- March 23, 2019
The AIM Market – heading for trouble in 2019?
On the face of it, things do not currently look too rosy for the AIM market. There has just been one new IPO on AIM since the turn of the year. In the same period last year, there were nine.
Indeed, last year as a whole saw a regular stream of IPO’s on AIM. In 2018 there were 9, 19, 6 and 8 listings respectively, per quarter.
The health of any market is shown, to a greater or lesser extent, by the number of new companies that are willing to go through the time and (considerable) expense to raise finance.
Moreover, given that Q4 of 2018 saw an almost record breaking number of trade and Private Equity M&A deals (748 in total), it would be easy to conclude that the AIM market is facing trouble with company owners increasingly considering alternative ways of obtaining the finance to either exit or grow their business.
However, as always when confronted by headlines and statistics it is worth digging deeper to understand the broader picture.
On a macro level, whilst the 43 admissions of 2018 is down from 50 l in 2017, it is still one more than the 42 that occurred in 2016. This would seem to indicate that there is no overall downward trend –other factors are likely to be at play.
The overwhelming weight of evidence indicates that the principal reason for the lack of AIM IPOs so far this year is nervous investor sentiment generally. There is no shortage of companies seeking admission to AIM.
We have recent first-hand knowledge of companies who are keen to IPO but have had to delay on advice from their brokers that the market would not buy at a price that would have made the transactions viable.
It is undeniable that in the short term, the uncertainty of Brexit has caused a pause in making such “public” investments by Institutional investors. However, monies have been raised and need to be placed in order to grow. With the comparable difficulties of finding the “right” investment to place PE money, it is likely that, once the markets have settled (hopefully by this summer) a flurry of deals will come to AIM.
Ironically, whilst there are risks associated with any investment, the requirements of AIM Rule 26 that each AIM company must adopt a corporate governance code, identify the chosen code on its web-site and explain how it complies (or why it has not complied) with that code makes the AIM market a better regulated place for making investments.
We will continue to watch the AIM market with interest and will provide updates throughout the year. For further information or to discuss any questions you may have, contact Stuart James.
- March 22, 2019
Executive pensions – do you know your limits?
In the past, pension benefits used to form a substantial proportion of top executives’ total remuneration. This was not just because their entitlements were based on higher salary levels than employees generally but also because these executives had more generous percentage employer contributions or accrual rates. Moreover, the full value of directors’ pension rights was not always apparent because of incomplete disclosure in companies’ accounts.
The combination of controversy about executive pay levels and the Government’s wish to reduce the costs of tax reliefs has now led to severe restrictions on the value of executive pension benefits.
Corporate Governance Code and investor guidelines
The July 2018 UK Corporate Governance Code, which applies to all companies with a premium listing, requires that “pension contribution rates for executive directors, or payments in lieu, should be aligned with those available to the workforce”.
In its November 2018 Principles of Remuneration, the Investment Association (IA) supported this provision, interpreting it to mean “the rate which is given to the majority of the company’s workforce”. The IA went on to announce on 21 February 2019 that the Institutional Voting Information Service (IVIS) will:
• ‘red-top’ companies which pay new directors, appointed from 1 March 2019, pension contributions which are not in line with the majority of the workforce; and
• ‘amber-top’ companies where any existing executive director receives a pension contribution of 25% of salary or more.
The Directors’ Remuneration Report Regulations now require listed companies to disclose in their annual reports the value of all pension-related benefits, including payments made in cash or otherwise in lieu of retirement benefits and benefits from participating in pension schemes. The Remuneration Policy approved by shareholders must include the maximum pension benefit and, if this amount is exceeded, the directors who authorised the payment may be liable for any resulting loss.
Annual contribution limits
Changing tax rules may have had an even more dramatic impact. From April 2015 the annual limit on tax-relieved pension contributions for a member of a registered pension scheme has been reduced to £40,000 (or 100% of taxable earnings, if less). This ‘annual allowance’ includes contributions by the employee, employer or any third party to a money purchase/defined contribution (DC) arrangement and additional accruals to a defined benefit (DB) scheme. If the limit is exceeded, a tax liability arises (the ‘annual allowance charge’).
Individuals can, however, carry forward any part of the £40,000 allowance which was not used in the previous three tax years, provided they were members of the pension scheme in those years.
Since April 2016, the standard ‘annual allowance’ has been reduced for high earners with an ‘adjusted income’ (which includes total taxable income plus employer pension contributions) of more than £150,000. The annual allowance is ‘tapered’ from £40,000, for those with ‘adjusted income’ of up to £150,000, down to £10,000, for individuals with an ‘adjusted income’ of £210,000 or more.
Those who have already drawn from DC schemes
Since April 2017, there has been a substantially lower ‘money purchase personal allowance’ of £4,000 for individuals who have already drawn money from their DC pension schemes under flexible access arrangements. This is to discourage people from obtaining additional tax relief by reusing funds which have already received tax relief. This £4,000 allowance cannot be topped up with unused allowances from earlier years.
In addition to the annual contribution restrictions mentioned above, there is a ‘lifetime allowance’ which limits the total value of pension benefits which an individual can draw without an additional tax charge to £1,030,000 (2018/19). This includes the value of all an individual’s pensions, through DC and DB schemes, but not the State Pension.
