Danish LTIs: evolution without conformity

Recent commentary has pointed to a broadening of long-term incentive (LTI) practice in Denmark, including greater interest in restricted shares and relative Total Shareholder Return (TSR). We think this overstates the reality somewhat. There is no fundamental shift at play. And that is a good thing.

Most C25 companies continue to use a single, performance-based LTI vehicle, typically over a three-year period. Only around 12% operate a recurring executive LTI using more than one award vehicle, and a similarly small proportion use genuine time-based RSUs as part of the normal executive LTI.

It has always been our experience that Denmark, in not adopting a conformity of practice, maintain a focus on what is right for the company – not what makes activist shareholders or proxy advisers happy. This is a good lesson for other markets.

The company’s economic model must dominate thinking

One of the more attractive features of the Danish market is that LTI performance measures remain relatively diverse, reflecting the specific needs of companies.

Around 84% of C25 companies disclose specific LTI measures, but there is no single dominant performance framework. Companies use different combinations of earnings, revenue growth, returns, cash generation, strategic objectives, sustainability measures and shareholder returns.

TSR is used by around 44% of C25 companies, meaning the majority do not use it at all. Relative TSR is used by only around 36%. Where TSR is included, its weighting also varies significantly, upwards from only 20%.

This contrasts with markets such as the UK, where remuneration structures have become more standardised and familiar measures such as TSR and EPS are predominant.

Again, the company specific factors must determine the best LTI approach. A capital-intensive industrial company, for example, may need management to focus on returns on invested capital and cash generation. A growth company may need revenue growth at minimal margin. A pharma company may need to deliver pipeline, development or commercial milestones.

An LTI should therefore start with the company’s strategy and value-creation model, rather than with a list of commonly used market measures.

Relative TSR is not a silver bullet

Relative TSR has obvious attractions. It measures shareholder returns and compares performance against other companies. It also avoids the need to set precise three-year financial targets in an uncertain environment.

But it has significant weaknesses as an incentive measure.

First, TSR is an outcome, not a driver of performance. It can also produce counterintuitive outcomes. A company can generate a negative absolute shareholder return and still achieve a high relative TSR ranking because its peers performed even worse. Further, results depend heavily on the choice of comparator group. Changing the peer group can materially change the outcome without changing any underlying value drivers.

There is also a significant starting-point effect. A company whose share price begins a performance period at a depressed level may subsequently produce a strong relative TSR result simply through recovery. Research has shown that this can reward volatility rather than sustained long-term value creation.

None of this means TSR is without value. It is a useful measure of the shareholder experience. The question is whether it should always be a core incentive measure.

RSUs also need context

A similar argument applies to restricted shares/units.

The conventional criticism of RSUs is straightforward: they are not directly leveraged to performance. But that does not make RSUs inherently inappropriate.

There are circumstances where they can make considerable sense. A company may be undergoing a strategic transformation where value creation will take longer than a conventional three-year performance period. It may be operating in a highly cyclical or uncertain environment where setting credible long-term targets is particularly difficult. Retention may also be critical.

In those circumstances, an appropriately sized restricted-share award can create long-term ownership and retention without pretending that a board can accurately forecast a narrow financial outcome several years ahead. A reasonable trade-off may then be lower performance leverage. That may normally be reflected in lower award quantum, longer holding requirements and meaningful executive share ownership.

The relevant question is therefore not whether RSUs are “better” than PSUs. They perform a different role and should be used where the company’s circumstances justify them.

Proxy advisers should inform, not dictate

Proxy advisers have a fundamentally different task from a remuneration committee. ISS, for example, says its infrastructure supports research and voting across more than 50,000 shareholder meetings annually for more than 1,600 clients. A system operating at that scale inevitably benefits from consistent rules, comparable measures and structures that can be assessed efficiently across thousands of companies.

There is therefore an institutional self-interest in standardisation.

The board has a different responsibility. Its job is not to design an LTI that is easiest for an external scoring framework to assess. Nor is it to reproduce whatever has become the dominant market structure.

It is to determine which arrangement is most likely to attract, retain and motivate the right executives to execute that company’s strategy and create sustainable long-term value. That decision may introduce less ‘popular’ plan designs rather than following the herd.

Dogmatism is rarely beneficial over the long-term.

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