For over two decades, many remuneration committees, their advisers, institutional investors and proxy advisers have accepted the myth that assessments of relative TSR performance are transparent.
They are not.
There is no independent source that publishes the percentile rank of a company’s TSR relative to a specified group of other companies. Relative TSR is only transparent if the detail of how it is calculated and assessed against peer companies is also comprehensively disclosed.
The absence of a questioning of relative TSR results appears to stem from the common belief that there is only one methodology to calculate and assess it. How could anyone make a mistake, or worse, manipulate the outcome?
The two main sources of variation are:
- The formula used to calculate TSR. This includes the definition of share price, the treatment of dividends and the date they are applied
- The percentile ranking process. This includes whether or not the company being assessed is included in the peer group and how many decimal points of accuracy are used for percentile rank (i.e. if the percentile rank is 49.5, is it rounded to 50, potentially triggering vesting?)
For some remuneration committees, this discovery has been a rude shock, because some of the rewards that have vested to executives should not have vested. They only discovered this lack of transparency after they commissioned independent testing. Good on them, for it seems no external stakeholder has yet questioned relative TSR results.
We have often found errors when we have been asked to independently audit a relative TSR outcome. While it is difficult to ever conclude that someone may have intentionally manipulated the outcome, we have observed that license has been taken in interpreting the method for calculating relative TSR outcomes.
This is the problem remuneration committees must face; that is, the absence of a relative TSR calculation methodology that can be subject to audit.
It is estimated that less than half of the ASX 300 companies have detailed the arithmetic formula and definitions in their LTI offer documents. Those that do have a formula, often still omit important details and definitions. Certainly, very few companies disclose the calculation method. In the past year we are only aware of one ASX 300 company that has the calculation method clearly disclosed in its annual report, while another has comprehensive disclosure on its website.
Some may ask how can a simple calculation that includes the gain in share price, adds dividends, and divides by the share price at the beginning be incorrect, or be gamed? There are numerous ways this can happen unless the exact calculation is prescribed in the relevant documents. For example, consider the following:
- is the beginning price averaged?
- Over what period?
- Before or after the start date?
- What about the peer companies’ start price?
- Is this averaged too?
- What about the end price?
- Is the average volume weighted (VWAP)?
- Is the VWAP method the average of daily VWAPs or the true VWAP?
- Are the dividends over the period simply summed? or
- Are they calculated as additional pro rated shares on a reinvested basis?
- When were they reinvested – on the ex-div date or date paid?
- What share price was used on this date – end price, start price, or VWAP?
- Was the same method applied to peers?
- Which of the 4 different percentile methods were used?
- Was the target company included or excluded for percentile purposes?
- How were peer companies treated if they were delisted?
- How were peer companies treated if they were suspended – or did this vary with the length or timing of the suspension (particularly at the start and end of the period)?
- How were peers treated when 2 or more peers merged?
- To how many decimal places is TSR calculated?
- Are decimals rounded down or rounded up?
- How do you treat dividends in a currency different to the share price?
- How do you finalise TSR for peer companies listed on different foreign exchanges?
While initially you may think these treatments would have an immaterial impact on the ranking, our analysis has shown significantly different outcomes.
In the absence of a clearly defined formula, whoever is doing the TSR calculations, is forced to make many assumptions. For an independent adviser, this introduces an element of judgement into a process that should be essentially quantitative. For management, it provides scope for error and conflict of interest.
Perhaps the simplest question a remuneration committee can ask is whether the relative TSR calculation is consistent with the method used in prior periods.
While we have yet to see an external stakeholder question the TSR outcome or calculate its own version, with the beefing up of institutional shareholder governance teams, it’s reasonable to expect this will soon happen.
To avoid the day when an external stakeholder embarrasses the board with their own calculation, and simply for the sake of good governance, here is a checklist for all remuneration committees:
1. Recognise that relative TSR that is not clearly defined is not transparent, and as such could be prone to error and/or different interpretations
2. Ensure each element of the relative TSR method is clearly defined in both words and arithmetic symbols
3. Include prescribed treatments for peer company suspensions, delistings and mergers
4. Be clear on rounding, because there will be instances where a decimal point can make the difference between an executive receiving something, nothing or less than expected
5. Be clear on dividend treatment
6. While averaging share prices may sound like a good approach to guard against windfall gains or losses, it is important to prescribe exactly how it is to be applied and apply it to peer companies as well
7. Ensure the formula is in each LTI offer document, or is at least referenced
8. Disclose the formula on the web site and/or in the notice of meeting for an executive director’s grant
9. Do not put management in a position where they have a conflict of interest by requesting them to provide the TSR results. An independent adviser provides both the board and management with the assurance that the TSR outcome is calculated objectively and with regard for the rules and formulae in the offer documents and plan rules. Importantly, an independent adviser provides the necessary level of governance over an increasingly sensitive aspect of executive remuneration© Guerdon Associates 2022 Back to all articles