Archive for August, 2013

How to fix the Ceo and other main executives cash bonus. (II)

Using the wrong Performance Metric.


Dysfunctional compensation introduces incentives for managers to increase their pay, even at the expense of the long-term value of the firm. The perfect measure for a Ceo would be his contribution to the (increased) value of the firm. As this is hardly measurable, performance metrics need to be determined that are correlated with it, even if some side effects are generated:


a)      Accounting profit: accounting metrics do not generally recognize all actions by Ceo with an effect on long-term value; they are affected (sometimes materially) by external factors outside the control of managers; and these metrics ignore the cost of capital.

b)      Ratios versus absolute metrics: EPS, RoA, RoE or RoC can lead to value destruction when the manager just focuses in the denominator, (number of shares) instead of in the numerator, (profit or true performance). Thus, the authors propose their Principle 6: performance metrics should not be a ratio.


The cost of Capital.


Those metrics that do not consider the cost of capital might work well, provided the managers cannot affect the capital allocation decisions. But if they can, the possibility of value destruction appears again.  So, the authors introduce their Principle 7: performance metrics should consider the cost of capital and the volume of capital used. So, Economic Profit can be drafted as:


EP = Operation Profit – Capital*Cost of Capital = (Return on Capital – Cost of Capital) * Capital Invested


Apart from evident advantages, this procedure externalizes the target, as the cost of capital is settled by capital markets.


The definition of Economic Profit, (Eva is nowadays the most common), can vary by three reasons:


–         The definition of Operational Profit

–         Concept of capital: assets, equity, etc.

–         The value of the Cost of Capital.


Even if this seems complex, the authors propose to get rid of all complexities provided by consultants, and keep the simplicity, introducing the firm`s usual plan in a different way:


Bonus = Target Bonus + b (Roa – Threshold Roa)*Assets,


(if the firm`s operating profit metric is RoA. This formula fulfills all principles, (where b is a percentage signaling the part of profit shared by the executive/s).


Ex-Post adjustments and discretion granted to the Compensation Committee.


Denial or adjustment of bonuses allowed in case by whatever circumstance bonuses are not earned by the managers, or are earned at the expense of the long-term value of the firm. The reason is clear, no measurement is perfect or considers every factor affecting the different variables involved  in the bonus calculation. These adjustments should at least come from:

a)      subjective evaluations of the manager, (Principle 8: every bonus plan should include a subjective evaluation of the Ceo/manager);

b)      factors beyond the manager`s control, only to the extent that he cannot control the effects of those factors in the performance of the firm, (Principle 9: managers need to be held accountable for factors out of their control if they can control the impact of those factors on the firm).

c)      Any factor showing the bonus paid in previous years was not due, (when a critical indicator on which the rewards were based is revised). That leads to Principle 10: a system for recovering those bonus needs to be established. Deferral of payments, or Bonus banks may help make this clawback policy palatable.



Even if the Principles depicted by the authors seem obvious, there is a danger when a newly designed plan according to them is presented to controlling shareholders, or a Compensation Committee that will face the scrutiny or both shareholders and proxy advisors: those plans with no caps, sometimes with no hurdles, could be perceived as an attempt by managers to increase their pay; the case should be made very carefully, with historical comparisons and scenario analysis that can provide assurance to all groups involved that the particular plan is adequate to the company, when it is proposed, and given the challenges it may afford in the near (performance) period.


1 Bonus Program Practices, a Survey of members of Worldatwork, 2005.

2 Ceo Bonus Plans: and how to fix them, by Kevin J. Murphy and Michael C. Jensen, November 19, 2011.

3 Sistemas de Retribución variable e indicadores de Control de Gestión, by Ramon Prat y Luis Muñiz, Partida Doble Review, number 135.

Categories: Compensation Tags: ,

How to fix the Ceo and other main executives cash bonus. (I)

When dealing with the bonus schemes, there are certain topics to be tackled if manipulation of earnings and certain risk behaviors are to be avoided, if the company wants to be sure all profitable projects (once considered the cost of capital) are approved, ….in brief, if incentives are to be established in an efficient manner.

We will avoid very particular bonuses, (such as retention, referral, sign-in or others). 1

We will mainly refer to performance cash bonuses, where some general comments can be made, following Murphy and Jensen (2), our main source in this post:

a)      Bonus plans need to be understood by managers, as to what actions generate the performance target.

b)      Bonus plans may contain subjective elements, so that implementation may be made “ad person”.

c)      Unlike equity awards, (only a few managers may actually affect the stock price with their actions), bonus plans can be applied widely through the organisation, and sometimes are more tangible and motivating.

