- January 30, 2019
Update on the changes announced in the Budget to the rules for entrepreneurs’ relief and their impact on employee incentives
In the Autumn Budget, the Chancellor had announced that the definition of ‘personal company’ for the purposes of ‘entrepreneurs’ relief’ for capital gains tax purposes would be tightened so that, with effect from 29 October 2018, a company will qualify as a ‘personal company’ only if, in addition to the existing requirements relating to share capital and voting rights, the individual is also beneficially entitled to at least:
• 5% of the company’s distributable profits, and
• 5% of its assets available for distribution to equity holders on a winding up.
Amendment to the proposed definition of ‘personal company’ in the Report Stage
In the Report Stage in the House of Commons, an amendment was made to the definition of ‘personal company’, effectively relaxing the requirements proposed in the Autumn Budget (see above).
The amendment would enable an individual to qualify for entrepreneurs’ relief on disposal of shares on or after 29 October 2018 if, in addition to the existing requirements relating to share capital and voting rights, the individual is beneficially entitled to either (or both) of the following:
• 5% of the company’s distributable profits and, on a winding up, 5% of its assets available for distribution to equity holders;
• 5% of proceeds in the event of a disposal of the whole of the company’s ordinary share capital (“5% Proceeds Test”).
For the purposes of determining whether the 5% Proceeds Test is met, the following three assumptions apply:
• the whole of the ordinary share capital is disposed of for market value consideration
• the individual’s share is what the individual would be beneficially entitled to at that time
• the effect of any tax avoidance arrangements would be disregarded.
How does this change affect employee incentives?
The position of EMI Option holders, including holders of EMI Options over ‘growth shares’, remains the same as before i.e. EMI Option holders continue to enjoy the benefits of entrepreneurs’ relief on the disposal of their qualifying shares.
In respect of other employee shareholders, for example, holders of ‘growth shares’ (holding 5% of the issued share capital with voting rights), while the amendment is certainly a relaxation on the changes to the rules originally announced in the Autumn Budget, most such employee shareholders are unlikely to benefit from it.
- January 24, 2019
Executive Director Pensions and Post-Employment Shareholding
Our December e-news described the new Investment Association (IA) Remuneration Principles published on 22 November 2018. On 23 January 2019, the IA announced the specific approaches which IVIS will take at AGMs in 2019 on two of its new requirements: Executive Director Pensions and Post-Employment Shareholding Periods. These apply to companies with year ends on or after 31 December 2018.
Executive Director Pensions
The new Principles recommend that pension contribution rates for executives should be aligned with those available to the rest of the workforce. The IA has announced that, to avoid a “Red top” header:
• New Remuneration Policies seeking shareholder approval in 2019 should make it explicit that any new appointees will have their pension contributions set in line with those provided to the majority of the workforce; and
• New appointees from 1 March 2019 must not have pension contributions at a higher level than a majority of the workforce.
Resolutions to approve Remuneration Policies and Remuneration Reports will be “Amber topped” if an existing Executive Director receives a pension contribution of 25% of salary or more.
Companies are asked to disclose the pension contribution level which they consider to be available to the majority of the workforce and to confirm whether or not contributions to Executive Directors are at that level.
The new Principles recommend that companies should require Directors to continue to meet shareholding requirements for a period of at least two years after their employment ends. The number of shares to be held should be not less than the lower of the company’s shareholding requirement in force immediately before leaving and the Director’s actual shareholding at that time.
The IA has announced that if there is a Remuneration Policy vote this year it should include post-employment holding periods in line with these new Principles; otherwise the Policy will be “Amber topped”.
A “Red top” header in IVIS reports shows the strongest level of concern. An “Amber top” header raises awareness to particular elements of a report.
Contact Mike Landon or your usual MM&K contact for more information on 020 7283 7200.
- January 22, 2019
New Financial Reporting Lab report on Performance Metrics – what Remuneration Committees should take away
The Financial Reporting Lab was launched in 2011 to provide an environment where investors and companies can come together to develop pragmatic solutions to today’s reporting needs. The Lab has worked with 65 different companies, 60 investment organisations and over 300 retail investors to bring insight and understanding to a number of key areas of disclosure.
At the beginning of 2018, it launched a project to look at the investor’s perspective of performance metrics. In June, it published a brief report carrying guidance for companies about the way their reports can best serve the needs of investors. In November 2018, it produced a fuller report, Performance metrics – Principles and practice, which contains examples of good practice for various aspects of reporting.
