- February 27, 2019
The Holt – MM&K – Buyouts Insider North American PE Compensation Survey 2018
Holt Private Equity Consultants, MM&K’s allied firm in the US for Private Equity compensation matters, recently published the results of its North American PE Compensation Survey. This survey is the sister survey of our European PE and VC Compensation Survey. The results from the North American survey make for interesting reading.
The survey analyses compensation data from over 100 North American PE and VC firms. The headlines include:
• In 2018, compensation in North American Private Equity and Venture Capital spiked for many employees.
• For non-partner level employees, the median total cash (salary + bonus) increased by 20%.
• The biggest increases were seen at the Associate and Vice-President levels.
• The standard model of two and twenty still pertains.
• Partners tend to take 71% of the carry pot.
• The vesting of carry plans now is spread over a longer period. The typical length of time that it takes to get to full vesting is now eight years.
• Only 31% of VC funds in North America require a hurdle rate of return before carry clicks in.
MM&K is pleased to announce that copies of the North American survey report are available to be purchased from us at a price of £2,000 (plus VAT).
A copy of the Preview of the North American PE Compensation report can be found here:
- February 27, 2019
Are you getting the best out of your LTIPs?
Whether you are a well-established organisation or still in early stages, it is important to make sure that the long term elements of your executive and key personnel remuneration are working properly for your business.
Whilst establishing whether or not this is the case will take some time and discussion, it is important for anyone connected with executive remuneration in an organisation to have an initial sense or understanding of what a plan is delivering.
To help with this, here are five quick-fire questions which will help you evaluate your long term incentive plans (“LTIPs”):
1. Do your LTIPs meet the reality of what is happening in your business?
Plans which were put in place during a more prosperous period may start to look out of kilter with the value now being delivered to owners/shareholders. Alternatively, if you are growing, current levels of reward may not lock in the people you need.
2. Is a change of direction appropriate?
Doing the same as last year may be cost-effective and simple but it could also generate disquiet if it is not aligned with the business. A good LTIP reflects and rewards the important things both in terms of performance and culture.
3. Are you making awards with the right frequency?
Where the value of the company has dipped, a single larger award (rather than annual awards) could generate more interest and be a better retention tool, so long as suitable balances and checks are also put in place.
4. Have you spread the awards widely enough?
Whilst award sizes should not be so small as to be meaningless, there is a correlation between increased retention and access to LTIPs. Even if the current LTIP doesn’t lend itself to wider participation, there may be another complementary structure which could be introduced.
5. Is now the time for succession planning?
Part of any effective succession plan will include giving those coming through the business a clear view and a tangible understanding of what they are working towards. Similarly, current owners need to be prepared for future changes.
For further information or to discuss any questions you may have, contact Stuart James.
- February 27, 2019
Enterprise Management Incentives and Brexit
Like any EU member state, the UK is subject to the ‘state aid regime’ regarding competition law, governed by the Treaty on the Functioning of the European Union and associated European legislation. These rules are in place to ensure open and fair competition and to prevent subsidies causing unfair distortions within the single market.
State aid is relevant to Enterprise Management Incentives (“EMI”). This is because it is an employee share incentive arrangement with very generous tax reliefs that is available for the benefit of selected employees of small and medium sized companies which meet certain legislative requirements. In other words, EMI is an advantage or benefit that is being conferred to certain undertakings on a selective basis by the UK.
For so long as the UK remains in the EU, it will need continued approval from the European Commission for EMI share schemes to be operated by ‘selected’ undertakings. The current state aid approval for EMI, which was granted on 15 May 2018, is valid until 6 April 2023, subject to the terms of any withdrawal agreement between the UK and EU.
What happens after 29 March 2019?
The government has indicated that if there is a ‘no-deal’ Brexit, from 29 March 2019 the ‘EU state aid rules will be transposed into UK domestic law under the European Union (Withdrawal) Act’ (See https://www.gov.uk/government/publications/state-aid-if-theres-no-brexit-deal/state-aid-if-theres-no-brexit-deal). The guidance also indicates that existing state aid approvals will be carried over to UK domestic law.
