Measuring Performance in Turbulent Times
The impact of CV19 on the global economy has been huge. Shareholders have seen market value declines not seen since the last financial crisis, staff have been furloughed and made redundant and many businesses now stand on the brink of bankruptcy. Predictions abound that the long-term economic effects may dwarf those of the 2009 financial crisis. In among the growing sea of uncertainty, organisations are battling to do what is right for today, but also what will allow the organisation to show resilience and grow again into the future when the economy begins to stabilise. So reward structures need to balance the current and urgent operational requirements to ensure survival, while ensuring that the right leadership and talent are retained and motivated in order to preserve enterprise value in the short to medium-term and rebuild it into the future as new opportunities arise.
Impact and Response
The response by companies across the FTSE to the crisis has been as significant as it has been varied. Reductions in fixed compensation - and not just for executives - have become the order of the day with up to two-thirds of FTSE listed organisations responding to date having introduced temporary reductions. While the magnitudes vary quite significantly from company to company, the vast majority of organisations have applied a reduction of 20 per cent (the same figure has also been reported most often in relation to NED fee reductions). The impact on variable compensation on the other hand, is not quite as clear, with both market practice and guidelines from investors being at times quite different and broad in context.
A significant number of organisations have however either cancelled or deferred annual bonuses for 2020. The response in terms of LTIPs has been more cautious, with few organisations adjusting “in-flight” awards but many delaying or postponing the issuing of their 2020 LTIP awards. Caution and the option to delay, where possible, are sensible and natural responses to a situation that is evolving and changing on a weekly basis.
It is likely that changes in the world will also crystallise some of the potential changes to particularly bonus and LTIP structures that were mooted even prior to the crisis. The crisis acts as a catalyst allowing progress in areas where previously it was slow, as it accelerates people across the chasm of change more quickly. Simplified bonus and LTIP structures and a potential return to less geared incentive vehicles, such as restricted shares, are now very much on the cards.
Role of Board Discretion
One of the areas where we are likely to see increased activity in order to try and manage the uncertainty is in the use of board discretion in allocating awards. Discretion, applied wisely, can help to mitigate some of the uncertainty and also reduce the potential for reputational damage that might easily otherwise occur in moments like this. To apply discretion wisely requires a steady and informed hand. It is also more likely that discretion around the quantum and timing of awards is likely to land closer to the mark than in trying to apply discretion to the assessment of performance, which will be an order of magnitude more complex. There is already significant noise around what a “good performance” will look like during the current year and beyond; is it maintaining the dividend, is it in protecting jobs, is it in shoring up and protecting shareholder value, or is it in some other area? Applying discretion in this area has two primary weaknesses:
1. It will allow mostly only for an ex-post assessment of performance; and
2. Setting goals and measuring performance objectively will become even more difficult at a time when it is most necessary for leadership teams to be focused intently on re-evaluating their strategies and working harder than ever to identify creative solutions to problems and opportunities
Measuring Performance in Turbulent Times
If performance is to be measured objectively in turbulent times, how do we go about setting targets and measuring results? In part we already have the answer to this question, in part some additional creativity will be required to get us through. Industries like oil and gas with high endemic volatility were the first to move away from defined absolute measures of performance to defined relative measures of performance. No matter whether the industry and broader economy were in a period of expansion or contraction, a performance measurement strategy built around performance relative to that of industry competitors worked well to assess the extent to which a particular organisation or management team had ridden the waves succesfully. Out of this, relative total shareholder return was born, a simple and elegant metric where total returns earned by shareholders over a defined period of time could be ranked against other similar organisations to gauge performance. No additional adjustments were required for external or internal factors. Its strength lay in its simplicity, flexibility and objectivity. We are likely to see organisations which do not use RTSR adopting it as one of their core metrics going forwards and we are likely to see those who already employ it relying on it more heavily into the future.
The logic of a relative measure of performance in times of change is compelling. For this solution to become more relevant however, two additional questions must be properly answered:
1. Who are the industry competitors against whom we should compare ourselves; and
2. How do we apply the same logic to other important measures of performance like profitability, cash flow, or return on capital?
