Joseph E. Bachelder III ()
Three categories of performers are rewarded for value creation in U.S. public corporations. They are: (1) the executives who manage the corporations; (2) the directors who oversee the performance of these corporations; and (3) the individual asset managers and others who provide investment services to investors who own, directly or indirectly, these corporations.
The following discussion takes a look at the correlation between the long-term incentive compensation of these three categories of performers and long-term value creation in U.S. public corporations that is attributable to them. In fact, such correlation appears to be limited. In addition, the article will consider a definition of “long-term” value creation, the roles of these three categories of performers in creating “long-term” value and the methods of compensating these different categories of performers in their respective roles in “long-term” value creation.
‘Long-Term’ Value Creation
When reference is made to the value of a U.S. public company, it is typically a reference to the total market value of its stock. Whether the reference is to total market value of a company’s stock or to some other measurement of value, the value must be coupled with sustainability to be meaningful for the purposes of this column. Sustainable value creation in a business enterprise, for purposes of the following discussion, assumes the creation of value that grows consistently with (or exceeds) the growth of the economic community (including the industry (or industries)) of which the business enterprise is a part.
What constitutes “long-term” for purposes of satisfying a sustained value requirement will vary depending on the perspective of the investor. A hedge fund, and its investors, will generally have a different time horizon for their investments than Warren Buffet has for his. For purposes of the following discussion, a period of five or more years is considered “long-term.”
Roles of Performers
The three categories of “managers” discussed in this column differ considerably in their roles in “long-term” value creation.
Executives. The executives who manage corporations are, generally speaking, responding to current challenges and those they face over the next one to three years (i.e., short-term). The extent to which an executive is expected to step back and “look down the road” several years, or even longer, varies by the executive’s level and function in the organization.
A chief executive officer will spend a significant portion of his or her time on long-term performance planning, often in coordination with members of the board of directors. A senior executive for corporate planning spends a significant portion of time on long-term matters. Generally speaking, however, an executive’s primary role involves performance measured over terms of one to three years, not, say, five to 10 years. As discussed below, their compensation reflects this.
Directors. While it must address short-term issues, including periodic emergencies, a major role, if not, the principal role, of a board of directors is to oversee the long-term well-being of the enterprise. These long-term needs include strategic, financial and human resource planning.
Asset Managers. Asset managers of funds investing in publicly traded companies look at the value of an enterprise from the perspective of those they represent in managing an investment in it. This means considerable variation in the time horizon depending on the type of fund the asset manager is running. A hedge fund involved in short-term holdings will have a different time horizon from a mutual fund run by Vanguard or Fidelity.
Most long-term incentive compensation is not a reward for “long-term” value creation. While the most significant portion of long-term incentive awards is in the form of employer shares or share-related awards (such as stock units and stock options), the period of time over which the awards are earned is too short a period to represent an award for “long-term” value added.1 While stock options generally have an exercise period of 10 years, they vest and many are exercised (or forfeited) over much shorter periods. Following is a closer look at the methods of compensating the three categories of performers.
Executives­: Duration of Awards. Typically, vesting periods for long-term incentive awards (whether based on time-vesting or performance-vesting) are three years.2 The median of three years must be adjusted to reflect the fact that most time-vested long-term incentive awards vest in equal installments. (For example, a three-year time-vesting award that vests one-third at the end of year 1, one-third at the end of year 2 and one-third at the end of year 3 has an average earn-out period of two years.)
Most performance-based long-term awards have a performance period of three years and cliff vest at the end of year 3 if performance targets are met. (“Cliff vest,” for this purpose, means the award vests at the end of the three-year period (i.e., on the date on which the performance targets are met) rather than in installments over that period.)
Award periods such as those noted do not match the definition given above for “long-term” investment holding periods—five years or more. (As in the case of other equity awards, the median vesting period for stock options is three years. While most stock options are exercisable for 10 years from date of grant, most options, in fact, are exercised or forfeited much sooner than 10 years.)