In a recent meeting between HMRC and UK tax advisers, HMRC stated that, in the event of a “no-deal” Brexit, the current state aid approval for EMI will continue to remain valid until 6 April 2023, without any break.
If, on the other hand, the UK reaches an agreement with the EU to the effect that the UK remains subject to the EU’s state aid laws, it is also reasonably expected that the existing state aid approval for EMI will remain effective at least until 6 April 2023.
In short, irrespective of whether there is a ‘no-deal’ Brexit or the UK reaches an agreement with the EU in which the UK remains subject to the EU’s state aid laws, qualifying UK companies should be able to grant tax-advantaged EMI options to selected eligible employees for the foreseeable future.
- February 26, 2019
Labour Party policy input on executive remuneration
In November 2018, John McDonnell, Shadow Chancellor, published a review he had commissioned from a group of 13 academics into the thorny subject of executive pay. The review is described as “independent” but the intellectual allegiance of the contributors is evident in the title: “Controlling Executive Remuneration: Securing Fairer Distribution of Income” (my italics). The unfairness of current pay differentials and the belief that it will only ever be addressed by legally enforceable controls is the starting premise of the paper.
A number of the writers are active in the Labour party, including the editor, Professor Prem Sikk (University of Sheffield); one contributor, Professor Alastair Hudson (University of Strathclyde) ran for Parliament on a Labour ticket in 1997; Anne Pettifor, Director of Prime economics policy research, is on the Labour Party Economic Advisory Committee and is declaredly anti deficit reduction and pro-state. Several of the academics, for example Jeroen Veldman and Martin Parker, believe that current capitalism is profoundly biased in its allocation of resources and privileges to managerial and shareholder “elites”.
I point out these strong inclinations not to present an opposing political viewpoint, but to highlight the danger in believing this is in any way an “independent” review, which the Shadow Chancellor claims. He says in his introduction that “the contents of this document form a submission to Labour’s policy making process; they do not constitute Labour Party policy nor should the inclusion of conclusions and recommendations be taken to signify Labour Party endorsement for them.” That is questionable. There are some very radical proposals in this report, including employee votes on individual directors’ pay and a stakeholder-set total pay cap. If Labour were to win a general election, we could expect similar measures to form part of an assault on the current status quo in UK corporate governance.
I would add that the document lacks the intellectual rigour we might expect given the academic credentials of the various writers, four of whom (including Prem Sikk) are professors of Russell Group universities. Following academic protocol, the research quotes its sources at every point in its argument, but it merely quotes the conclusions that support its own arguments. There is no attempt to appraise the quality of each source. Notable cases are the citing of the 2014 IDS report for the High Pay Centre, stating that there is either no relationship or at best a weak link between directors’ pay and performance; and repetition of the research conclusion in The Spirit Level, written by meta researchers Richard Wilkinson and Kate Pickett that health and social problems are worse in countries with high wealth disparity. The IDS methodology produced statistical nonsense (as I have previously demonstrated) and any top grade business professor should have spotted it. The Spirit Level is still the subject of debate after a thorough debunking by Christopher Snowdon (The Spirit Level Delusion).
Following an executive summary of recommendations and an introduction, Chapter 2 of the review presents the context of executive remuneration – it describes current practices for executives and other employees. It shows how the differential of FTSE 100 executive to average pay increased from 20 times in the 1980s to 160 times in 2017. Subject to a missing definition of total remuneration and distinction between remuneration awarded and remuneration realised, we do not dispute their findings and anyone must find them disturbing. What we do dispute are the accompanying statements that the link with company performance is virtually non-existent (this is not true) – it contrasts executive pay increases with low growth in the FTSE 100 index, ignoring dividends entirely, a key element of shareholder returns. It makes the extraordinary sweeping accusation that “the financial sector has been a serial offender, and actively engaged in mis-selling financial products, rigging foreign exchange rates, interest rates, money laundering, tax avoidance and tax evasion to boost profits, shareholder returns and performance related executive pay.”