For DC schemes, including personal pensions, the value is the pension pot used to fund retirement income and any lump sum. For DB schemes, the expected annual pension is multiplied by 20 and any lump sum is added to the total. So an individual on a 60ths accrual rate and 40 years of service would exceed the lifetime allowance if his final salary was £78,000 (40/60 x £78,000 x 20 = £1,040,000).
Any pension pot worth more than the allowance is subject to a tax charge of 55%, if paid as a lump sum. If paid as a pension, the tax charge is 25%, but the gross amount is also subject to the individual’s marginal tax rate.
Some executives have preserved a higher earlier level of ‘lifetime allowance’, for example at £1.25 million by taking out Individual Protection 2016 or Fixed Protection 2016. Those with Fixed Protection, in particular, need to ensure that they do not build up any further pension benefits after 5 April 2016. They should have opted out of automatic enrolment and any life assurance cover may have to come from a different source than the pension scheme.
What should companies be doing about this?
It is clear that the days of generous executive pensions are now over. It is becoming standard practice for companies’ contribution rates to executive pensions to be equalised with the majority of the workforce. This can be achieved easily for new appointments and promotions. For existing executives, the contribution rate is part of the employment contract and cannot be reduced except by mutual agreement. However, companies will wish to note that the IA Principles of Remuneration state that shareholders expect contribution rates for incumbent executive directors to be reduced as soon as possible and that no compensation should be awarded for this change. Recent press reports suggest that the major UK banks have adopted this approach.
This reduction in pension entitlement will change the balance between the fixed and variable elements of remuneration. Depending on their remuneration strategies, companies may choose to readjust this new balance by modifying other parts of the total package.
In cases where the statutory annual and lifetime allowances prevent executives from receiving even the standard workforce pension contributions, the practice of paying cash in lieu of pension is likely to continue. In determining the size of any cash alternative, companies should take into account the extra employer’s NICs costs of cash payments (in comparison with pension contributions) and whether the payments will increase entitlement to bonuses and other benefits.
This article is intended to draw attention to possible implications arising from the variety of restrictions on building up pension benefits for executives. Please note that MM&K’s consultants are not pension experts and you should obtain advice from an appropriate professional adviser before taking any action on any of the issues discussed.
For further information contact Mike Landon
- March 20, 2019
International Share Incentive Plan – a case study
This case study explains how a FTSE 250 company, with MM&K’s help, adapted a UK Share Incentive Plan (SIP) for its employees in Germany and Luxembourg.
The Company regards employee ownership as essential to aligning employees and shareholders by creating a common interest in the growth in value of the Company.
The UK SIP
The Company established its UK SIP in 2017 to give all permanent UK-based employees an opportunity to invest in partnership shares annually up to the lower of £1,800 and 10% of their taxable earnings. Each employee can choose to make either monthly salary deductions or a single annual contribution, following payment of annual bonus.
The Company matches each partnership with an award of one free matching share. Provided that the partnership shares and the matching shares are held in the SIP Trust for five years, no tax liability will arise on participants in respect of those shares.
Replicating SIP in Germany and Luxembourg
The Company’s business in Germany and Luxembourg was growing. Its workforce in those countries was expanding and the Company wished to provide equity incentives on similar terms to those provided to the UK workforce. Unfortunately, neither Germany nor Luxembourg has any tax advantaged legislation equivalent to the UK SIP.
A challenge was to design a plan whereby German and Luxembourg employees could be awarded matching shares when they purchased partnership shares without:
(a) a ‘dry’ tax charge arising on the award date, as employees would receive no benefit from their matching shares until after the end of a three-year forfeiture period; or
(b) additional cost (such as hedging costs) to the Company for the provision of the matching shares.
Additionally, the Company did not wish to establish an offshore employee benefit trust to ‘warehouse’ shares during the three-year forfeiture period.
The plan for Germany and Luxembourg is administered by a professional administrator, which also acts as nominee for the employees. The administrator collects monies from employees out of their post-tax income and purchases partnership shares for them participants as nominee. As such, it holds the legal title to both partnership and matching shares on behalf of the participants.
No ‘dry’ tax charge arises in respect of an award of matching shares . Instead, the tax liability is delayed until after the end of the forfeiture period when the shares are transferred to them by the administrator in its capacity as nominee.
No additional cost, such as hedging cost, is incurred by the Company, which pays for the matching shares at the time of award.
Whilst participation terms are similar to the UK SIP, modifications had to be made to deal with issues under local laws. We worked closely with local lawyers to ensure the procedures for making salary deductions, acquiring partnership shares and awarding matching shares avoided the law of unintended consequences.
Whilst German and Luxembourg participants do not enjoy similar tax advantages to their UK colleagues, the outcome ensures that the charge to tax coincides with the receipt of benefits and the Company’s commercial objective to provide an opportunity for substantially the whole of its workforce in the UK, Germany and Luxembourg to participate in equity on similar terms has been achieved.
For further information contact Mike Landon
- 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.
For further information contact Mike Landon
- 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