Why the New PvP Disclosures Are a Game Changer
September 22, 2023
Why the New PvP Disclosures Are a Game Changer
Executive summary: Farient’s analysis shows that the Compensation Actually Paid figure from the new PvP disclosure relates pay to performance in a way that the Summary Compensation Table Total pay was not capable of doing.
For as long as executive compensation has been a governance concern, “pay for performance” has been the mantra. Investors accept that top executives make big bucks if they are creating value. However, when investors suffer, they expect executives to share their pain. Unfortunately, the total pay figures in the Summary Compensation Table (SCT) have been the only uniformly disclosed pay data that investors, the media, and other governance constituencies have had access to, and those figures are inapt for determining the degree to whether pay-for-performance alignment exists.
SCT total pay consists of three primary elements: salary, bonus paid, and the grant date value of equity awards. To understand why this measure isn’t helpful in determining alignment, consider a manager whose total pay consists of a salary plus a target bonus. If the company performs well, the actual bonus may significantly boost actual total pay. If the company performs poorly, the actual bonus may be low or non-existent. In each case, target pay is unaffected by performance, so there is no logic in comparing it to performance. The relevant comparison to performance would be realized pay—e.g., salary plus actual bonus.
For the senior executives whose pay are disclosed in the SCT, equity awards comprise the bulk of their total pay. Like target bonuses in the example above, those grants may change little from one year to the next, regardless of performance.
To properly evaluate executive alignment, investors need a measure of realized or realizable pay in long-term incentives to compare to performance. The new PvP rule provides that: Compensation Actually Paid (CAP). CAP is comprised of realized or realizable pay year by year. These disclosures have resulted in a trove of new pay data. Our analysis confirms that we are seeing for the first time a uniformly disclosed measure of pay that is appropriately comparable to performance.
For the three-year period disclosed by S&P 500 companies in their 2023 PvP reports, the relationships between total shareholder return (TSR) versus SCT CEO pay and CEO CAP, respectively, look like this:
Source: Farient Advisors
Trying to find a relationship between pay and performance in the left graph is futile; SCT total pay is entirely uncorrelated to TSR. On the other hand, the relationship between CAP and TSR is clearly visible. Even the outliers tell part of the story with some significant outliers showing an exaggerated relationship between negative CAP and negative TSR.
To better understand the possibilities of this new data it is helpful to distinguish three key factors driving the CAP vs. TSR relationship.
The biggest factor is the change in value of accumulated unvested equity, which is entirely determined by changes in the stock price. Most executives are heavily exposed to the ups and downs of their stock through their unvested (as well as vested) equity. Most of that variability is out of their control, but that exposure nevertheless ensures they are in the same boat as their shareholders.
The second next biggest factor is the value of equity grants awarded to executives within a given year. The value of new equity grants works against alignment since, like target bonuses, they generally represent target long-term compensation. In most cases, the value of new equity grants is greatly outweighed by changes in the value of unvested equity from prior grants due to changes in the stock price, but if the executive is relatively new and has not yet accumulated significant unvested equity or if the company grants equity episodically instead of annually, the annual equity grant may dominate CAP. The highest dot in both charts is the $225 million paid to Sundar Pichai, the CEO of Alphabet, because of a $218 million equity grant. This is a massive grant by any measure, but since Mr. Pichai has received grants only every third year, we can expect his 2024 and 2025 CAP figures to be nearer the bottom of companies for the next two years.
Finally, there is the treatment of vesting performance shares. These awards are reported in CAP at their target amount until the year of vesting. Then the entire difference between the target and vesting amounts shows up all at once in the vesting year. In other words, if performance share units (PSUs) vest at 2x target CAP will appear to noticeably jump. The net effect on PvP alignment is unpredictable, but PSUs will generally appear to result in less alignment than we would see with restricted stock or options without performance conditions.
In comparing pay to performance, CAP is a greatly improved measure of “pay.” It helps to also have a clear measure of “performance.” The PvP rule requires performance to be measured as TSR, Net Income, and a measure of the company’s choosing called the Company Selected Measure (CSM).
As investors begin to appreciate the superiority of CAP for determining pay-for-performance alignment, we should begin to see a shift away from the use of SCT Total pay in those comparisons. As this shift happens, boards and management teams will benefit from anticipating a new set of assessments in the design and disclosure of their compensation programs. Three ways they can do so include:
1. Understand what is driving CAP relative to TSR at their company. In particular, understand the degree to which the executives’ CAPs are being driven by the magnitude of unvested equity relative to new equity grants.
2. Pay particular attention to how PSU vesting aligns with TSR to see whether PSUs are helping with alignment over time.
3. Develop tight disclosures that explain the company’s alignment to the extent that alignment is visible, how prior grants contributed to that alignment, and how current awards will contribute to future alignment.
4. If the PvP results show poor alignment, particularly versus TSR, companies should determine why, and either remedy the causes of misalignment or explain how they are addressing it. Companies should not rely on alignment between CAP vs. Net Income or vs. their CSM to defend a long-term misalignment between CAP and TSR.
PvP disclosures enable investors to accurately assess the relationship between how executives are paid and how the company is performing. Every company has a story to tell. Investors were willing to accept bare bones disclosure in the rush to compliance this year. Next year they will be looking to hear more.
Note: Data cited in this article was sourced from Farient’s PvP TrackerTM .
By Marc Hodak