Key takeaways:

• The absence of a board approved TSR methodology leaves room for “liberal” interpretation and could get the company in hot water.
• A robust TSR methodology provides consistent, replicable results.
• The TSR calculation considers the averaging period at the start and end, dividend treatment and foreign currencies.
• The vesting calculation considers how the comparator group is defined, how percentile ranks are calculated, how delisted companies, M&A and suspensions are treated, the vesting scale and how rounding is applied.

The most common measure in long-term incentive (LTI) plans is relative total shareholder return (TSR). Absolute TSR measures are also used, albeit less frequently. The prevalence of these measures is due to investors and proxy advisers both demanding some portion of an executive’s long-term remuneration to be directly tied to shareholder value creation. As Nobel laureate Michael Jensen (with William Meckling in their “Theory of the Firm” article) argued, the duty of management is to maximise company value.

For their significant prevalence and material influence on remuneration outcomes, relative TSR methodologies are rarely transparent or well defined. Even internally, a lack of a set TSR methodology is commonly rationalised by the misconception that there is only one way to calculate TSR. This is wrong. There are multiple methodologies for calculating TSR vesting outcomes. We have observed even how decimal rounding methods seem to vary from one year to the next to get a company across the line for LTI vesting. Not only is this ethically dubious, we have also observed that one proxy adviser is inclined to question methods when vesting is borderline, casting aspersions that may damage a board’s credibility, as well as its remuneration report vote.

Hence, it is important to document a methodology that can be followed consistently and provides robust results that are replicable, irrespective of who is conducting the test or when.

This means leaving little to interpretation. Any “wiggle room” in a methodology allows for gaming of results to maximise outcomes. Additionally, a clearly documented TSR testing methodology goes some way to placate executives given that “thems the rules” that they signed up for at the beginning.

There are two main parts in TSR testing methodologies that require consideration:

• How TSR is calculated.
• How it is used to determine the vesting outcome.

TSR Calculation

TSR is driven by two components, share price appreciation and dividend yield. The general form is share price at the end of the performance period (adjusted for dividends paid and reinvested during the period) minus the share price at the start period, all divided by the share price at the start of the performance period.

There are some key considerations for the TSR calculation:

• Averaging:
  • Should the start and end share prices be averaged to minimise the effects of short-term volatility?
  • How long should the averaging period be?
  • Are the first and last days of the performance period included?
  • Should a simple average or a volume-weighted average price (VWAP) be used?
• Dividend treatment:
  • How are dividends incorporated?
  • Should dividends be included on a reinvested basis or summed up and accumulated on an absolute basis?
• Foreign currencies:
  • How are share prices and dividends in foreign currencies treated?
  • How is the calculation protected against FX changes?
  • Should the calculation consider variance in inflation rates in different currencies?

Vesting Calculation

Vesting calculations that determine how the TSR value generates a vesting outcome, generally takes one of two forms:

• Absolute TSR: where the company’s performance is measured against fixed growth targets; and
• Relative TSR: where the company’s performance is measured relative to peers, either on an index or bespoke peer group basis.

Focusing on the most common form, relative TSR against a peer group, there are additional considerations:

• Should the TSR calculation be applied the same way for both the company being tested and comparators?
  • The answer is almost always yes as this ensures a valid comparison of performance.
• How should the comparator group be defined so that it is replicable and fixed throughout the performance period?
  • If it is based on an index, the effective date at which constituents are taken to form the comparator group should be clear.
  • If a specific methodology is used to include and exclude comparators, this should be defined and the changes to the comparators over the period should be replicable.
  • If a bespoke peer group is used, it should be clearly communicated which companies comprise the group.
• How should percentile ranks be calculated?
  • There are nine methods of calculating percentile rank when positioning a company within a peer group. The chosen method must be clear.
• How should delisted companies, mergers and acquisitions, and suspensions be treated?
  • Companies that delist due to acquisition are typically excluded while companies delisting due to liquidation or insolvency usually have a TSR of -100%.
  • Companies that are suspended for a significant portion of the performance period are usually excluded.
  • Mergers between companies in the peer group usually don’t require any additional adjustments, but company demergers may need special treatment.
• What vesting scale applies and how is rounding applied?
  • ASX and FTSE market practice is 50% vesting for 50^th percentile TSR and 100% vesting at the 75^th percentile with straight-line interpolation in between. Australian proxy advisers and investors are opposed to vesting at lower performance levels.
  • US and Canadian listed companies generally have wider scales with threshold vesting starting as low as the 25^th percentile and maximum vesting at the 80^th or 90^th . A wider range helps motivate executives even during periods of market downturn. It also varies total remuneration with performance better than UK or Australian models, so that pay declines when performance is below median.
  • The rounding applied when calculating the vesting outcome and percentile rank should be consistent and defined.

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