Home > Value Creation > Performance Metrics and long term alignment (III)

Performance Metrics and long term alignment (III)

In this third and last post based on the IRRC Research Report, on The Alignment Gap Between Creating Value, Performance Measurement, and Long-Term Incentive Design”, (1) and (2) , we will refer to the alignment between Compensation and Value Creation. See our previous posts here (3) and here (4).

The survey shows that there is a low correlation between performance and compensation, even when pay is measured as Realizable Pay, (thus including the value change in unvested equity). The authors explain that this is partly due to something slightly unavoidable: the fact that pay needs to be competitive, so that correlation with value drivers, economic returns and underlying five-year economic performance suffers.

In any case, the research (by Shareholder Value Advisors) considers 75% of change in Ceo pay is explained by certain known factors, only 12 points out of these 75% are tied to performance, (revenue size, industry and inflation account for 44 points and previous years`s compensation accounts for 19 points).

The authors then analyze the state of the art in Long-Term Compensation Design.

Their key findings follow:

–         25% of forms don`t use any long-term performance based award, although this number has decreased the last years, (48% in 2009). They instead use time-based restricted stock units (quite stable) and stock options, (in the decline).

–         Metrics used to assess performance are diverse:

o       Financial: connected to Revenue, Earnings, CF or Balance Sheet, (EP among them).

o       Stock Market variables: absolute or relative TSR, (50% of firms use it).

o       Other operational and strategic variables.

The report by IRRC argues against TSR, because it may be affected by many factors out of the managers` control range, because it can be altered by several financial methods, because it is not really aligned with value creation, (see previous posts), and because the peer group selection is critical. This is why some firms use TSR as a condition, (awards are granted if goals are reached given that TSR is over a certain value) or as a modifier that raises or lowers the award.

Less than 25% of firms use balance sheet, capital efficiency or return metrics. But as the authors have stated before, Return on Invested Capital (ROIC) and Economic Profit, (EP) are the best measures for competitive advantage and value creation.

What is more, less than 13% of firms use performance indicators of future value, which is even more remarkable when it is noticed that long-term is usually understood as less than 3 years, (90% of firms). This last feature has particularly been the focus of long-term investors, (Pension Fund managers and so on).

Connected to this short to mid-term focus, the authors outline the fact that LTIP, Peer groups, are usually changed or modified very often, thus preventing firms and managers to keep their long-term perspective.

Consequently the IRRC introduces several recommendations:

First: Performance measurement needs to be tied to “business performance and value drivers”; compensation plans reward that and are the incentive managers need so that firms generate value; shareholder value is not more than an outcome.

Second: as for performance measurement, companies need to include capital efficiency; they need to distinguish between current and future value and their respective measures; companies also need to consider long-term, that is, more than five years.

Third: metrics and peer groups need to have some stability inside LTIP`s.

Fourth: if a higher correlation between pay and value creation is to be achieved, apart from tackling the subjects mentioned above, focusing on the life cycle of the business model in order to have a more competitive pay package could help, (see also our previous posts).

  1. http://irrcinstitute.org/projects.php?project=75, by Organizational Capital Partners and commissioned by the Investor Responsibility Research Center Institute (IRRCi), (Mark Van Clieaf, Karel Leeflang, Partner and Stephen O’Byrne).
  2. See also interviews with Jon Lukomnik, Executive Director, Investor Responsibility Research Center Institute (IRRCi), at https://www.nyse.com/corporate-services/nysegs/videos/twib, (January 15th and previous).
  3. https://joaquinbarquero.wordpress.com/2014/11/29/performance-metrics-and-long-term-alignment/
  4. https://joaquinbarquero.wordpress.com/2015/01/17/performance-metrics-and-long-term-alignment-ii/
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