Boards and remuneration experts have long acknowledged the temptation for executives to take actions that will not benefit shareholders’ long term interests but might be the difference between long term incentives vesting or not vesting and hence benefit executives in the short term.
Scepticism has surrounded reductions in research and development spend that lead to a temporary reduction in costs but potentially damage future prospects; announcing share buybacks that reduce the number of shares on issue and therefore improve earnings or other per share ratios; and initiating mergers or acquisitions that will increase the share price in the long term but might not serve to increase company value in the short term.
If these actions were being made for the good of the company and its shareholders, the research and development spend would have to be inefficient to justify a reduction; the company’s shares should be underpriced to justify the company’s decision to buy them back; and the planned merger or acquisition should also be underpriced such that an acquisition or merger would represent long term shareholder value.
Research has investigated whether executives are giving into the temptation to increase their short term vesting prospects at the risk of long term shareholder interests. One paper investigated the effect on investment of high levels of equity vesting in a given quarter, showing that higher levels of vesting equity in a particular quarter is correlated to reductions in investment.
More recent US research (see HERE) investigated share buybacks and mergers and acquisitions. The value of these events can be assessed by considering the buy and hold abnormal return after a buyback, which represents the return the organisation receives from conducting the event instead of continuing operations without.
The research investigated the level of equity vesting, actual repurchases, and mergers and acquisitions per quarter over the 2006 to 2015 period. It found that one standard deviation’s increase in vesting equity in a quarter increased the likelihood of a share buyback by 1.2% (with the base probability of a share buyback being 37.5%). The likelihood of a significant buyback (above the mean buyback) increased by 1.02% against a base probability of such buybacks being 20%.
For mergers and acquisitions, a one standard deviation increase in vesting equity resulted in a 0.6% higher probability of a merger or acquisition against a 15.8% unconditional probability of a merger or acquisition occurring.
Following both events, there was a higher return for the two quarters after the event, and then a lower return for the years after that, with the low return persisting for two years in the case of a share repurchase and four years in the case of a merger or acquisition.
A one standard deviation increase in vesting equity was associated with an annualised 0.61% higher return over the two quarters surrounding a repurchase, but a 1.11% and 0.75% lower return during the first and second year after the repurchase respectively.
For mergers and acquisitions, a one standard deviation increase in vesting equity was associated with an annualised 1.47% higher return over the two quarters surrounding an M&A announcement but a 0.81%, 0.35%, 0.72% and 0.62% lower return in the first, second, and third and fourth subsequent years.
The research controlled for other CEO incentives that might arise from unvested and already vested equity holdings, salary and bonuses. While vested equity was negatively correlated with the likelihood of repurchase and unvested equity was positively correlated, the research did not reach a conclusion on whether vested or unvested equity might have a mitigating effect on the likelihood of an executive conducting a share purchase or merger/acquisition, stating only that their likelihood of unvested equity exacerbating myopia depends on when it vests. For mergers and acquisition, unvested equity was significantly positively correlated with a merger/acquisition.
In theory, minimum shareholding policies and rolling annual grants of long term incentives such as are the norm in large Australian companies should act to reduce the likelihood of myopic share repurchases and mergers/acquisitions (depending on the change in control vesting policy and board discretion utilised in the latter case), but as the study is conducted with US companies that theory remains untested.
Interestingly, repurchases were more likely for CEOs on higher salaries and less likely for older CEOs. Looking at company metrics, repurchases were more likely for companies that were large, low value, less leveraged, more profitable and performing sluggishly in the share market. New CEOs were less likely to embark on mergers & acquisitions.
The upshot of the research is that concerns held by remuneration advisors and investors that executives might try and manipulate performance hurdle outcomes to improve the level of vesting equity were justified. There are a number of steps that boards could take to try and reduce the likelihood of such manipulation, including:
1. Adjust performance hurdles to exclude the effects of buybacks, mergers and acquisitions
2. Have a constant pipeline of vesting equity such that there is no more temptation for executives to manipulate results in any one year
3. Carefully monitor the reasons for mergers and acquisitions and share buybacks
4. Introduce minimum shareholding policies or escrow policies for vested equity
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