It states: “There are no statutory mechanisms for clawing back bonuses though a number of companies claim to have mechanisms for clawing back some of the bonuses at the board’s discretion.” In fact clawback in banks in large financial institutions is mandated under the EU Capital Requirements Directive (CRD IV).
The report claims that executive pay continues to soar – yet even the High Pay Centre has recognised that it has flattened out in recent years. It takes a few egregious cases of abuse (eg Carillion and Persimmon) and draws the conclusion that controlling action is required for the 7,000 UK companies with more than 250 employees.
Chapter 3 looks at the consequences of inequitable income distribution, including its implications for access to housing, education, food, pension, healthcare, transport, justice, security, democratic institutions “and much more” and builds a case for stronger control of executive pay.
Chapter 4 seeks to document the failure of Government, shareholders and institutions to exercise such control. Here the political slant is evident. The section starts with an attack on the failure of corporate governance codes from the time of the original Combined Code in the early 90s: “The corporate governance codes assume that corporations exist primarily for the benefit of shareholders and that the levels of remuneration are a matter for elites. Professor Sikka is particularly fond of the word “elites” (he clearly does not number university professors in their ranks). The paper rolls out the old canard that directors sit on each other’s remuneration committee and have no interest in controlling executive pay, in democratising decisions or choosing lower benchmarks. We believe this is serious libel of non-executive directors who, in our experience, are fastidious in dealing objectively with executive pay. The paper goes on to attack the concept of maximising shareholder returns and builds a case for attending to the interests of all stakeholders.
The attack on the UK corporate governance record is particularly weak and full of errors. For example, “the corporate governance codes have secured some disclosures of executive pay but the information is poor. Executive remuneration disclosures in annual accounts often understate the pay collected by directors. Many receive perks such as subsidised housing, chauffeur driven cars, the use of private jets, private healthcare help with house buying and school fees, and these are often poorly accounted for. The use of share options complicates calculation of the value of executive package and often understates it. Company executives have also been known to fiddle share options by backdating them (sic) to maximise their own personal gain.” Spot the hidden truth amongst the lies (answer – executives do get private healthcare!) The writer of this section does not seem to realise that directors’ pay disclosure is not a matter of corporate governance codes but is mandated by regulations under the Companies Act. The value of all remuneration has to be disclosed, the valuation methodology is prescribed and the reports are subject to audit. The writer of this section presents no evidence to support these gross statements.
The section goes on to attack the “notion” of maximising shareholder returns and the use of shares and share options to align the interest of directors with shareholders at the same time allowing them to push up share prices through share buybacks, excessive dividends and by issuing optimistic earnings forecasts. Next the section demonstrates how the interests of shareholders have become increasingly short term and claims shareholders have become increasing unfit to exercise any joint control on executive pay.
Finally, the chapter attacks the failure of the Conservative Government to check executive pay. It acknowledges the introduction of the new June 2018 disclosure regulation requiring listed companies to report and explain the pay ratio of CEO to employee pay quartiles and the encouragement given to the Investment Association in publishing the name and shame list of shareholder resolutions obtaining less than 80% of shareholder votes. But it complains that the name and shame register has not led to a more equitable distribution of income. In fact, the register was published for the first time in December 2017, so it is hard to see how the impact might be felt by now. The report said the only sanction the shareholders have is to sell their shares – but of course they can also vote directors off the board. It also complains that the new UK Corporate Governance Code, introduced by the FRC in July 2018, has failed to curb excessive executive pay.
Chapter 5 presents the researchers’ recommended reforms. Having concluded that the pay gap is growing and damaging to society and that current corporate governance regulations and codes have failed to control executive pay, they have recommended a number of radical new control measures. “The challenge is not only to devise mechanisms that constrain undeserved executive pay in large companies but also create mechanisms to enable workers to secure an equitable share of income/wealth created with their own brain, brawn, sweat, commitment and energy. The key to that is to empower employees of large companies to vote executive pay.”
The precise recommendation is rather confused. Employees would have the power to vote on individual “executives’”pay. It is not clear whether this means parent company executive directors or a wider population of executives and managers. Certainly they are proposing reporting the names and total remuneration in bands of people earning more than £150,000. In a major multinational this could include well in excess of 1,000 employees and it seems unnecessarily intrusive. It implies there is something reprehensible about earning that much rather than recognising the important contribution these people make.