The Lab identifies five principles for reporting, designed to consolidate the views of a range of investors. The findings are of high importance for the choice and application of metrics for management incentive plans and the linkage of the Annual Remuneration Report to the company’s Strategic Report. MM&K has studied the Lab’s findings carefully in order to provide guidance to remuneration committees.
Principle One: Aligned to Strategy
Understanding how the management and board measure the success of its strategy is crucial for shareholders. Performance measures, especially in terms of management incentive plans, provide insight into the company’s business model, strategy, and the potential for creating long-term value.
“Many investors expect a clear link between the metrics used by management to monitor and manage performance and remuneration. Some investors expressed more scepticism about the application of wider metrics on remuneration, as they felt that the boundaries and reliability could be less clear, giving an impression that these could be more easily managed”.
The Lab gives two examples of companies explaining the link between KPIs and remuneration. Great Portland Estates plc present their KPIs with an ‘alignment with remuneration’ narrative, explaining links to annual bonuses and long-term incentives. InterContinental Hotels Group use symbols to identify the link between their KPIs and long-term and annual remuneration.
RemCos should ask themselves:
• Is there a clear link between the metrics that drive our business model and strategy and our remuneration policy?
• Further, do our management incentive plans’ performance metrics clearly link to our company’s strategy and value drivers?
Principle Two: Transparent
“Transparency” is considered a key principle, which adds to understanding and builds credibility. Understanding how metrics are calculated and defined, and clear explanations of why metrics are used and reported, are key to the transparency of a metric.
“There is a range of views about the use of metrics for remuneration that have been further adjusted from the KPIs and metrics reported elsewhere. There is a view among some investors that such adjustments are not appropriate. Other investors are more accepting of ‘adjusted adjusted’ metrics, as they consider that they can help them more accurately assess the value added by the current executives”.
The Lab urges companies to “provide full explanations and justifications for the metrics used to determine remuneration outcomes, particularly where these have been adjusted from metrics disclosed elsewhere”. In terms of management incentive plans, this is essential. If shareholders cannot understand or trust a performance metric, then they cannot use it to reliably assess potential long term value.
RemCos should ask themselves:
• Is it clear to shareholders why management incentive plans’ performance metrics are used and how they drive the company’s strategy?
• Are we transparent about the way in which our metrics are calculated and defined?
Principle Three: In Context
Information that is presented in context allows for an understanding of the positioning of a company. This information could relate to the context of the performance achieved, the context of the company in the market, or some other context-setting which aids an understanding of the company and its prospects.
“Providing information on a company’s aims builds credibility and can help create alignment and understanding of incentives, provided that they do not encourage management to short-term targets. Ranges or longer-term objectives are well received where specific numbers might prove commercially sensitive or difficult to determine”.
The Lab advises that where companies feel they cannot disclose specific targets they may be able to provide ranges and longer-term targets. An example shows Halma plc presenting current targets, a graphical illustration of the past five years performance, and the link to remuneration. Another example comes from Anglo American; they provide information about progress towards their targets.
RemCos should ask themselves:
• Do we explain performance measures in relation to targets and what we actually achieved? Is the reasoning behind incentive plan pay-outs sufficiently explained?
• Do we explain what performance our metrics are trying to achieve in the future, and provide an understanding of our overall long-term objectives?
Principle Four: Reliable
The Lab’s fourth principle, “Reliable”, relates to trustworthiness and credibility. It is about understanding which metrics are used, how they are put together and who has oversight over the process.
Some companies report that strong oversight processes over externally reported information could prevent them from reporting other information that could potentially be of use to investors. The Lab takes the view that just because information is not audited does not mean it is not of interest. Instead of omitting them, explaining the levels of scrutiny to which metrics have been subjected is valuable. Rentokil Initial plc is given as an example, they disclose internal employee engagement scores alongside relevant external metrics from Glassdoor.
RemCos should ask themselves:
• Do we provide an overview of how our management incentive plans’ performance metrics have been developed and monitored to allow investors to assess their reliability?
• Do we outline where we have had oversight and/or considered the appropriateness of metrics or adjustments relating to management incentive plans?
• Do we explain what additional scrutiny may be given to adjusted metrics being used in remuneration?