Defining the Performance Comparison Group
In some industries, choosing relevant industry peers appears to be fairly easy, in others less so. A number or organisations that have already gone down the RTSR route have taken just a broad slice of a relevant index (e.g. the FTSE 250) as a representation of their peers. Others have tried to refine this by looking at business descriptions or some combination of individual share price correlation and volatility. Both have shortcomings. Still others have struggled to define a compelling peer group and have moved away from relative measures of performance. Now more than ever an approach is required that will allow for a fair and accurate comparison of performance through the continuing ups and downs of the market.
In looking for an alternative approach, applied corporate finance theory, as contained in asset pricing models, is instructive and available to guide us:
The arbitrage pricing theory where share prices (and returns) can be shown to be correlated to a series of several underlying leading economic indicators
The capital asset pricing model, where share prices are correlated to just one factor, that being the return on the market portfolio of shares
Economic profit or economic value added analysis allows us to separate market value premiums (or discounts) into two streams: value derived from current operations plus the expected value to be derived from future growth opportunities
Of all of these, the CAPM, and its core component part, the business risk index map is potentially most instructive. The BRI map shows us how different shares and industries move through the ups and downs of the business cycle and allows us to identify relevant peers for just about any industry.
The BRI map for a small selection of topical industries
is shown below:
Interestingly, the BRI map, which has tended to be fairly stable over time and across markets, identifies those industries most at risk in a severe downturn. In a declining market, the high BRI shares are disproportionately affected (and in some cases eliminated), as indeed it is in the current situation within particular oil and gas and air transportation companies. Similarly, for pharmaceutical companies there is significant risk, but also great opportunity. To the victors in the fight against CV19 will go the spoils. Applying the BRI analysis sensibly will allow for the accurate identification of relevant peers for just about any organisation, allowing for the accurate measurement of true relative risk-adjusted performance, regardless of what the market is doing. Getting the detail of the peer group right is however imperative.
The BRI map at a sub-industry level provides key insights into different businesses that at a macro level might otherwise appear similar; it is driven by important underlying differences in the factors affecting business risk: revenue volatility, asset intensity and, perhaps most importantly, operating leverage (the ratio of fixed to variable costs in the total cost structure).
Other Performance Measures
Outside of total shareholder return, a relative approach to measuring performance might be equally well applied to other performance measures. Return-based measures, those that combine some measure of profitability or loss, with capital or asset efficiency, are best suited to a similar approach. Relative return on capital, economic profit and other similar measures can easily substitute for the traditional measures typically employed in either an annual bonus or long-term incentive plan. Now is the time for organisations to seize on and employ these approaches, with a view to using them to aid in the application of discretion in the end of day assessment of how the organisation has performed, through the crisis and beyond into the recovery.
Conclusion - the Way Forward
The world and business landscape have both changed dramatically in 2020. As a result, boards and their remuneration committees are facing new and challenging decisions, some perhaps for the first time. In responding, we believe caution will be the order of the day, with a combination of three approaches likely to be employed to mitigate risk, while at the same time driving recovery and performance:
1. The increased use of discretion will be used to manage situations where both business and reputational risk imperatives must be balanced and addressed. We advocate that the use of discretion is probably best applied to the timing and quantum of rewards, both fixed and variable, not in the target setting or performance assessment arena.
2. Where targets are set, or performance evaluated, the use of relative performance metrics will greatly assist in the determination of levels of performance. Relative performance measures can as easily be applied to annual bonuses as to longer-term incentives. They can also be applied to performance measures outside of total shareholder return. Important here is in the determination of an appropriate comparator group to ensure that a truly comparable risk-adjusted return is employed in measuring relative performance.
3. It is also likely that a move away from more complex to simpler bonus and long-term incentive structures will be seen, with restricted shares and other less geared incentive vehicles being employed more widely.
As published in Executive Compensation Brief - June 2020
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