How the vote would work is vague – if the vote goes against the package, what happens then? Incentive payments require a vote on each element with at least a 50% voting turnout and a 90% vote in favour but, again, it is not clear what happens if the vote is less than 90%. There is then a complicated system of yellow cards for the directors if any remuneration vote is less than 80%. This is accompanied by the threat of being voted off the Board.
Employees and customers will also have the power to impose a cap on individual total remuneration. The practicalities of this are not discussed. Who proposes the cap that employees vote on?
For me, the big problem with employees voting for executive pay is they have no accountability for the impact of the pay package, ie the success of recruitment, retention or motivation of the executives. So what reason would they have for being anything but parsimonious? The report also recommends a limit to corporation tax deductability for total executive remuneration. This would presumably require the Government to specify a limit.
The report recommends a downgrading of the remuneration committee responsibilities to advising the Board (if the board chooses to have a rem com at all). But the IA Working Group and the FRC in the new UK code have both emphasised the importance of having a rem com which is expert in remuneration matters and particularly a rem com chair who is expert. They hope this will avoid the sort of error that was seen with the Persimmon share plan. Passing the responsibility to the whole board will be a backward step.
The review says that if there is a rem com it must have representative of employees and other stakeholders. Do the writers really mean a customer representative? How is such a person selected? I suspected the “other stakeholder” piece is a way of justifying the increased influence of employees.
The cult of bonuses is to be discouraged. Bonuses, if any, should only be paid for carefully specified and extraordinary performance. The word “cult” is heavily value laden and the recommendation shows a failure to understand the principal reason for bonuses, which is to ensure pay is justified. The writers seem to subscribe to a belief that most high pay in large companies is not justified; yet they are seeking to destroy the very mechanism that ensures it is.
The same applies to share incentives. They recommend proscribing them and allowing cash only, in order to avoid abuses and complexity. Executives would have to buy their own shares.
A number of other recommendations in the review appear to be redundant given Government existing and pending new regulations:
• publishing executive remuneration contracts – all the information on executive directors is already disclosed in the annual remuneration report;
• pay differentials between executives and employees to be analysed by gender and ethnicity and published – the former requirement is already in place; proposals for ethnicity analysis are currently under consultation;
• executives should not be compensated for tax changes – most companies do not do so anyway;
• clawback should be reinforced by the Companies Act – this is generally unnecessary as it is open to companies to sue dishonest or grossly failing executives. For Banks and major financial institutions, it is already inscribed in the regulations;
A particularly radical proposal is that in the case of companies with deficits on their employee pension scheme, their directors must not be eligible to receive any bonus or increase in remuneration unless they have reached a binding deficit reduction agreement with the Pensions Regulator. Given that a pensions deficit is a theoretical figure determined by the actuaries, such a proposal could put some serious pressure on the actuaries.
Finally, they recommend a newly constituted Companies Commission to oversee and enforce all these new controls and other aspects of UK company law – in other words a good old-fashioned Quango.
The sad thing about this report is that 13 highly intelligent and well informed academics can only come up with solutions which involve legislative control. There is a widening gap between top and bottom pay, although top pay is not growing at the speed they report. More serious is the problem of upgrading low value work at the bottom end of society. Pulling down top pay is not going to help this. All the time these academics are blinded by a prejudice about executive greed and capitalism and false assumptions about variable pay and the lack of a link of pay and performance they are not going to come up with any real and lasting solutions.
What is MM&K’s diagnosis and prescription?
1. High pay is principally a matter for shareholders, and the main test should be that it is justified by performance. This makes the use of bonus plans and share plans essential.
2. Capping executive pay is a potentially damaging interference in free markets and must be resisted.
3. We think all the measures are available in terms of disclosure, shareholder voting and incentive plan design. It is now up to shareholders to exercise their stewardship to ensure companies justify their pay levels.
4. We agree with the academics, however, that pay ratios have damaged trust over time. This issue has come to a head in recent years because of the publicising efforts of the High Pay Centre, not because the gap is still widening faster.
