01 October 2019 by Peter Swabey
Share buybacks do not inflate executive pay or crowd out investment
Regular readers of Governance and Compliance may recall a debate in these pages in November 2015 about share buybacks. According to one view, they “are frequently more concerned with boosting a company’s financial indicators or executive remuneration packages rather than enhancing value for shareholders” and demonstrate a lack of initiative on the part of a company which is unable to find investment opportunities for cash sitting in the balance sheet.
Conversely, there is a view that there are good reasons why a company may undertake a share buyback, including: the execution of a capital allocation model agreed with shareholders; to consolidate ownership to reduce the cost of capital by paying less in dividends; to take advantage of market undervaluation; to avoid investor dilution by repurchasing to offset shares issued under share plans; and to make the shares more attractive to investors by boosting earnings per share (EPS) or the price/earnings ratio. Buyback proposals are often popular with investors. This is not least because their impact on EPS and return on assets are usually at least as positive for investors as they are for managers. One of the reasons why investors like to see EPS and total shareholder return (TSR) as common metrics for executive remuneration schemes is that they directly link executive remuneration to shareholder interests. But a vocal minority continued to argue that share buybacks were tantamount to fraud and, in January 2018, the Government announced “new research to address concerns that companies may be repurchasing shares to artificially inflate executive pay”.
That research, undertaken jointly by Professor Alex Edmans of London Business School and a team from PwC led by Nick Forrest and Tom Gosling, has now been published. According to the LBS press release, “The research aimed to answer two main questions. The first is whether buybacks are used to inflate executive pay. Perhaps the most striking finding was that, over the 10 years studied, not a single FTSE 350 firm successfully used share buybacks to meet an EPS target. Specifically, there was no firm that ended up above its EPS target that would have been below had it not repurchased shares. Moreover, firms that ended up above their EPS target bought back fewer shares than those that ended up below – inconsistent with concerns that they hit the target through buybacks”.
That seems a fairly clear answer, but even more interesting was further research into the terms of the executive pay arrangements in companies, which found no link between share buybacks and EPS targets in executive pay schemes. Put simply, the evidence was that “executives with EPS targets did not undertake more repurchases than those without”. And moreover, “there was no relationship between the proportion of an incentive award linked to EPS and the amount of buybacks”.
The second question that the research sought to answer was whether buybacks crowd out investment. “The authors found no relationship between share buybacks and investment, inconsistent with concerns that executives were scrapping investment projects to fund repurchases. Instead, it appears that companies make investment decisions first, and only engage in buybacks if there is spare cash left over”. This was the case even in companies which would have missed an EPS target in the absence of a buyback.
In addition to looking at the links between buybacks and executive pay, and between buybacks and investment, the authors also looked at the links between executive pay and investment. This was more interesting. What they found was that companies where EPS is a factor in executive pay seem to invest less than firms where it isn’t, which suggests that any problem with investment might be more related to EPS targets rather than share buybacks. The evidence is of a correlation, not causation and again there could be good reasons for this link. As Professor Edmans commented, “The link between EPS targets and investment is intriguing and warrants further investigation. It may be that simpler, longer-term pay structures promote investment, which is key to companies growing the pie for all of society”.
All this comes as no surprise to those who did not believe there was a problem with share buybacks and regarded the research in the same light as sending an expedition to the moon to prove that it is not made of green cheese. But it is really good to have a sound academic basis for our saying so and I agree with Professor Edmans’ view that BEIS are to be applauded “for taking an evidence-based approach to policy and engaging in diagnosis before treatment”. Would that other Government and regulatory change were subject to the same enlightened approach.