Principle Five: Consistent
“Consistent” metrics and messaging builds credibility over time. Comparisons with industry benchmarks or standards can allow assessment against a consistent base and help companies present their performance in context. Companies note that certain sectors lend themselves more easily to standardisation and comparison. However, the desire for standardisation may raise a tension for companies that are seeking to tell their story.
Some companies use benchmarks in response to the challenge of comparability. Derwent London plc is provided as an example; they illustrate five-year performance against an industry benchmark. Another, Great Portland Estates plc, also include five years’ worth of data against relevant benchmarks each year.
RemCos should ask themselves:
• Are our performance metrics relating to management incentive plans, especially long term incentive plans, consistent year-on-year? If our metrics have changed, do we provide a clear explanation as to why the change has been made and why the new metric is better? Do we provide comparatives for a number of years?
• Is a track record of performance measures provided? If not, would including one help to justify and explain executive pay to shareholders?
• Are our performance metrics consistent with an industry standard or our close competitors? If not, do we explain why our metrics are more appropriate?
Identifying appropriate performance measures and setting targets for executive incentive plans is essential for a company with ambitious goals. MM&K have extensive experience advising on and designing incentive plans and their performance measures. If you would like to discuss these issues and what they mean for your company, please contact Harry McCreddie
- January 10, 2019
The 5th Annual GECN Conference in Sydney – “MM&K continues to develop its global reach”
Between 4th and 7th January, Paul Norris and Nigel Mills attended the fifth Annual Conference of the Global Governance and Executive Compensation Group (“GECN”) in Sydney.
The GECN is a group of independent firms, whose logos appear below, specialising in advising corporate clients on executive compensation and good governance. GECN member firms have offices in London, Geneva, Zurich, Kiev, Singapore, Melbourne, Sydney, Los Angeles and New York. MM&K has been the UK member firm since 2015.
It is consistent with good corporate governance principles for remuneration committees to have access to high quality independent advice on executive pay. Increasingly, clients need advice which combines best in class local know-how and a deep understanding of policies and practice on a global scale, so a core theme of this year’s conference was how GECN member firms can work even more effectively together to serve this need.
A practical example of GECN’s ability to present a global perspective was the lunch organised by our Australian member, Guerdon Associates, with one of Australia’s largest investment banks, which also has a significant global presence. MM&K advises the bank’s alternative investment arm in London. The lunch was attended by the bank’s Chairman, CEO, Remuneration Committee Chair, Committee members and Global Head of HR. During lunch, GECN members (who, in addition to Guerdon and MM&K, included Farient Advisors, from the USA and HCM, from Switzerland) were able to recount their first-hand experiences of advising other global banking entities in the world’s financial centres on dealing with challenges similar to those confronting our hosts, whose feedback clearly indicates that they found the discussion stimulating and helpful.
Collectively, the GECN gathers and analyses a large amount of data. Swiss member firm, HCM, has established a data collection and analysis centre in Kiev. Recognising the importance of data and its role in providing clients with intelligence and independent advice, conference spent some time considering how best to harness GECN’s collective resources to provide clients with relevant data, intelligence derived from that data and sound, independent advice.
Conference also considered important external issues concerning executive pay and good governance. Ms Pru Bennet, who heads BlackRock’s governance and voting for all Asia Pacific, gave a presentation and answered questions on the challenges and potential in China. Ms Bennet’s colleague, Ms Flora Wang, who has specific responsibility for the People’s Republic of China and Hong Kong, attended by phone to contribute some specific local knowledge. This was a most informative session, which added to our global font of knowledge.
Conference was not all work over a long weekend. It was summer in Sydney (a welcome change from winter in London!) and conference organiser, Guerdon Associates, made sure we had opportunities to enjoy both Sydney’s hospitality and its culture. Next year’s conference moves back to Europe, where it will be hosted by our Swiss member firm, HCM.
- January 3, 2019
Wishing all our clients a successful and prosperous 2019
Regardless of what happens concerning the UK’s continuing relationship with the rest of Europe as the PM seeks to re-open negotiations, life will continue, decisions will have to be taken, strategies formulated and business plans executed. It’s going to be a busy year. News of potentially the biggest ever gas discovery in the North Sea is good news for the energy sector and the jobs of those who depend on it – albeit amid warnings from environment groups that it is bad news for the climate.
The climate for executive remuneration is also changeable. The forthcoming AGM season promises to be lively. Numbers of listed companies will be submitting their future remuneration policies to a binding shareholder vote after a year which has seen the heat turned up on disclosures, executive pay levels and remuneration committee members, many of whom work diligently within a solid governance framework to ensure their remuneration policies are genuinely fit for purpose.