Using a somewhat out-dated Human Resources term this is a matter of internal equity. In the late 1970s and the early 1980s, the principal aim of pay structures was to achieve internal equity – which required equal pay for work of equal value and a means of assessing the value of jobs – ie job evaluation.
Grading structures based on job evaluation controlled the salary differentials between roles. They also determined the level of access to bonuses and benefits. But they fell out of favour in the late 1980s and the 1990s because:
• grade changes had become the principal route to earning more money and employees and their managers devoted much time to getting jobs re-evaluated and upgraded.
• managerial and professional pay, in particular, became more focussed on external benchmarking as the talent markets became more active. Salaries were pegged to external benchmarks often at an individual job level rather than a structural level. This has led to criticism of benchmarking as an inherently inflationary process.
• the de-layering of organisations which was possible with modern technology meant that managers (at least in their own eyes) often added substantially more value than the individuals who reported to them, so there was no natural brake on increasing the pay differentials.
5. There may now be a case for re-introducing a framework of internal differentials using job evaluation concepts. This could be communicated to employees as part of the Section 172 disclosure and would be more informative than the statutory pay ratio reporting.
6. We see no reason to change the composition and responsibilities of the remuneration committee. Corporate governance guidelines are emphasising the importance of remuneration experience in committee members. We think putting employees on the remuneration committee will achieve very little and create expectations that cannot be met.
For queries and further information, please contact Damien Knight
- February 25, 2019
Might EVA be making a comeback?
Economic Value Added (EVA) was a popular financial measure in the 1990s, used by many major companies as well as investment analysts. Interest in EVA has recently re-emerged as a result of the acquisition of EVA Dimensions by Institutional Shareholder Services (ISS) last year.
EVA is defined as:
EVA = Net Operating Profit after Tax (NOPAT) – 〈Total Capital (TC) x Weighted Average Cost of Capital (WACC)〉.
So for example, if NOPAT in one year was £2m and the Total Capital figure was £15m and the WACC was 8%, EVA that year would be £800,000. If the following year NOPAT was £2.6m, Total Capital was £22.5m with the WACC still at 8%, the EVA figure would still be £800,000. So NOPAT would have increased by 30% while EVA would not have increased at all.
The EVA measure is supposed to overcome one of the perceived problems with accounting profit, the fact that it does not account for the cost of equity, and therefore the full cost of capital. Whether or not NOPAT growth is truly value-creating depends on how quickly capital is growing and the cost of that capital.
A key benefit of EVA is how it tracks changes in value over time. To create real value, earnings must grow by more than the return required by investors on any new capital invested. In other words, a 20 percent growth in earnings will drive up value much more if it is achieved with minimal capital expenditure than if it is the result of a major acquisition.
Like accounting profit, a company’s EVA can be divided into business unit EVA (or EVA contribution) to provide a common measure across an organisation. EVA enables comparisons to be made between divisions with very different business models; a manufacturing division can be compared to a service or finance division in terms of their relative contribution to overall corporate value.
In the 1990s EVA also was used by a number of companies in their incentive plans. In some notable cases this was done by awarding management a defined share of EVA growth over time. This EVA plan worked particularly well for large, multi-divisional, capital-intensive firms, promising an enduring, definitive linkage between management rewards and (EVA) value creation. Once calibrated, this mechanism could operate without budget-based goal setting or any significant plan changes over many years. This longevity is itself a benefit, with EVA companies knowing that they will reap the rewards of a growth in profits exceeding the growth in capital used to generate them, even if it takes years for their projects to mature. This extends management’s time horizon beyond the end of the fiscal year, enabling them effectively to balance short-term and long-term imperatives.
By the late 1990s the limits of EVA began to become apparent. Unlike the well-understood standard of accounting profit, EVA is very much a non-standard measure, subject to numerous adjustments. These adjustments enable EVA to be tailored for each firm, but also make the measure more complicated for management to understand, and more suspicious to outside investors, especially as the basis for management incentive pay.