Executives: Other Design Characteristics of Awards. As noted, the predominant forms of long-term incentive awards are: shares, share units and stock options. Some of these awards are time-vested and some vest on the basis of performance. Performance metrics vary. An increasingly used performance metric is total shareholder return (TSR) (or relative TSR (meaning TSR compared with a peer group or an index)). TSR is simply a snapshot of value based on the increase (or decrease) in market value between two dates (a base date and an end date) plus dividends attributable to this period.
Two snapshots of market price obviously do not represent a measure of “long-term” value creation.3 Other criteria that are used and are more relevant to creating and sustaining “long-term” value include operating and/or financial criteria such as cumulative growth in earnings per share or return on invested capital. But even these “engines” of “long-term” value creation have limited usefulness as a metric of actual “long-term” value creation because two or three years of performance does not necessarily mean “long-term” value will be created.
In short, there is not an exactness in “fitting together” the idea of long-term incentives for executives with the idea of “long-term” value creation. This is true as to both the design and duration of such incentives.
Directors. Until relatively recently, directors’ compensation has not been the subject of much public attention. Since the Securities and Exchange Commission, in 2006, adopted regulations requiring more detailed information on directors’ pay, more attention has been given to this subject.
An examination of major surveys indicates that directors’ pay generally is short-term rather than long-term.4 Most of directors’ compensation is a combination of cash-based fees and equity awards that vest on grant or within one year of grant. Somewhat less than one-half of major U.S. public corporations delay the delivery of stock awards (or the payment of cash in respect of the stock awards) to a date later than the vesting date. Almost all of the companies delaying payout of equity awards delay it until the individual director retires from the board.
Asset Managers. For decades, entities performing as asset managers have been compensated on a formulaic basis by those whose assets they manage. Currently, a prevalent formula for hedge funds is an annual fee of 2 percent of assets under management and 20 percent of gains realized. This contrasts with a typical formula for mutual funds of 1 percent or less of assets under management.
Within an institutional asset manager, the individuals doing the asset management are compensated on whatever incentive formulas the institutional asset manager (their employer) provides them. These formulas generally are not publicly available. It appears that a substantial portion of incentive compensation for asset managers whose portfolios are invested in public companies is deferred through participation in the funds they manage. But, as in the case of executives’ long-term incentives, it appears that a substantial portion of time-vesting is on an installment basis such as three years.
A three-year time-vesting deferral, as already noted, is really one that, on an equal-installment basis, is an average of two years. Some long-term amounts awarded to individual asset managers appear to be in the form of equity in the employer itself (and thus do not relate directly to the management by the individual asset managers of “long-term” investments they are making in public corporations).
Long-term incentive compensation is not really designed as an award for “long-term” investment performance (i.e., over a period of five years or more as described at the outset of the column). Perhaps it is unrealistic to expect that any form of incentive compensation can be designed that will correlate with the economic performance of a business enterprise over a period of five to 10 years.
There is a significant degree of uncertainty as to the correlation between creation of value in a publicly owned enterprise over a “long-term” period and management’s role in the creation of that value. In an article published in the fall of 2012, Roland Burgman and Mark Van Clieaf noted that:
An untested but generally accepted rule of thumb is that 50 percent of long-term change in a share price is due to broad macroeconomic factors, 25 percent to industry-specific factors, and 25 percent to company-specific performance factors. Thus, some 75 percent of the influence over share price is broadly out of management’s control.5
This observation is consistent with another by David F. Larker, in an article published by the Stanford Graduate School of Business, also in 2012:
Although a considerable number of theorists and practitioners have argued that CEOs play a critical role affecting firm performance, the empirical research on this issue is mixed. Thomas (1988) finds that CEOs are responsible for only 3.9 percent of the variance in performance among companies, while Mackey  finds that the impact is much greater: as high as 29.2 percent.6
Keeping performers “on track” by encouraging behavior today that is consistent with sustaining value over the “long-term” is what long-term incentive compensation, in most cases, is designed to do. But, again, we should not confuse an award for performance over a two- or three-year period as a reward for achieving “long-term” value enhancement. It goes in that direction but it is not contingent on achievement of that enhancement.
Some Suggestions. While long-term incentive pay does not necessarily match with “long-term” value creation, following are some suggestions for enhancing the effectiveness of such compensation in enhancing such value creation.
