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Linked to performance

26 June 2017 by Neil Tsappis

Linked to performance - read more

Strategic metrics aligned to long-term value creation will mitigate investor and public mistrust

On 5 April, the Business, Energy and Industrial Strategy (BEIS) Select Committee published recommendations that the Financial Reporting Council should lead a process for reshaping executive incentives.

Government, public and investor trust in executive remuneration is at its lowest point in recent memory, and reward systems are at an inflexion point. According to a 2016 study carried out by Li and Young of Lancaster University Management School, CEO reward in FTSE 350 companies increased by 83% between 2003 and 2015, whereas return on investment grew by just 1%.

In 2011, the One Society reported the average estimated FTSE 100 CEO total remuneration was 408 times the National Minimum Wage and 219 times 2010 UK median earnings. The highest estimated FTSE 100 CEO total remuneration was for Reckitt Benckiser’s Bart Becht, at £14.4 million, which was 1,262 times the National Minimum Wage and 679 times 2010 UK median earnings. Whatever the arguments in favour of CEO performances through recession to recovery during this period, the gaze of public disapproval is inescapable.

Reckitt Benckiser recently bowed to shareholder pressure by reducing current CEO Rakesh Kapoor’s 2016 pay by more than £10 million. Following the AGM vote of almost 60% against last year’s remuneration report, BP acted this year by cutting Bob Dudley’s 2016 pay by 40%, and significantly reduced his incentive potential. A wave of re-basing pay appears to be under way, though how far this goes remains to be seen.

Deferred preferred

Although falling short of imposing upper thresholds or pay caps in favour of a suite of measures promoting pay restraint, a key recommendation in the BEIS Select Committee report was to phase out long-term incentive plans in favour of deferred stock plans based on share price growth vesting beyond five years.

These plans have the advantage of simplicity and alignment with investors, but there are fears that yet another cycle of hope and disappointment is beginning.

Weak correlation

Except in specific circumstances, the correlation between CEO and corporate performance, as measured by financial and market-based metrics, is at best weak. Typically, CEOs have a highly constrained impact on financial performance, largely because they have no leverage over the company’s economic and competitive environments, and limited indirect leverage on movements in financial markets.

One exception centres on earnings that are highly sensitive to cost. A strong CEO can quickly turn around an ailing company. Measurement of CEO performance in those circumstances is more tangible and evidence-based. However, cost-cutting represents the easiest lever for a CEO to pull, and creates little or no long-term value.

A second exception is the founder/owner model of leadership as illustrated by the US tech giants, where financial and market performances are more closely aligned to the attributes of the CEO. However, acquiring such exceptional talent is rare for the vast majority of mature companies.

Previous CEO’s legacy

For a period after appointment, an incoming CEO will build on the legacy of the previous management’s efforts and decisions. Filtering out the effects of these in the CEO’s package is fairer to the CEO and to investors.

Talent plurality

The CEO is increasingly recognised more as an orchestral conductor and less an absolute monarch. Numerous studies have found that financial volatility increases with the concentration of CEO power. A more collegiate style reduces volatility and increases the potential for future value creation.

Although CEOs set the environment for tangible value creation, they rely heavily on the talent around them. Indeed, a 2000 study by Bhagat and Black indicated that executive plurality on the board improves the quality of strategic decisions, so a system that incentivises talent diversity is desirable.

To recap: the link between the CEO’s and the company’s performance is weak for the majority of maturing organisations. Corporate performance relies on wide-ranging external factors, and on a broader pool of internal talent. It is fairer to the CEO and investors to filter-out the effects of previous management when setting CEO pay. It follows then, that CEO incentivisation and reward should be aligned with drivers of long-term value creation under the CEO’s span of control.

A new approach

These factors can be addressed by a potential new approach to reward – performance attribution – tailored to the specific functions of the CEO. There are various performance models in regular use now for annual CEO appraisals. For example, Rivero and Nadler outline three measures of CEO performance: bottom-line impact, operational impact, and leadership effectiveness. However, these measures are often too vague for use as reward metrics.

In his article, ‘How Do You Evaluate CEO Performance? 6 Ways To Grade The Chief’, Joel Trammell proposes six key metrics: vision, human resources, capital, culture, decisions, and performance. Reformulating these into specific drivers or indicators of future value creation makes for better empirical measurement.

There are many potential candidates, such as the quality of strategy, entrepreneurial culture, stewardship culture and attraction of talent (there is a broader list, along with possible approaches to measurement, payout and disclosure, on the demyst.co.uk website). Remuneration committees can select a basket of metrics best suited to their company’s requirements.

For metrics to be seen to work effectively, it is important that actions leading to value erosion are penalised, though not necessarily in equal measure to value creation. In the UK we need to allow more room for CEOs to make mistakes in a culture that promotes entrepreneurialism.

To gain wide acceptance and trust, a suite of suitable metrics would need to be developed with the following characteristics: broad applicability and reliability across sectors, reporting periods and in varying conditions; transparency; the facilitation of accountability; and safeguarding commercial confidentiality. Balancing robustness and simplicity is also a key demand of major investors.

Reduce mistrust

Eradicating financial and market-based metrics will go a long way to reducing investor and public mistrust in executive pay.

A performance attribution approach based on long-term value drivers would also help address management fixation with short and medium-term measures to boost earnings or the share price. More than ever, during and after the current Brexit negotiations, investors and society need CEOs to think longer term, creating world-class businesses while the UK repositions itself in the world.

Neil Tsappis FCIS is a Strategic Company Secretary and Governance Expert

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