Executive compensation
“Mature companies will take a different approach than growth companies.”
predictions of long-term performance. Even without those complicating factors, meanwhile, there is no ‘one-size-fits-all’ approach. For example, an industry- specific lens is often required to refine the details of any given programme.
“Creativity is often in the eye of the beholder and there is a question about how much creativity is possible while balancing internal and external stakeholder preferences with the overarching requirement for participants to understand the design mechanics and drivers,” explains Darren Moskovitz, a partner at Meridian Compensation Partners. “Over time, a practical observer would say that not much has changed,” Moskovitz continues, “as there has been lot of consistency in LTI programs, but you need to peel back the layers of the onion to look at the specifics of the industry you are in. In financial services, for example, regulators have had a significant influence on design. The biggest banks in the world have additional stakeholders – the Federal Reserve or the Prudential Regulation Authority – that are focused on balancing risk and reward.”
In other sectors such as technology or energy, different factors are at play, as Meridian partner Jon Szabo well knows. “Any LTI programme must align with corporate strategy and the company’s compensation philosophy and objectives. But companies need to be more transparent about any features that deviate from market norms so there are limits to the appetite for creativity,” Szabo explains. “There is a push to awarding increasing amounts as performance-based LTI, but a lot depends on where companies are in their life cycle. Mature companies will take a different approach than growth companies. “The oil and gas industry, for example, has gone through a whirlwind of change over the past few years,” Szabo adds. “Independent exploration and production companies have adopted sweeping changes in LTI design driven by a downturn in the market a few years ago, as traditional energy investors fled the sector and new value-focused investors came in demanding improved returns.
“The result is that the once typical 50/50 mix of time- based and performance-based restricted stock – where performance was almost exclusively based on relative total shareholder return (TSR) – has shifted in response to shareholder pressure to now be more weighted to performance-based award that often are earned based on absolute TSR or capital efficiency. Relative TSR hasn’t gone away, but its influence on payouts has been significantly reduced. More broadly across the general industry, companies now use multiple metrics in their performance-based LTI programme as they strike a balance across various performance metrics used across both the cash bonus plan and the LTI programme.”
32 Tools and trends in LTIs
Before facing the challenge of measuring performance, compensation committees must fully understand the different instruments that can be used to create LTI programmes. Three LTI vehicles are most common here. The first is performance-based full-value shares or units (PSUs). These are allocations of company stock that are typically granted to managers and executives if certain company-wide performance criteria are met, such as earnings targets. The second is service-vesting full-value shares or units, or restricted stock/RSUs. These awards come with conditions, usually a vesting period before they are transferred. A restricted stock unit (RSU) will vest at some point in the future so long as the recipient remains employed by the company and will have some value upon vesting – unless the underlying company stock becomes worthless such as in a bankruptcy. The final vehicle is stock options or – though less common – stock appreciation rights that give an investor the right but not the obligation to buy the company stock at an agreed-upon price. Unlike restricted stock/RSUs, stock options only have value if the price of the stock increases. Meridian’s 2022 corporate governance and incentive design survey surveyed 200 large publicly traded companies across a variety of industries and found most companies (55%) use two LTI vehicles, while 38% use three or more and only 7% use one vehicle to grant LTI awards.
Almost all public companies (97%) grant performance-based full value shares or units as part of a pay-for-performance approach to executive compensation. Restricted stock and RSUs are used by 73% of companies, while 54% grant stock options. The survey also revealed that since 2012, performance- based vehicles have comprised of at least 50% of total LTI value, but that portion is trending higher in recent years, especially for larger companies. LTI awards, including performance-based vehicles, are awarded based on a targeted dollar value denominated in an equivalent number of shares on or near the grant date. The leverage, the ability to earn above or below target, is applied to that number of shares that suggests companies are seeking more shareholder alignment, additional leverage, compliance with ownership guidelines, conservation of cash and fixed accounting treatment.
A question of metrics The use of performance-based LTI tools raises the crucial question of what metrics should be used to measure performance. Turning again to the Meridian survey, it seems that the most prevalent performance metrics continue to be relative TSR (76%), operating income, revenue, cash flow and EPS. A significant
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