Remuneration Committee Chairs and committee members will need to prepare thoroughly for this year’s AGM season. A particular challenge will be the edict from the Investment Association that the pension contribution rate for executives must be aligned with the contribution rate for the majority of the workforce. This is the subject of an article in this Newsletter by my colleague, Mike Landon.
Last year, changes were made to the Directors’ Remuneration Reporting Regulations to strengthen the disclosure requirements required by law. The changes come into force for financial year-ends on and after 1 January 2019, which means that most companies will not be required to comply until 2020. However, numbers of companies are taking the opportunity of a dry run in this year’s Directors’ Remuneration Report, which will give them an opportunity to test the waters and to ensure that they are fully prepared for their reports in 2020.
Finally, MM&K has always advocated that remuneration policies and incentive plans in particular, should be designed to meet the specific requirements, business strategy, culture and philosophy of the company. A solid governance framework is essential to provide necessary checks, balances and disciplines but remuneration strategies work best if they are tailor-made.
Current code provisions and investor guidance appear to support this view but attempts by some companies to introduce plans which do not adhere to the norm have failed. There may have been good reason for this. I hope, however, that remuneration committees will not be deterred from adopting policies and plans which are demonstrably fit for the purposes of the businesses whose interests they serve – but which may not conform to a standard template. This will be a challenge for those who chair remuneration committees, who face both internal and external pressures and who must balance the interests of all stakeholders in the business.
- December 18, 2018
Launch of the Wates Principles for large private companies
As we have already mentioned in our “Executive Remuneration Landscape” article, which was published in our September e-newsletter, 2018 has been one of the most eventful years in terms of remuneration governance in the UK.
Earlier this year we saw the publication of the 2018 UK Corporate Governance Code, which is applicable to all companies with a premium listing on the London Stock Exchange and states general corporate governance principles for them to comply with.
Now, as we reach the end of the year, the Wates Principles for large private companies have been launched for companies to adopt for financial years starting on or after 1 January 2019. This new requirement applies to companies that have either or both of the following characteristics, and will cover about 1,700 private businesses:
• more than 2,000 employees;
• a turnover of more than £200m, and a balance sheet of more than £2bn.
The companies that adopt the Wates Principles as a suitable framework are expected to apply them fully and provide a supporting statement explaining how the Principles have been applied to create good corporate governance.
Ahead of the Launch of the Principles, the FRC organised a consultation, which closed on the 7 September 2018. As a result of this, we can see that a lot of respondents support the initiative; however, some expressed a concern about the ambiguity of the Principles.
We, in MM&K, support the initiative of the Wates Principles; the proposed Principles are short, logical points that map out the way towards a transparent corporate governance practice. The companies that apply the Principles will be able to develop/improve all aspects of their corporate governance. We also think that application of the Principles will generate a positive change in the relationship with stakeholders.
Without a doubt, the “BHS scandal” was a trigger to the formalisation of corporate governance practices in the UK for private companies. It is unlikely that the Principles would have prevented the scandal from happening; however, there is hope that it would have made the board aware of the damaging effect of their actions for other stakeholders. And this is one of the purposes behind the Principles – to bring awareness into the boardroom.
An especially remarkable aspect of the Principles, in MM&K’s view, is their “apply and explain” nature. It highlights the point that one size doesn’t fit all. Private companies have an opportunity to apply the Wates Principles the way they see fit. The freedom of interpretation makes the Principles appealing for a larger number of companies.
On 12 December, the FRC held a launch event for the Wates Principles, which yet again affirmed that the Principles are welcomed by the attendees, as many large businesses already have similar corporate governance policies in place; the Principles are viewed as a guideline to consistent reporting practice. The discussion panel saw additional value created for companies that adopt the Principles, and view it as a competitive advantage.
One of the points raised, as a part of a discussion at the launch even, was an adoption of a “Name and Fame” practice for monitoring purposes by the FRC. As a result, the FRC hopes to provide an illustrative guide on the good examples of the Principles’ adoption or of good corporate governance in general.
The Wates Principles were not designed for companies to “tick the boxes”, but to provide guidance towards a healthy corporate governance environment. The Principles are designed to help companies of all sizes and types to understand the good leadership and performance essential for a successful business.
For further information contact Margarita Skripina.
