Since 2010, performance-contingent awards have been the most widely used long-term incentive (LTI) grant type among the Top 250 companies  and are now in use by 89% of the sample. The prevalence of performance awards and investor preferences have spurred considerable interest in relative total shareholder return (TSR) as a performance metric. Relative TSR measures a company’s shareholder returns  against an external comparator group and eliminates the need to set multi-year goals. Use of relative TSR performance awards among the Top 250 companies has increased from 29% in 2010 to 49% in 2014, and relative TSR is now the most prevalent measure used to evaluate company performance for performance awards.
Posts Tagged ‘Performance measures’
CEO compensation in U.S. public firms has attracted a great deal of empirical work. Yet our understanding of the contractual terms that govern CEO compensation and especially how the compensation committee ties CEO compensation to performance is still incomplete. The main reason is that CEO compensation contracts are, in general, not observable. For the most part, firms disclose only the realized amounts that their CEOs receive at the end of any given year. The terms by which the board determines these amounts are not fully disclosed.
Standard principal-agent theory prescribes that managers should not be compensated on exogenous risks, such as general market movements. Rather, firms should index pay and use contracts that filter exogenous risks (e.g., Holmstrom 1979, 1982; Diamond and Verrecchia 1982). This prescription is intuitive and agrees with common sense: CEOs should receive exceptional pay only for exceptional performance, and “rational” compensation practice should not permit CEOs to obtain windfall profits in rising stock markets. However, observed compensation contracts are typically not indexed. Specifically, stock options almost never tie the strike price of the option to an index that reflects market performance or the performance of peers. Commentators often cite this glaring difference between theory and practice as evidence for the inefficiency of executive compensation practice and, more generally, as evidence for major deficiencies of corporate governance in U.S. firms (e.g., Rappaport and Nodine 1999; Bertrand and Mullainathan 2001; Bebchuk and Fried 2004). This paper therefore contributes to the discussion about which compensation practices reveal deficiencies in the pay-setting process.
The hedge fund industry has grown tremendously over the last two decades. While this growth is due to a number of factors, one explanation is that its performance-based compensation system creates incentives for managers to generate alpha. This incentive system, however, could also motivate some managers to manipulate net asset values or commit outright fraud. Due to the light regulatory environment hedge funds operate in and their secretive nature, monitoring managers is generally difficult for investors and regulators.
In response, recent research has attempted to infer malfeasance directly from the distribution of hedge fund returns. In particular, the finding of a pervasive discontinuity in the distribution of net returns around zero has been interpreted as evidence that hedge fund managers systematically manipulate the reporting of NAVs to minimize the frequency of losses. This literature, however, has not recognized that performance fees distort the pattern of net returns.
In our paper, Are Hedge Fund Managers Systematically Misreporting? Or Not?, forthcoming in the Journal of Financial Economics, we show that inferring misreporting based on a kink at zero can be misleading when ignoring incentive fees. Because these fees are applied asymmetrically to positive and negative returns, the distribution of net returns should display a natural discontinuity around zero. In other words, there is a mechanical explanation for the observed kink in the distribution of net returns. We demonstrate this effect by showing that funds without incentive fees have no discontinuity at zero until we add hypothetical incentive fees to their returns.
Institutional Shareholder Services, the influential proxy advisory firm, has published for public comment two proposed changes to its proxy voting guidelines for U.S. companies. The proposals are limited and do not include any change related to the effect of longer board tenure on director independence. ISS had previously surveyed institutional investors and public companies on the topic of director tenure and received strong, but deeply split, responses from both constituencies. The proposed changes are:
Editor’s Note: The following post comes to us from Ron Shalev of the Department of Accounting at New York University, Ivy Zhang of the Department of Accounting at the University of Minnesota, and Yong Zhang of the School of Accounting and Finance at Hong Kong Polytechnic University.
In our paper, CEO Compensation and Fair Value Accounting: Evidence from Purchase Price Allocation, forthcoming in the Journal of Accounting Research, we investigate the influence of bonus intensity (i.e., the relative importance of bonus in CEO pay) and alternative accounting performance measures used in bonus plans on the allocation of purchase price post acquisitions. Upon the completion of an acquisition, the acquirer is required to allocate the cost of acquiring the target to its tangible and identifiable intangible assets and liabilities based on their individually estimated fair values. The remainder, namely, the difference between the purchase price and the fair value of net identifiable assets, is recorded as goodwill. The recognition of goodwill has different implications for subsequent earnings than that of other assets. Tangible and identifiable intangible assets with finite lives, such as developed technologies, are depreciated or amortized, depressing earnings on a regular basis. In contrast, goodwill is unamortized and subject to a periodic fair-value-based impairment test. As write-offs of goodwill impairment are infrequent (Ramanna and Watts, 2009), recording more goodwill generally leads to higher post-acquisition earnings.
The confluence of Say on Pay (SOP) votes and heightened scrutiny plus the influence of proxy advisory firms (particularly ISS) are having a major unintended consequence—the movement to “one-size-fits-all” or homogenization of executive compensation programs. It is true that SOP votes have encouraged some valid governance enhancements, for example, significantly more shareholder outreach by many large companies. However, in order to minimize the potential for a negative SOP vote outcome, many companies are changing their pay practices based more on potential external views than business/talent needs. This is particularly apparent in the design of performance share plans with the increasing use of relative TSR (at nearly 50% prevalence). Below we summarize other areas of the executive compensation program that are exhibiting homogenization, the resulting risks and potential steps companies can take to preserve/maximize the linkage to a company’s business strategy and talent needs.
The State Board of Administration (SBA) sponsored an executive compensation research study by Farient Advisors LLC, covering 1,800 companies, 24 Industry groups, and fourteen years of data (from 1998-2011). The research project identifies the primary metrics used in executive compensation plans, overall and by industry, company size, and valuation premiums, and then tests these metrics to determine whether the metrics being used have the highest impact on total stock returns.
The study provides the most definitive answer to date on a critical question—are companies choosing their long-term incentive metrics wisely for the most sustainable benefit to shareowners?
Current views regarding the proper pay plan design to achieve pay for performance vary. This post discusses the three dimensions of pay for performance, demonstrates how to measure them using historical pay data, and presents a simple pay plan that achieves perfect pay for performance (PP4P) using annual grants of performance shares. It also highlights pay practices that weaken pay for performance and offers recommendations for directors to deepen their understanding of pay-for-performance issues.
A growing number of corporations are releasing stand-alone sustainability reports. To provide insight into corporate sustainability performance, many reports contain sets of performance indicators. However, questions remain about what should be reported and the indicators disclosed vary widely. This report presents an analysis of the indicators disclosed in 94 Canadian corporate sustainability reports.
Sustainability policies, plans, programs, and projects have been initiated in corporations around the world. Given the broad nature of sustainability, the breadth and depth of these initiatives varies widely. For example, initiatives as diverse as measuring a corporation’s carbon footprint, fostering diversity in the workplace, and supporting community development could all be classified under the umbrella of sustainability. These initiatives are of interest to a variety of internal and external stakeholders. Depending on the issue, these stakeholders may include employees, investors, customers, suppliers, regulators, nongovernmental organizations, and local communities, to name a few.
One important way corporations share information about their sustainability initiatives is through the release of publicly available reports. Although the titles of these reports differ, they typically include words such as “sustainability,” “responsibility,” “accountability,” or “citizenship,” and they focus on addressing the economic, environmental, and social dimensions of corporate performance through a review of both qualitative and quantitative information. (For the remainder of this issue, the term “sustainability report” is used.)