and targets over multi-year periods.

Here are some of the more common problems followed by a Check List of What to Do .

TSR gateways

There is a real prospect that over a 3-year period, a company may perform well relative to other companies, but have a total shareholder return that is negative.

Many large companies now require TSR to be positive before an LTI grant can vest. Even if companies do not have similar policies, it is unlikely they will receive investor and proxy adviser support if a grant vests and TSR is negative.

WACC

As interest rates and stock volatility increase, the weighted average cost of capital (WACC) will also increase. Incentives that vest based on returns relative to WACC will require higher absolute return performance for a reward to be realised. Low inflation limits the extent that price and revenue increases can recover high funding costs.

Asset rationalisation and losses

Businesses may look to “cash up” to be more resilient in the face of economic headwinds expected down the track, or take advantage of competitors more distressed at a future date. Any losses on asset disposals necessary to provide this cash will hit earnings, and incentives may not vest unless companies rely on an “underlying earnings” figure. However, skepticism about such measures among investors and proxy advisers mean they are likely to take issue with the measure and there may be other unintended consequences from excluding gains or losses on asset disposals from an earnings figure.

Lower incentive target re-sets

Depending on the nature of the company, a late economic cycle cycle will impact earnings in different ways. Companies that depend on offshore funding, such as Australia’s retail banks, or equity asset management returns, such as wealth managers and life insurers, will expect lower profits. Management incentives based on realistic budgets may see incentive payments for poorer profit performance and lower TSR. This will not be well received by proxy advisers and investors.

The purpose of incentives is to focus management on outcomes prioritised by the board in the interests of the company. This may not be the same as the interests of many of the company’s investors. In fact, as we have observed over the years, investors with a short term focus tend to be the difference between a remuneration strike or not (see HERE). Long term strategy, company sustainability and longer term shareholder returns count for little.

So what to do – a check list

Rely less on relative TSR. In suggesting this we know it is counter to the preference of the many investors who have their own incentives benchmarked against an index. But to align with the short term interests of fund managers is not the same as alignment with the long term beneficial owners who are members of a pension fund. To an extent this has been recognised by two of the three proxy advisers.

Introduce another measure. Reducing reliance on relative TSR implies a redistribution of weightings on other measures. More measures reduce risk for the company in that management does not overly focus on one outcome at the expense of others. It also reduces risk of management turnover in that there is a higher probability that something will vest. In addition, more measures probably represent a fuller and more valid picture of management performance than a single measure.

Respond by changing emphasis between growth and capital efficiency. Late economic cycles tend to favour growth over capital efficiency. Yields on equities become less attractive as alternative investments offer better risk adjusted returns. Hence boards may want to consider more emphasis on earnings growth measures, such as EPS growth. This does not mean capital efficiency measures should be ignored. These will come into their own as the cycle advances, economic growth slows, and interest rates decline again. However, there is probably some time to go before there needs to be a re-weighting to capital efficiency measures.

Consider changes to the reward vehicle. Market corrections and declining share markets do not favour options and share appreciation rights, although this depends on each company and where it is in its respective cycle. Late economic cycles tend to favour resources stocks (For example, see graph HERE). But board remuneration committees need to think ahead. In a year or two executive equity grants for resources companies may need to revert back to share rights and RSUs, in anticipation of the end of the 3-year performance period typical of resources stocks.

Consider changes to the reward framework. Higher levels of volatility typical of late economic cycles make it very difficult to forecast beyond 12 months. Setting financial targets to be achieved over a 3 year performance period becomes fraught. There are alternatives to the traditional STI and LTI combinations (see HERE) . But be aware that that this current AGM season has seen significant pushback from investors and proxy advisers against alternative frameworks.

In truth, it appears that many of the frameworks implemented by companies experiencing high no votes against remuneration are not ideally suited to the company’s strategy. Also, as noted previously (see HERE), companies struggling with poor performance are likely to face much more scrutiny when changing plans or bedding down recent plans.

In instances where an alternative is better fit for purpose, and communications and engagement are well timed and executed they will  stand a reasonable chance of being acceptable to external stakeholders on their merits.

© Guerdon Associates 2021
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