- December 18, 2018
The Investment Association’s new principles of remuneration for 2019
These changes to the IA guidelines have been made against the backdrop of the new remuneration provisions in the UK Corporate Governance Code and the changes to the reporting of directors’ remuneration which is due to come into force for accounting periods beginning on or after 1 January 2019.
However, it appears that many of these principles are aimed at reducing the risk of “excessive” pay or increasing the justifiability of pay.
Main areas in respect of the principles of remuneration
The main policy areas for the new principles are as follows:
Levels of Remuneration
It was noted that levels of remuneration must reflect corporate performance and pay should be no more than necessary and linked to long term value creation.
The remuneration committee should seek points of reference against which appropriateness and quantum of pay is judged. Useful reference points are:
• prescribed policy that links remuneration to overall corporate performance
• the remuneration policy of the company as a whole
• fairly constructed peer universe
• remuneration paid to groups of employees including the median, upper and lower quartile through the use of pay ratios
The IA observed that the discretion of the remuneration committee can assist in ensuring that executive pay schemes properly reflect overall corporate performance and value creation. It also observed that payment of variable remuneration to executive directors should be discouraged even if specific targets are met where the business suffers a negative effect and in such circumstances shareholders should be consulted.
The IA recommends that:
• the remuneration committee should be accountable for the way in which discretion is used and should have sufficient legal power to exercise discretion
• discretion should be used diligently, aligned with shareholders’ interest
• discretion to be exercised within policy boundaries
• use of discretion should be clearly disclosed
Pay for Employees below Board Level
The IA recommended that:
• the remuneration committee should have a role in pay for senior management and review workforce remuneration especially where the levels of pay or the risks associated with the activities are material to the overall performance
• the remuneration committee should fully explain why the pay figures are appropriate where they are reported and disclose any action necessary to rectify issues
IA expressed its concern that shareholder consultation is being used as a validation of decisions taken by the remuneration committee rather than taking and understanding shareholders’ views.
IA recommends that:
• consultation needs to focus on major strategic remuneration issues
• details of whole remuneration structure should be put forward so that the investors are provided with a full picture and sufficient information so that they can make an informed voting decision
• shareholders’ feedback and response should be listened to by companies
• remuneration committee should understand the voting policies of the shareholders
• after the end of the consultation process and before finalising details in the remuneration report, the remuneration committee should review policies taking into account subsequent events occurring in between so that the proposal remain appropriate
Malus and clawback
The IA observed that the current standard trigger events (gross conduct or misstatement of results) for malus and clawback are rarely used in practice. Moreover, even if a trigger occurs, it is difficult to relate the same to an individual director. It therefore recommends a significant strengthening of these provisions.
The new principles recommend that:
• a “more substantial” list of specific circumstances should be established when malus and clawback could apply and they should also be disclosed to the shareholders
• the malus and clawback terms are set out clearly and accepted by the executive (executives should sign a form of acceptance at the time of the award)
• LTIP rules, allied documentation and communications materials are consistent in relation to the scope and application of malus and clawback provisions
• remuneration committees should develop clear processes for assessing whether malus or clawback is triggered and how and when they will exercise a discretion to apply the such provision; the process and decision must be clearly documented
The new principles include a recommendation that:
• executive directors and senior executives should build up a significant shareholding
• executives are encouraged to purchase shares out of their own resources to align their interests with the other shareholders
• remuneration committees should set out minimum shareholding levels and the time period in which to reach them for executives and also the consequences for non-compliance
• shares only count towards an executive’s shareholding if vesting is not subject to any further performance conditions; unvested shares not subject to performance conditions can count on a net of tax basis; vested shares subject to a holding period or clawback count towards the shareholding requirement
• shareholding used in hedging arrangements or as collateral for loans should be fully disclosed
The new principles include a recommendation that:
• companies should set up post-termination shareholding requirement for a period of at least two years and at a level equal to the lower of the company’s shareholding requirement in force immediately before leaving or the executive’s actual shareholding on leaving
• remuneration committee should determine the structure and processes (which might involve using an employee benefit trust or nominee arrangements) to ensure compliance with the post-employment shareholding requirement
• the post-termination shareholding requirement should be introduced for all new and existing executive directors as soon as possible and by the next remuneration policy vote at the latest.
