How companies choose peer groups for relative TSR
07/11/2022
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Relative TSR is preferred as a long-term incentive (LTI) performance measure by most investors and some proxy advisors. However, TSR responds to market sentiment and can produce a “lottery-like” system that is not reflective of management actions (see HERE)

Peer group selection is an important component in determining how relative TSR as a performance measure:

  • Aligns outcomes with shareholders; and
  • Appropriately rewards value added by management.

A broad based market index (e.g. ASX 100 or 200 Index) provides greater alignment with outcomes for fund managers whose own performance are assessed based on returns relative to an index benchmark.

A sector-based index (e.g. ASX 200 Materials Index) or bespoke peer group aims to compare TSR performance relative to a group of companies that share similar operational risk factors with the intention to neutralise sector specific factors (e.g. commodity prices) outside of management’s control.

Summary of ASX 100 relative TSR peer group practice

Guerdon Associates researched LTI plan market practice on relative TSR peer groups used by ASX 100 companies.

The results are summarised as follows:

  • Among the 94 companies with LTI plans, 77 companies (82%) use a relative TSR measure.
  • The majority (62%) of companies use a broad-based market index, such as the ASX 100 Index, as their relative TSR peer group.
  • Among those with a broad-based peer group, 44% of companies adjust the broad-based market index constituents to exclude certain sectors or companies.
  • Thirteen of 77 companies with a relative TSR measure (17%) use two peer groups for relative TSR. The remaining companies use one peer group.
  • Among those with a relative TSR measure, 84% of companies use a percentile ranking method to assess relative performance.

ASX 100 LTIs Market Practice
Table 1 below summarises the number of ASX 100 companies with relative TSR measures in their LTI plans.

Table 1: Prevalence of Relative TSR in ASX 100 LTIs

 

Number of Companies

Companies with relative TSR measures in LTI

77

Companies without relative TSR measures in LTI

17

Companies without LTI plans

6

ASX 100 Total

100

 

Despite the many problems with a relative TSR measure (for example, see an archive article HERE), it remains the most popular performance measure used by 77 of the 94 (82%) ASX 100 companies with LTI plans.

Figure 1 below shows the type of relative TSR peer group used by ASX 100 companies in their LTI. Note the total peer group count is above the number of companies with relative TSR measures due to 13 companies using two peer groups.

Figure 1: Types of Relative TSR peer groups used in ASX 100 LTIs

The majority of ASX 100 companies use a broad-based peer group in the relative TSR measure. This is a puzzle. Broad based groups do not control for a common beta component in share price volatility. Hence assessing performance on this basis will not consider and neutralise the relative industry riskiness of the target company against peers. One proxy adviser is not supportive of broad based index groups, and 2 others wax and wane. Several institutional investors have guidelines that do not support broad based groups.

Yet, the data indicates that most companies persist with peer groups comprised of dissimilar companies subject to different market cycles, investor sentiment, and risk.

One alternative approach is to use a broad-based peer group, but adjust the peer group to exclude certain sectors or industries (e.g. ASX 100 Index excluding financials and resources). This approach recognises some sectors have unique operational risks, such as commodity price cycles, impacting stock prices from time to time.

Figure 2 below shows the proportion of ASX 100 companies which adjust their broad-based peer groups in this way.

Figure 2: Type of broad-based peer groups used in ASX 100 LTIs

Among the companies with a broad-based peer group, 44% of companies adjust broad-based peer group to exclude certain sectors or companies (e.g. ASX 100 Index excluding financials, energy and materials).

Another approach is to use multiple peer groups. Figure 3 below shows the proportion of ASX 100 companies with one or two relative TSR peer groups used.

Figure 3: Number of peer groups used in ASX 100 LTIs

Figure 4 below shows the mix of peer groups used by ASX 100 companies with two relative TSR peer groups in their LTIs.

Figure 4: Mix of peer groups used in ASX 100 LTIs among companies with two peer groups

Among the companies with a relative TSR measure, 17% used two peer groups to assess relative TSR vesting outcomes. Using multiple relative TSR peer groups can diversify both market and operational risk, increasing the probability of vesting for either peer group but increasing the difficulty of maximum vesting as the company needs to outperform both the overall market and sector peers.

Methods of TSR testing also vary. Table 2 below summarises the methodology used by ASX 100 companies to test relative TSR measures in their LTIs.

Table 2: ASX 100 LTI relative TSR testing methodology

Relative TSR testing methodology

Number of Peer Groups

Percentage

Percentile vesting scale

76

84%

Other vesting scale (e.g. Index + X%)

14

16%

Total

90

100%

 

Over two-thirds (84%) of peer groups are measured for relative TSR performance using a percentile ranking approach. While a percentile ranking method can be easy to “set and forget” (e.g. 50th to 75th percentile vesting), it increases complexity, requires a well-defined methodology (see HERE) and can be difficult to track performance without interim testing.

A vesting scale relative to the index return itself (e.g. Index + 20% TSR) is simpler and transparent, but may fail to accommodate other issues. For example, an index may include the return of the target company. Indices are also market weighted, so in effect it is a comparison with the TSR of the 2 or 3 largest companies, rather than all companies equally weighted.

© Guerdon Associates 2022
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