Shareholder value creation is the flag that virtually all company directors are saluting these days. The problem is that their allegiances often lie elsewhere. Managers are happily saying one thing about their corporate strategy and yet rewarding themselves for doing something quite different. Very often, they are effectively paying themselves to destroy shareholder value, not create it. Financial Director was given an exclusive first look at research conducted by consultancy Stern Stewart that shows how some of Britain’s leading companies are guilty of this two-faced approach to corporate strategy. Two executives from the firm’s London office, Phani Solomou and Fredrik Gustavsson, have discovered that, while 90% of companies in the FT-30 say in their annual report that they are committed to creating and maximising shareholder value, fewer than half – 47% – make it plain that they remunerate their board members in a way that actually encourages them to do so. “We find this alarming,” the authors say in their report, UK Remuneration Practices: Do UK incentives align managers with shareholders? “Most academics and investors consider alignment with shareholders as one of the most effective corporate governance mechanisms.” Without “naming names”, the researchers say that some of the country’s leading companies have short-term incentive schemes that use too many measures and, worse, measures that bear little or no relation to the creation of shareholder value. More than a third of them, in fact, use at least four to seven different performance measures. Moreover, some companies are using targets based on profit margins (which says nothing about volumes), sales growth (easy to conjure up with a badly planned acquisition), market share (which can be bought in a way that destroys shareholder value very quickly), Y2K-compliance (obviously not a long-term bonus measure) and growth in earnings per share (a measure that, statistically, bears almost zero correlation with shareholder value). Even “individual performance objectives” feature in the list of measures used by one or more FT-30 constituents. About a third of the companies use non-financial measures such as compliance with ethical guidelines or customer satisfaction. This is fine, argue the Stern Stewart pair, in situations where the particular measure is a good leading indicator of future financial performance. Customer satisfaction might be worth tracking, for instance, where sales are sufficiently lumpy and infrequent that sales levels themselves give inadequate feedback. They say, however, that such measures are often too vague and can easily wind up rewarding undesirable behaviour: “Managers should consider the trade-offs between the cost of improving customer satisfaction and the benefit in terms of volumes or prices.” Solomou and Gustavsson argue that, while eps growth and sales growth may be used by about a fifth of the companies surveyed (21% and 18% respectively), these are measures that encourage “over investment” with no regard to the returns generated by that investment, nor to the cost of the capital. Moreover, they criticise the use of accounting-based measures which, they claim, can result in managers making easy – but ultimately costly – cuts in research and development or marketing, because these items are expensed rather than capitalised. Only 7% of the sample state that they use measures such as return on capital employed or return on assets. Even then, they argue that such measures may result in managers declining to invest in projects that would have created shareholder value – by virtue of generating returns that exceed the cost of capital but which are below the company’s current average return – simply because to do so would lower the measure on which the management is being remunerated. One company bases annual bonuses on total shareholder returns (TSR) – share price performance plus dividends. Ideal? Not quite, say the Stern Stewart team. “Over multi-year periods, TSR is an excellent measure of performance for shareholders,” they say. The problem is that, as the basis for a short-term bonus scheme, it’s a “noisy” measure because of share price volatility over a single year. “Managers might be more concerned with investor relations than managing the business itself,” they say. Solomou and Gustavsson also found that all but one of the FT-30 use performance measures that are set or negotiated annually. “Such practice encourages the management of expectations rather than performance and the concealment of information about opportunities,” they argue. What this means is that, in principle, the managers of a declining business unit that manages to exceed lowly expectations is more likely to get rewarded than the managers of a fast-growing division that falls just short of ambitious targets. “Managers are not encouraged to ensure that actual performance is enhanced over time.” More obviously, perhaps, they say that focusing on the short term discourages managers from taking a long-term view: “Good ideas that have negative short-term impact and benefits in the future are penalised now and merely built into future budgets, taking away the reward to the manager. This creates conflicts and dilemmas.” This attitude, they insist, has had a real impact on the relatively low level of R&D spending in the UK compared with overseas companies. Solomou and Gustavsson also found that most FT-30 companies put caps on directors’ annual bonuses, set as a percentage of base salary. These ranged from 25% to 150% of basic pay; the average was around 60%. But they found no evidence that high bonus potential went with low salaries, or vice versa. The bottom threshold also means that it doesn’t matter much whether performance is poor or utterly dreadful: the bonus is foregone. And yet, in that situation, it makes sense for managers to make the performance look as bad as possible. What the hell? The bonus is shot to pieces anyway – perhaps by bringing forward next year’s expenditure, it will make next year look even better. The combined effect of such floors and ceilings is that excellent performance goes unrewarded, while dull performance might as well be horrible. The Stern Stewart pair call these cut-off levels the “Go golfing” point and the “Take a big bath” point. “By removing such caps and thresholds we allow managers to face more opportunity for upside and accountability for the downside,” they say. Indeed, Greg Milano, managing director of Stern Stewart Europe, argues in the foreword to the research that “the media should stop its harassment of so-called fat cats. With incentives that better align the interests of managers and owners, corporate governance would be greatly reinforced. If managers are paid more like entrepreneurs, UK companies will be more aggressive, innovative and competitive, while also being more sensitive to risk management.” Funnily enough, corporate governance – especially the Greenbury variety – was a direct reaction to the fat cat allegations being made in the media (particularly against utility bosses). And yet, the research suggests, the corporate governance debate has failed to address the issue properly. Solomou and Gustavsson say that “corporate governance committees and Stock Exchange listing rules have led to a ‘same plan applies to all’ situation” in which a suggested maximum immediately becomes the de facto minimum. Long-term incentive plans – L-tips – suffer many of the same short-comings as annual bonus schemes, particularly the use of inappropriate measures and targets such as eps growth. The good news is that more than half of the companies surveyed use share-based incentives where the shares are held in trust for perhaps three years – “This provides a strong retention incentive,” the researchers say. In other words, good managers are motivated to stick around. Just over a third of the FT-30 have share option schemes in place, while an additional 10% combine options with share schemes. As required by Greenbury, there are performance criteria to be met before options are granted. “Without a performance test, the option-holders would benefit from any increases in the share price, even if too small to provide an acceptable return,” say Solomou and Gustavsson. They found that 87% of companies with restricted share schemes use a total shareholder return test, while the remainder use eps-based measures. Only 29% of option-based schemes are geared to TSR, however, while 57% are eps-related and 14% unspecified. Disclosure, in fact, is one of the researchers’ bugbears. They consider that the level of disclosure about share options is simply inadequate to make an accurate assessment of the incentives on offer to managers. Option awards are aggregated to the point where it is sometimes impossible to determine whether share options are in-the-money, at-the-money or out-of-the-money. Moreover, they say, “It is unclear whether remuneration committees consider the most appropriate vehicle of attaining the desired wealth gearing – or whether they consider wealth gearing at all.” They warn, in fact, that there is a trend away from granting options in favour of shares: “This,” they say, “will lead to less innovation, less accountability and poorer performance over time.” Copies of the report are available from Anne Davis at Stern Stewart Europe, price £12.50. Tel: 0171 399 3650; e-mail: email@example.com.
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