The new principles include a recommendation that:
• pension contribution rates for executives should be aligned with those available to the majority of the workforce
• new executive directors and directors whose roles are being changed should be appointed on the new pension contribution level
• contribution rates for existing directors should be reduced over time to comply with this requirement. Clearly this reduction cannot be made without the agreement of the director concerned
Restricted Share Awards
Restricted shares (in the UK) are awards of shares (or nil cost options) which vest to the relevant director based on time only and not according to main performance conditions. The new principles include detailed recommendation on the awards of restricted shares, including:
• restricted share awards may be appropriate depending on the sector and situations such as turnaround situations; they should be assessed on a case-by-case basis, considering the context and the strategic rationale
• remuneration committees should have the ability to exercise discretion on vesting outcomes to ensure there is an appropriate connection between pay and performance and non-payment on failure; some investors have expressed a preference for a quantitative underpinning condition to be achieved prior to vesting
• vesting periods for restricted share awards should be at least five years; in addition, the post-employment shareholding rules should also apply
• if there is a proposal to switch to restricted share awards, investors will consider the company’s previous approach to remuneration, comparing the proposed award levels, performance and vesting criteria with previous award levels and performance conditions
• if the company moves from an LTIP to a restricted share awards, the remuneration committee should consider the appropriate discount to award levels; the discount should be at least 50% and grant levels should be held without gradual increase.
A new ‘leaver provision’ has been added with a recommendation that:
• individuals who are not ‘good leavers’ should be regarded as ‘bad leavers’; in other words there should not be any ‘intermediate leaver’ category
• for ‘good leavers’, only a portion of the award may vest based on time in service and achievement of the original performance conditions; however, if the award needs to vest early, for example on death, awards should vest by reference to performance criteria achieved over the shorter period
• deferred bonus and LTIP awards should continue to be satisfied in shares and subject to appropriate performance conditions
• appropriate mitigation clauses should be included in awards to deal with individuals retiring as a good leaver to take up further executive roles
- December 13, 2018
MM&K Annual Survey shows positive trends for Venture Capital Firms but a slowdown for Private Equity Firms
MM&K has published its 2018 PE/VC Compensation Report. The Report, published annually, provides participating houses with comprehensive and incisive up-to-date information and data on both the quantum and structure of remuneration paid to individuals working in and for PE & VC fund management entities in the UK and continental Europe.
The outlook for 2018 is now becoming clearer and in terms of deal activity, the statistics show a rather mixed picture.
European Private Equity (“PE”) activity, as measured by deal count, declined throughout the first three quarters of 2018. At the end of Q3, annual deal flow throughout Europe is showing a 15% decrease in the number of deals compared to the same period in 2017. Deal Value is also down by some 15%, suggesting perhaps that the uncertainty over Brexit is having an effect.
In contrast to PE, the Venture Capital (“VC”) industry appears to be booming with European VCs deploying capital at a record pace. However, the number of deals is slightly down on the same period as last year.
Looking at exits, it appears that there has been a 24% decrease in the number of PE exits in the first three quarters compared to the same period last year. This is in contrast to Venture, which has seen European exit activity at a four year high. The value of VC exits in the first nine months has exceeded their value in the whole of 2017.
But on another downbeat note for PE, LPs have so far committed €56bn to European funds that closed in the first nine months of the year, a noticeable decrease in committed capital compared to the same time period last year.
What all this will mean for PE and VC compensation next year is difficult to predict, although it suggests that the VC community will for once be seeing better rewards (relatively) than the PE houses. We would expect though that the industry’s focus on ensuring that the middle ranking investment roles are well rewarded (and therefore able to be retained within their current firms), will continue.
Whether these trends will affect the remuneration structures of both VC and PE portfolio companies, is another question…
- December 5, 2018
New Investor Remuneration Guidelines
As we move into 2019, the investor institutions and proxy agencies have been busy, producing their revised remuneration guidelines. After a very active year in corporate governance there are, not surprisingly, a lot of changes.
Starting with Glass Lewis: this major voting advisory agency has just issued its 2019 Proxy Guidelines specifically for the UK . It is really worth reading, not least because the document provides the best summary we have seen of all the UK corporate governance regulations and other initiatives from 2018, put together in one place.
Their new guidelines focus particularly on the capability and evaluation of the board and its committees and the guidelines on remuneration itself are generally modest. One curious rule is that target bonuses should not exceed 50% of the bonus maximum. MM&K considers that that this is misguided. The right relationship between the maximum bonus and the on-target bonus is not a matter to be dictated by rules. It depends on the dynamics of the business, the extent to which out-performance is possible or likely and the sensitivity of forecasting. There are businesses where target and maximum should be the same and others where 50% is fully justifiable.