EVA’s ability to track value creation is severely degraded when returns lag investments by a year or more, for example in technology firms or any sector undergoing disruption. The dot-com boom in the late 1990s, characterised by companies using a lot of investment without generating any NOPAT, made EVA look irrelevant.
Finally, any incentive plan is only popular as long as it is paying out. In the wake of the bursting of the dot-com bubble in 2001, many bonus plans, including EVA plans, were dropped.
Although EVA lost much of its popularity as a corporate measure, a sizeable corner of the investment community continues to see it as the best proxy for value creation, at least for capital intensive firms that don’t suffer from a significant investment lag. Other analysts continue to see EVA as a fundamentally useful analytical tool. After all, a return above the cost of capital is the literal, textbook definition of value creation.
The governance community has kept its own little corner of sustained interest in EVA. They regard it as an economically sound measure, which is attractive to fund managers focused on value creation. Bonuses which are driven by EVA performance require management to overcome a capital hurdle before getting paid, which is attractive to fund managers looking to hold management to a higher standard. ISS is in the business of creating governance standards, including for compensation governance, in order to advise their investor clients how to vote their proxies. Until now, ISS has taken the path of least resistance by assuming that what investors care about most is total shareholder return (TSR). Although this may be true, the focus on incentive pay versus TSR has had the unintended consequence of significantly increasing the use of TSR as a performance measure, particularly in long-term plans.
This use of TSR has created problems. For one, TSR is not something that management can directly “manage” quarter-to-quarter, or even year-to-year, at least not in a way that is good for shareholders. Strong TSR is the expected result of running one’s business well over a business cycle. Using TSR over three years—the typical duration of a “long-term incentive” plan—sounds better, but near the end of the performance period, management is still left with trying to “manage” TSR.
So focusing on another measure of value creation based on operating results, like EVA, makes sense to some governance experts. But if ISS decides to push EVA as an alternative basis for assessing all the companies it covers, it will need to consider the evidence that it is not a good standard for all, or even most companies, and be flexible in how it is applied. It will also have to recognise that the definition of EVA will need to differ across industries, undermining it as a “standard.”
With ISS paying attention to EVA, companies can prepare for potential renewed interest in it by investors, by taking the following steps:
1. Calculate both a “basic EVA” (as ISS is likely to calculate it across all companies) as well as an “adjusted EVA” (based on NOPAT, Capital, and Cost of Capital suitable to your sector) for your company and its peers to see where your company would stack up.
2. Determine the degree to which your EVA level or growth trend provides an accurate reflection of your company’s value creation over the last three-to-five years.
3. Prepare to explain your company’s position on the applicability of EVA as a measure in your shareholder engagement activities, including in disclosures and other communications, as appropriate.
Some companies with the right set of characteristics noted earlier may even find that EVA is a better measure than the one(s) they are currently using. These companies will have an easier time justifying tracking and reporting it, and even building it into their reward system.
This is an edited summary of an article prepared by Marc Hodak of Farient Advisors, MM&K’s US partner in the Global Governance and Executive Compensation Group (GECN).
- February 22, 2019
FRC strengthens Stewardship Code
The Financial Reporting Council has published a consultation paper on a new Stewardship Code that sets substantially higher expectations for investor stewardship policy and practice. The proposed changes call for higher transparency regarding institutional investors’ stewardship activities and encourages more engagement with issuers (ie companies). The FRC and the FCA have also published a discussion paper “Building an effective regulatory framework for stewardship”.
Among the proposed changes to the Stewardship Code, which broaden its scope and require signatories to make public disclosures about their stewardship activities, there is an increased focus on the societal purpose and responsibilities of investment institutions. There are explicit links to the new UK Corporate Governance Code, which came into effect this year, as well as the EU Shareholder Rights Directive II, expected to be implemented in May. Behind the scenes, the US Stock Exchange Commission hosted a roundtable on the proxy process in November and BlackRock’s Larry Fink’s letter to CEOs last month encourages companies to establish a purpose and embrace their social responsibilities.
The proposed changes have significant consequences for investment organisations and the companies in which they invest. MM&K will be studying the new Code and researching the context surrounding it in depth. We will be publishing our insights and guidance for boards of directors in next month’s newsletter.
