This past 18 months we have reviewed more long-term incentive plan TSR test outcomes and methods than we would have expected. We suspect that this increased interest in having an external provider review TSR test methods has had more than a little to do with companies having to cope with unusually poor results during the GFC.
While most companies have been using an acceptable methodology to calculate relative TSR, we could not endorse some of the TSR test practices we have encountered. Disgruntled executives can challenge poor methods, so it behoves board remuneration committees to ensure that relative TSR results are calculated on a rigorous and consistent basis. There is good reason for long term incentive (LTI) plan rules to leave methodology details up to the discretion of the board, but the board should specify the methodology (with technical input as required) rather than leaving it up to the firm conducting the testing to decide.
Guerdon Associates has developed the checklist set out below as a guide to good relative TSR calculation practice, with suggestions on the methodology to be used where appropriate. We suggest that the remuneration committee apply these, or explicit variations from these, to specify the method of TSR test to be consistently applied to your executives’ LTI hurdle assessment.
1. Define TSR
The standard definition that should be used in most plans is:
(Share price at end of the performance period less share price at start of the performance period plus dividends reinvested at the ex-dividend date share price) divided by share price at start of the performance period
But check on your own company’s method. The dividend reinvestment method can vary. Some calculate TSR with dividends reinvested in shares at the share price at the dividend payment date, while others re-invest the dividends in shares at the average share price for a specified days before the dividend payment date.
2. What is good for the goose…align the target company and peer group measurement periods
In some cases we discovered that the target company measured its performance from the grant date to the end of the financial year, and the TSR for the other companies from the start of the financial year to the end of the financial year.
For valid results, performance for the target and comparator companies must be measured over the same period. A danger with using the share price at grant date as the starting price for measuring TSR is that the actual grant date can vary for different participants in the LTI plan. Grants are often made to most plan participants soon after board approval is received, but with grants to executive directors made after shareholder approval has been received. The terms and conditions of grants, including the performance periods, should be the same for all participants.
Relative TSR can be calculated from any start date – it does not have to be calculated over financial years. The performance period should be clearly specified in the offer letter.
3. Test start value and end value: averaging the share price
Averaging the share price used in the TSR calculation reduces the impact that volatility on any particular day may skew relative TSR results. Most relative TSR plans state that the company’s share price value at the start and end of the performance period for working out TSR is an average. But some are silent on this matter in the offer documents and plan rules.
Averaging periods range from 5 to 180 days. We suggest that averaging over 30 days should suffice for companies with low share price volatility, while 60 days would be better for higher volatility companies.
For the greatest accuracy and most reliable results, the volume weighted average price (VWAP) over the selected period should be used. The average of the daily closing prices over the relevant period can also be used.
4. When do you apply the averaging?
The objective is to calculate performance over the performance period, so it makes sense to start from the average share price for the specified number of (trading) days up to and including the day prior to the start of the performance period and to end with the average share price for the same number of days up to and including the final day of the performance period.
A consistent approach should be taken from one performance period to the next.
5. Target company only?
Share price averaging should apply to both the target company and to each of the peer group companies.
We have seen a surprising number of cases in which the TSR calculations do not average the start and end share prices of the peer companies as well as the target company.
Make sure that you specify the rounding to be applied to the TSR results – the nearest whole number, or to two decimal places. Specifying it up front may save some pain in assessing results and vesting later.
7. Exclude the target company when ranking companies?
Practice varies on whether or not the target company is included when the comparator companies are ranked according to their TSR performance. Which approach is correct depends on how the vesting scale for the relative TSR test is described.
If the description is along the lines of “all rights will vest if Company X’s TSR over the performance period is at least equal to the TSR of the company which is at the 75th percentile of the comparator group of companies, ranked by their TSR performance”, then the target company should not be included in the ranking list. The target company’s TSR is then compared with the ranked comparator group companies to determine the vesting outcome.
But if the description is more like “all rights will vest if Company X’s TSR performance over the performance period is at least at the 75th percentile of the comparator group of companies plus Company X, ranked by their TSR performance”, then the target company should be included in the ranking list.
On balance, we think the second approach is a bit simpler.
8. Peer group definition
The composition of the comparator group must be precisely defined. If the peer group refers to the companies that comprise an ASX index group, the fact that the composition of an index may change every quarter means it is essential to specify that the comparator group consists of the companies that comprise the index at the start of the performance period. The composition of the comparator group will then remain fixed for the duration of the performance period.
9. Drop outs
Change is a constant among ASX-listed companies – it is not unusual to have a 25% churn rate in peer group companies during a 3-year performance period.
It is therefore important to specify what should happen if companies become delisted in a range of different circumstances. E.g. if they are acquired, merge, delisted because they are insolvent, de-merge, delisted during the performance period but are present at the start and end of the period, change name and ASX code, but are otherwise the same. These and other events have all happened before, and your TSR test supplier should be able to advise on how each should be treated and standardised into the method.
It is remarkable that some definitions of re-testing are lacking. What is re-tested? Does it only apply if nothing vested at the 1st test? Or does it apply to the unvested amount from the 1st test to the next test? If the latter, do the unvested amounts vest only if the re-test level is above the level attained n the prior test?
Any provision for re-testing needs to be carefully defined. The performance period for the re-testing, the test to be applied and the interests to which re-testing is to apply must all be clearly set out.© Guerdon Associates 2023 Back to all articles