On 22 November, The Investment Association (IA) issued its new Principles of Remuneration, with a letter to Remuneration Committee Chairs from Andrew Ninian, its Director of Stewardship and Corporate Governance.
The new principles generally tighten up remuneration governance along the lines that the IA has been advocating since its Working Group reported in July 2016. The circumstances and requirements for describing Malus and Clawback have been clarified further; further guidelines around the use of restricted shares have been introduced; and tougher requirements for directors’ shareholding are stipulated, including the need for a post-retirement shareholding period of at least two years.
It is clear that the IA sees reduction in the levels of executive remuneration as a legitimate goal. For example, it mandates that, as soon as it is achievable within the limits of existing contracts, directors’ pension contributions should be aligned with those available to the workforce. This rule, of course, is there to meet the requirement of Provision 38 in the 2018 UK Corporate Governance Code which comes into force from 1 January. But it is also evident that IA members are coming under pressure from their clients to keep a ceiling on pay in “issuing companies” and curbing pensions is a gesture in this direction as well as appearing to be a move to reduce the gap between executive and general employee remuneration. The IA press release says that “investors will expect companies to pay pension contributions to Directors in line with the rate given to the majority of the rest of the workforce, rather than giving higher payments as a mechanism for increasing total remuneration.” In fact, the level of directors’ contribution has never been used as such a mechanism. It has its roots in history, when all directors were on final salary schemes and the level of contribution was dictated by much higher final salary directors earned. The DC contributions have been coming down over time as they could never be sustained at a level to match the old DB benefits. In any case, it is all rather academic as the HMRC Annual Allowance reduction of contributions to £10,000 a year means that most executives will receive cash in lieu and over time we expect that to become part of salary.
The IA is turning up the gas on corporate governance compliance. On 5 December it wrote to 32 companies in the FTSE All-Share which have appeared on the Public Register for both years. The letter expresses concern that these companies are on the Public Register for the exact same resolution in 2017 and 2018, suggesting that they did not respond sufficiently to investor views and in doing so are risking more shareholder dissent in the future. 15 of these are for Remuneration Report resolutions.
JD Ghosh will be writing a fuller article on the new IA guidelines for our December Newsletter. Click here to subscribe to our monthly e-newsletter.
The new IA guidelines are reflected in new house guidelines from Legal and General Investment Managers (LGIM), who updated their Principles on Executive Remuneration on 28 November.
The largest proxy agency, ISS, updated its 2019 Proxy Voting Guidelines for Europe, the Middle East and Africa on 19 November. Changes include the criteria for voting down a director and a requirement for remuneration committees to develop a formal policy for post employment shareholding. Like Glass Lewis, they say that the target bonus should typically be set at no more than 50% of the maximum bonus potential, with a demand for a robust explanation for any payments above target. The intention behind this is to stop excessive payments for mediocre performance. But we consider it is a blunt instrument.
ISS have sharpened up the guidelines on LTIP performance measurement and shareholding periods. They encourage performance periods longer than three years and a total holding period of five years. They suggest that on-target vesting for LTIPs should be less than 25% if the total grant is a large multiple of salary.
If a company’s share price has materially declined, the guidelines say, committees should consider reducing the size of LTIP grants. ISS are trying to avoid the situation where the number of shares covered by the grant is increased in order to preserve the face value of the grant. This can lead to excessive reward if the share price bounces back.
Finally they advise dilution limits in line with the IA guidelines.
The various guidelines can be downloaded by clicking on the links. For further information contact Damien Knight.
- November 27, 2018
Valuation of share-based remuneration: importance of underlying assumptions
There are particular circumstances when a company needs to calculate a fair value of share options or performance share awards. As the majority of performance shares in the UK are structured as nil-cost options this article refers throughout to options only. The most common circumstances are:
1. To recognise an accounting expense under IFRS2 or FRS102 (the Finance Director’s nightmare)
2. To agree the taxable value of the grant with HMRC – this can be needed, for example, to determine the taxable value (if any) on the acquisition of restricted securities, including growth shares or JSOP interests.
3. To ‘benchmark’ share-based rewards against competitive practice more precisely than would be possible using the ‘face value’ of the shares involved, for example where there are different performance conditions for the company’s own share-based rewards and for those of a comparator company.
