Short-Term Gain, Long-Term Pain

March 10, 2017

The Issue

Shareholders complain about executive pay systems that reward for short-term gains while they are left holding the proverbial bag well after performance has waned. With the heavy mix of long-term incentives in executive pay programs, our executive pay system is seemingly long-term in nature, but can still miss the long-term alignment mark. Why? What is the appropriate time horizon over which to measure shareholder value? How can the issue of pay and performance alignment over time be addressed?

This year, we are seeing several investors, including State Street and BlackRock, address their annual letters to CEOs and/or boards of portfolio companies to ensure accountability for creating long-term shareholder value. Although several rules of Dodd-Frank may be scaled back and/or not enforced, investors want their portfolio companies to focus on areas that contribute to long-term growth. Accordingly, investors will be zeroing in on how companies address environmental, social, and governance (ESG) factors. According to one large investor, it wants to see that companies are attuned to the key factors that contribute to long-term growth, sustainability of the business model and its operations, attention to external and environmental factors that could impact the company, and recognition of the company’s role as a member of the communities where it operates.

Farient’s Point of View

Shareholder communications will continue to be extremely critical to ensure that investors and executives are aligned. A central theme for executives is to manage for the long-term prosperity and sustainable value of the business. There are a number of issues with executive pay programs that allow for short-term profit-taking without the underpinnings of sustainable performance, including short-term incentive plans that can reward handsomely for results that don’t lead to value creation, and relatively short vesting periods and performance cycles in long-term incentive plans. But one of the most significant factors driving misalignment is often the length of option windows (i.e., the time between vesting and expiration), and the corresponding ability of the executive to accumulate options and then cash out during a secular market run-up. Farient supports a minimum of three-year vesting on long-term incentives and holding periods for CEOs and named executive officers after incentives have vested.

How Farient Can Help

We routinely assess timing issues for our clients. To do this, we assess the time horizon of the business, as indicated by investment time horizons relative to the time horizon of the pay programs. In this regard, we assess vesting schedules, performance measurement periods (including entry and exit points), option windows, clawbacks, holdbacks, ownership guidelines, and even executive behavior (e.g., do executives accumulate options and cash them out in a run-up, or do they hold their options generally to term?) to determine the ability and likelihood of executives realizing high gains in the short-term when performance is not sustainable in the long-term. We use our Shareholder Value Analysis™, Performance Alignment Reports™, and Farient Forecaster™ to understand the implications and potential consequences of incentive programs and then recommend changes in program design and features to help companies better align pay and performance outcomes over time.

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