How a bonus plan can be designed: different types.

The elements of a plan are:

–         Performance measures.

–         Thresholds: normally Lower and Upper performance thresholds are fixed, and in-between a Performance Target is determined. The lower one is a hurdle, and the upper one is a cap.

–         Structure of Pay-Performance relationship, (slope of pay function). It can be linear, convex or concave.

Thresholds: these plans, because of the hurdles, incentive managers to move metric units, (let`s assume “profits”) from one period to other, to lie in budget negotiations, …, consequently to value destruction. Apart from that, caps undermines retention efforts for talent.

Pay Performance relationship: convexity  introduces an incentive to increase the volatility in profits, whereas concavity has the opposite effect, (which is directly connected with taking too many or too few risks, so with an inefficient result).

Introducing linearity in the slope of the function, and eliminating upper and lower threshold, (salary reductions, deduction from a Bonus bank, cumulative performance bonuses, etc) is Principle 1 as depicted by Murphy and Jensen. It can be as simple a plan as a percentage of the metric, (Net Profit, Ebitda, etc).

a) Negative bonuses through Cumulative performance measures: negative results need to be made up before any profit is considered in a successive period. It allows only for small losses to be compensated.

b) Bonus banks: the bank is created in years in which bonus is positive, so that it is not fully paid, and a part, (or part of the base salary if no bonus is achieved), is kept in a bank account. If there is no cap, and bonus excess over the cap level is kept in the bonus bank, the measure is more palatable. The amount in the bank account is then used to compensate negative bonuses eventually being calculated in subsequent years.

c) Reduced salaries compensated by a bonus under the eventual threshold is also a way to introduce negative bonuses.

Using budgets to settle performance threshold: an incentive to lie.

Lower and upper thresholds for performance targets are generally established as a percentage of the budget target, so that the budget building process becomes a negotiation for bonus; there is an incentive to lie, to hide and destroy information, and to declare low growth capacity, so as to maximize bonuses.

Murphy and Jensen turn this into their Principle 2: separate the bonus from budget targets, so as to increase integrity and productivity.

Using the wrong benchmark or standard.

When performance is measured relative to a benchmark, there is always a possibility that managers affect not performance but the benchmark; the benchmark may be others` managers performance, which can be damaged by the executive; it can also be the case of a peer industry group, where managers may have the power to determine the peer group, while staying in a low growth industry. So Principle 3 follows: the executives under the plan should not be able to affect the peer group or standard against which relative performance (otherwise superior to absolute measurements) is going to me measured.

It is not a good idea to use prior year results as a benchmark: managers clearly learn to manage prior-year results so as to maximize bonuses. This constitutes Principle 4.

In general, Principle 5 states that benchmarks should not be under the managers` control or influence. The benchmark should then be externalized: in LBOs, the debt service could be used; using Cash-flow minus a charge for the use of capital allows to avoid budget targets; timeless standards may also be used to avoid that situation, (for instance where the metric is “Profit minus an absolute amount” that rises every year, so that the incentive is clearly to increase the profit performance.

(We will follow this analysis in a next post to be delivered soon).

1 Bonus Program Practices, a Survey of members of Worldatwork, 2005.

2 Ceo Bonus Plans: and how to fix them, by Kevin J. Murphy and Michael C. Jensen, November 19, 2011.

3 Sistemas de Retribución variable e indicadores de Control de Gestión, by Ramon Prat y Luis Muñiz, Partida Doble Review, number 135.

Categories: Compensation Tags: , , ,

On the benefits of Shareholder Engagement

On November 9th 2012 I wrote a post on Blockholder Disclosure: a case for transparency or for monitoring benefits?, where I gave arguments for and against a proposed regulation in the USA to limit the power of activist investors to hide their stakes, (both in volume and disclosure delay). Also on September 22nd 2012 I wrote about the engagement concept in my post Engagement: concept, objectives, and phases.

It is now time for Canada to think of an initiative similar to the one in the USA, and proponents advocate for a disclosure obligation once a shareholder reaches 5%, (instead of the previous 10%), in a lapse of two days, (full disclosure, not just a press release, which they ask to be required immediately).