4. To compare the value of share-based incentives with other parts of the remuneration package, where a trade-off between elements is being considered: such as a choice between share-based incentives and cash payments, or between different forms of long-term incentive.
In each case, another party has to be satisfied that the resulting fair value is indeed fair – the auditor on behalf of the shareholders, HMRC, the remuneration committee and the executives receiving the grants. Executives frequently prove to be the hardest to convince.
Nevertheless, it is probable that very few of these parties really understand the mathematics involved, and most take the calculation on trust or apply some standard formula. In fact, the final value is surprisingly sensitive to the valuation assumptions, such as share price volatility and the expected period before an option-holder chooses to exercise (“option life”).
Volatility is the key to calculating the value of share options and performance share awards with market-based vesting hurdles. The future pay-off from an option is a positive value or zero, depending on whether the share price at the time of exercise is higher than the exercise price (which is usually, but not necessarily, the share price at grant). There are two components to the price increase: the underlying drift of the share price (a function of market expectations) and the extent to which the seemingly random daily changes add up to produce a resultant increase or decrease. If a share price experiences large daily fluctuations, we say that it has high volatility. With a more volatile share price there is more chance of a high gain at exercise. There is also more chance of a low downside in the share price, but because the pay-off cannot be less than zero (the option holder just would not exercise), this does not cancel out the extra value from the possibility of a high upside.
Before we consider how different volatility assumptions affect the value of a share option, we need to find a workable definition of volatility. To calculate the daily volatility, we look at the standard deviation of the logarithm of the ratio of each day’s share price to that of the previous day. We then multiple this daily volatility by the square root of the number of trading days in the year to get the annualised volatility, which is the measure used in valuing options. We take the natural logarithm because it results in a normal “bell curve” for compounding returns – which makes it possible, later in the valuation process, to model future outcomes randomly in our valuation model. A key assumption in share price forecasting is that returns are normally distributed.
Not surprisingly, the value of a share option is highly sensitive to the assumption about share price volatility. The graph below shows how the fair value of an option varies with volatility in a typical company. For clarity, we have expressed the fair value as a percentage of the face value of the shares under option.
At 10% volatility, the fair value is 15% of the face value of the share. At 40% volatility, the fair value is 43% of the face value, with close to a straight line relationship in between. The fair value per share is almost three times as much at 40% volatility as it is at 10% volatility.
We can see that this variation matters when we make assumptions about likely future volatilities. The reality is we do not know what the future volatility will be or how it will vary. Most companies rely on the past as a predictor of the future. If the company issues traded options, we can work out the implied volatility (ie the volatility assumed by market makers) but this will not apply for most smaller companies.
The situation is even more difficult if we are dealing with a private company. The company is probably valued once a year for tax purposes or for internal share transfers. The valuation methodology typically uses a profit multiple, or maybe a projection of future profits. In this circumstance, there is no measurable “wiggle” in the share price. The company has to estimate its volatility, for example by using an average of the observed volatilities of listed peer companies in its sector to provide a proxy.
The table below shows how the volatility of one listed company’s shares has fluctuated, depending on the quarter over which it is measured. The volatility varied by a factor of three, depending on the period chosen, ie Q1 2017 vs Q2 2015. Neither historical period has a superior claim to representing the future. There may be industry characteristics for 2017 which suggest that figure is a better predictor because it is more recent, but it depends largely on judgement. As shown in the graph above, the volatility assumption has a crucial impact on the value of an option or performance share award.
Depending on the purpose of valuation, the company has a lot of opportunity to choose volatility assumptions which suit its own purpose, provided it can persuade the interested parties, HMRC, shareholders or executives, that the final result is reasonable – one might say “fair”. This persuasion/ negotiation is more important than the mathematical result. It could well be easier to take a rule of thumb of, say, 30% of face value (MM&K uses 30% of face value for share options in surveys and this is often talked about as a market norm) and agree with the relevant parties that that is a fair figure for the particular purpose in hand. Unfortunately HMRC is currently insisting that a Black-Scholes or similar option-pricing model is used for valuation of growth shares and JSOP interests, which therefore requires the use of a volatility assumption, even though we have shown this is effectively arbitrary.
Volatility is not the only assumption that introduces a large degree of imprecision. We also have to decide the likely behaviour of participants in exercising their options – in order to determine the option life (grant to exercise period). The graph below shows the impact of different option lives for the value of the option in a typical company. This is yet another reason for agreeing a rule of thumb.
For further information contact Damien Knight