• Once the long-term incentive compensation is vested, payout might be delayed for an additional two years or, if longer, to the date five years after the original award date.7 (In other words, if a long-term incentive award vests in equal installments over three years, actual payout would be delayed for all installments until the fifth anniversary of the award date.) In the case of an award that is taxed on vesting (i.e., stock) the after-tax value of the stock would be required to be held until the fifth anniversary of the grant. This requirement also could be applied to the deferral of individual asset managers’ incentive compensation into the funds they manage. This observation as to executives and individual asset managers also could be applied to awards of equity to directors that, under current practices, are distributed within a year or less of the award.
• As explained in footnote 1, most major U.S. public companies require their senior level executives and their directors to hold a certain amount of stock in the company (generally expressed as a multiple of salary or, in the case of directors, a multiple of annual cash retainer). A suggestion would be to extend the period of holding for a period after retirement of the executive or of the director. For example, the requirement might be for five years, decreasing 20 percent a year over the five years. A similar suggestion might be made for asset managers (applied to the deferred amounts in the funds they manage).
• At periodic intervals—such as five years—a business enterprise or an institutional asset manager might review performance of an individual executive (or an individual asset manager) over the applicable period and, if warranted, in the discretion of the company, make a special long-term incentive award to such individual based on his or her contribution to the creation of “long-term” value over that period. The award might cliff vest at the end of three years based on what the company considers generators of further “long-term” value. The total period covered by such an award (historic and prospective performance) would be eight years.
There is no way, practically speaking, to tie long-term incentive awards exactly to “long-term” value creation that is attributable to the respective performers. Improvement, however, can be made in the design of incentives that encourage “long-term” value enhancement.
Joseph E. Bachelder III is special counsel to McCarter & English. Andy Tsang, a senior financial analyst with the firm, assisted in the preparation of this column.
1. Most major U.S. corporations require executives to hold a certain amount of stock in their employer. This generally is expressed as a ratio of the executive’s base salary. Often this requirement is fulfilled by the executive over a period of years by holding stock awarded under short- or long-term incentive plans. Because it is more of a stock ownership requirement than a long-term incentive design, this requirement is not included in the text of the column’s discussion of long-term incentive compensation plans. (A similar stock holding requirement often is imposed on directors of major public companies.) A suggestion as to extending such holding requirement for a period following retirement for both executives and directors is made in the text at the end of the column.
2. A survey reporting on the duration of awards as discussed in this paragraph is “The 2013 Top 250 Report—Long-Term Incentive Grant Practices for Executives,” published by Frederic W. Cook & Co., Inc. (September 2013), at pp. 8 and 10. Document available at http://www.fwcook.com/research_reports.html.
3. For further discussion on this, see prior NYLJ column, Sept. 27, 2012. See also Roland Burgman and Mark Van Clieaf, “Total Shareholder Return and Management Performance: A Performance Metric Appropriately Used, or Mostly Abused?”, Rotman International Journal of Pension Management, 2012, Vol. 5, No. 2, pp. 26-33.
4. Points made in this paragraph are discussed in “2013 Director Compensation Study,” published by Steven Hall & Partners (Sept. 30, 2013), at pp. 9, 13 and 15. Document available at http://www.shallpartners.com/our-thinking/short-takes/2013-director-compensation-study/.
5. Burgman and Clieaf, supra, at p. 27.
6. David F. Larcker, Usman Liaqat and Brian Tayan, “What Is CEO Talent Worth?”, Stanford Graduate School of Business Case Studies, CGRP-23 (Jan. 24, 2012), at p. 2. The paper is available at http://www.gsb.stanford.edu/faculty-research/case-studies/what-ceo-talent-worth. See also Alan Berkeley Thomas, “Does Leadership Make a Difference in Organizational Performance?,” Administrative Science Quarterly, 1988, Vol. 33, No. 3, pp. 388-400; and Alison Mackey, “The Effect of CEOs on Firm Performance,” Strategic Management Journal, 2008, Vol. 29, No. 12, pp. 1357-1367.
7. For discussion of a specific example of extending the holding period for stock awarded under a long-term incentive plan, see prior NYLJ column, July 17, 2013.