Contact Harry McCreddie for further information.
- February 20, 2019
Companies’ social purpose
Over the last few years we have seen companies come under increasing scrutiny from the public, media and politicians. In response, we have seen a new Corporate Governance Code, new disclosure regulations and extra requirements for investors. One theme that has emerged is a new emphasis on companies’ social responsibility. This trend has the potential to shape the corporate landscape as well as impacting wider society.
In July 2018, the UK Corporate Governance Code was updated, applicable to accounting periods from 1 January 2019. The new Code requires companies to consider their contribution to society. Principle A used to state that “Every company should be headed by an effective board which is collectively responsible for the long-term success of the company”. In the new Code it is now “A successful company is led by an effective and entrepreneurial board, whose role is to promote the long-term sustainable success of the company, generating value for shareholders and contributing to wider society”. The UK Corporate Governance Code is not alone in this assertion. The QCA Corporate Governance Code, tailored for small and mid-size quoted companies, also advocates social responsibility. The Code’s third Principle is “Take into account wider stakeholder and social responsibilities and their implications for long-term success”.
Larry Fink, Chairman and CEO of BlackRock, the world’s largest investment management corporation, published his annual letter to chief executives last month. The letter focuses on corporate purpose, with the theme following on from last year’s letter in which he posits that society is losing faith in governments’ ability to address social and economic issues and “increasingly is turning to the private sector and asking that companies respond to broader societal challenges”.
This year’s letter continues the theme. It states “Trust in multilateralism and official institutions is crumbling”, and reiterates that “Society is increasingly looking to companies, both public and private, to address pressing social and economic issues”. Fink also urges companies to define their purpose beyond profit. “Purpose is not the sole pursuit of profits but the animating force for achieving them … profits are essential if a company is to effectively serve all of its stakeholders over time – not only shareholders, but also employees, customers, and communities.”
Although Fink proclaims that society has lost faith in governments and is now looking to businesses, there are many who would argue that companies have lost the public’s trust as well. In an article for the Financial Times, Standard Life Aberdeen’s Keith Skeoch writes that trust needs to be restored in businesses, citing Carillion and Lehman Brothers as examples of corporate failures that have done long-lasting damage to workers and communities. He also argues that “asset managers need to recognise that what is good for equity shareholders is not always in the interest of everyone who matters”. He notes that this is a big shift, “since the 1930s investors have believed that what is good for equity shareholders is also good for the corporation and other stakeholders”.
There are others who are pushing for investment institutions to fulfil a societal purpose, namely through stewardship of the companies they hold shares in. In a Financial Times article on stewardship, Catherin Howarth and Paul Dickinson of ShareAction reason that “effective stewardship of companies is not simply a tool to enhance long-term financial returns, it is the central device by which investment organisations can deliver on their purpose in society”. They point out that “big investors are strongly placed to encourage boards to invest in people through fair wages, adequate opportunities to learn and train, better health and safety and preparing workers for the future”.
So what is meant by a company’s social purpose? The UK Corporate Governance Code says “businesses underpin our economy and society by providing employment and creating prosperity”. It would seem that businesses should make decisions that will benefit their workers well into the future. This could mean having reasonable pension schemes in place, avoiding ‘short-terminism’ and taking responsibility for the environment. Larry Fink says companies are responsible for issues ranging from protecting the environment, to retirement, to gender and racial inequality. There is a clear trend towards companies being held to standards beyond simple financial returns, and that this will be enforced through the ever-tightening regulatory requirements.
Last month the Financial Reporting Council published a consultation paper on a new Stewardship Code. The proposed changes include a new definition of stewardship, which says that investors should “create sustainable value for beneficiaries, the economy and society”. We will be publishing an article on the consultations next month.
The changes we are seeing will have a significant effect. It is crucial that boards of directors are aware and prepared for new regulatory changes and shareholder expectations. MM&K is a leading advisor with a wealth of experience providing advice to remuneration committees on a range of issues surrounding corporate governance and regulatory requirements.
For queries and further information, please contact Harry McCreddie
- 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