As s response for the Administration`s requirement for comments, two associations of the institutional investor community (Managed Funds Association and Alternative Investment Management Association), sent a letter which shows their discontent with the measures, and in particular refers to:

1.     Benefits of shareholder engagement,

2.     Regulatory history and comments on the effects of the previous regulation,

3.     Regimes in other countries,

4.     The substance of the proposed changes, and their view.

We will in this post refer to the first part of their commentary, the benefits of shareholder engagement, thus the reasons why their economic incentives should be preserved. But we will just make a quick commentary on the different systems applied in the main financial economies.

1.     Different regulatory regimes.

United States. Section 13 of the 1934 Act establishes a 5% reporting threshold, and obligations to disclose plans by the acquirer in a 10 day period, during which shareholders are not prevented from dealing with shares, and further increase their stake, so their economic incentive in engaging with the company. Only derivatives granting the right to acquire the beneficial ownership of shares in 60 days need to be disclosed and included in the percentage calculations.

United Kingdom. The threshold is 3% for UK issuers, (5% for non UK ones). It applies to all shares, whatever their class, (it is not applied within each share class). The maximum delay is 2 days for UK issuers and 4 days for UK issuers, but the wording refers to the moment the acquirer is aware of the fact, which allows for some more time. Disclosure is just for the fact, not the plans, and there is no prohibition to trade in any period. Derivatives are counted if they give the right to acquire shares, or the right to vote.

Australia. It refers to relevant interest upper then 5%, so that it leaves aside most derivatives not entailing the power to dispose of the share or the vote. The acquirer has 2 days for “a soft” disclosure after being aware of the fact, with no moratorium on trading.

2.     Benefits of shareholder engagement.

Engaged shareholders exchange views and management recommendations with managers and boards in the investee companies; they monitor management, and are a tool against the agency problem, thus adding efficiency to the way companies are managed, and increasing their performance and value creation.

But before considering their benefits and costs, we will explore their objectives.

What are their objectives?

They look for under-valued companies in which to invest their funds, acting so that the market anticipates changes and corrects the undervaluation, thus generating a profit. Their engagement can be reactive, (when an otherwise passive investor accumulates concern, so that instead of selling it calls for change), or proactive, (where an investor has identified an inefficient company, has bought a stake and has called for change). In both cases the usual way to do things is through quiet conversations.

They usually own a minority stake, so that they usually target companies with enough institutional investor power, from which they try to obtain support. Proxy contests that pursue the substitution of directors are costly and thus rare. Successful activists obtain support for their reasoning on the change needs, and do it in a long-term and value perspective that guarantees the support of a majority of shareholders.

What are the benefits of engagement?

The most relevant are:

·       They provide a check on management that other investors, (retail or passive institutional investors) do not provide, so that they force efficiency and shareholder value up.

·       They push for improved corporate governance: they help not only targeted firms, but all others that consider they could eventually be the target of an “attack”.

·       Superior returns on investment: the market clearly recognizes a probability that share price or any other metric, (like TSR), increases after an activist campaign takes place.

·       Improved productivity: Roa and other operational metrics are said to improve as a result of activism, as some studies demonstrate. More relevantly, those improvements use to be preserved in the long-term.

·       A more efficient asset allocation: activists use to have a deep capital allocation experience, which benefits target firms. They help firms divest and refocus, and particularly help them match divisions with the correct expertise.

In summary, targeted firms reduce their size and improve their productivity KPI`s such as Roa and others.

What are the costs of engagement?

Costs of engagement include reputational risk, transaction costs, brokerage costs, legal fees, communication and printing costs, and the costs of soliciting the support of fellow shareholders. In the USA a campaign ending in a proxy contest can reach a cost of $11 million, (this is an average, but there is quite a lot of dispersion in figures). Of course, activists have previously afforded research costs.

This is why activists ask for enough time to accumulate a large enough stake with which to make a large profit that offsets all costs. The sooner they are forced to disclose their stake, more difficult for them is to make that profit.

Do all shareholders benefit from engagement, or is there any discrimination that should be dealt with?

In principle, engagement benefits activists if they succeed to convince enough shareholders, or simply if they make a decent profit; also, stable shareholders who remain in the company after the attack absorb their share of the long-term value unveiled; as for shareholders selling their shares to activists, the doubt that they can be harmed is slightly unfair, as they obtain a price which in any case is higher, due to the bidding pressure by the activist investor.

At the end, who is negatively affected?

Managers in inefficient firms, mature firms not adapting soon enough to market changes, are generally the only ones to suffer from the activist shareholder practice. This should not justify their protection against the huge benefits cited above.