Broadly speaking, hedge funds have one common goal – to maximise returns to their investors. Some hedge funds use an investment strategy called activist investing, which involves buying a relatively large stake in a company to pressure management to make changes, such as cost savings, spin-offs and hire new management. In some cases, management will negotiate with the activist shareholders. In other situations, activist shareholders conduct proxy contests to gain control.
CEO pay is an easy and obvious target for many activist shareholders as a lever to pursue their broader agenda that includes a desire for more board seats, changes in top management, or the pursuit of strategic change. The involvement of activist shareholders exacerbates the risk of ‘high pay and low performance’ situations for compensation committees. Creating aligned CEO pay for performance is very challenging in the current macroeconomic and regulatory environment. Each company has its own set of circumstances to ensure that the executive team is motivated and shareholders are satisfied (expressed via successful say-on-pay votes). This alignment frequently requires careful private analysis, negotiations and resolution under uncertainty. New shareholders with perfect hindsight may not agree with the prior decisions. Thus, good corporate governance and careful decisions about CEO compensation will be needed to withstand the potential pressure imposed by this type of investor.
We base this assessment on our direct experience with roughly 10 activist shareholders, plus a review of proxy statements where activist shareholders are compensation committee members. Each situation is unique, but there are some common themes. First, we provide our observations regarding an activist shareholder’s pitch to a target company’s shareholders to solicit votes for their recommended board slate. Next, we provide commentary regarding actions taken by activist shareholders when they become members of the target company’s compensation committee. In these circumstances, management and existing board members need to be open to valid suggestions regarding potential improvements to its executive compensation programme. However, we also provide strategies and analysis that can help provide justification for the executive compensation programmes and decisions.
Activist shareholder pitch documents
Typical activist solicitations involve requests for board seats so they can influence strategy and tactics, including executive compensation. However, occasionally, activists use proxy contests to solicit votes to increase their board membership. Proxy contests receive a considerable amount of press coverage due to the high stakes and personal criticisms that activist shareholders often make against the company, its board of directors and its chief executive officer. When activist shareholders directly pitch their rationale to a company’s shareholders to vote for their proposals, they provide the business case for change that often focusses on executive compensation and governance issues. Common executive compensation-related themes that we have observed in these pitch documents are detailed below.
Identifying pay-for-performance misalignment Activist shareholders generally start out identifying a pay-for-performance misalignment with a variety of analyses. The most common approach is to simply comment on the history of annual bonus payouts expressed as a percentage of target compared against year-over-year total shareholder return (TSR) and/or key financial results. This type of analysis can be compelling to show pay-for-performance misalignment if annual bonus payments have paid above target year-over-year while annual TSR declined during the same period. The compensation committee is generally criticised for making consistently poor choices of paying incentives when TSR is declining.
In a related analysis used by activist shareholders, they show realised pay compared to TSR. While definitions of realised pay varies, a common definition of realised pay equals sum of salary, bonus paid, earned performance shares, vested restricted stock and the gain from stock option exercises. Realised pay is generally calculated over the CEO’s tenure or over a three-year or five-year period. This type of analysis can be compelling to illustrate a pay-for-performance misalignment if the CEO is realising pay above target levels while TSR declined during the same period.
Activist shareholders will also show cumulative CEO pay over his or her tenure compared to TSR over the same period. The optics of this analysis can be embarrassing because the information is gathered from the summary compensation table (SCT) of proxies, which is mostly comprised of target pay as opposed to realised pay. The graphic typically shown by activist shareholders shows SCT pay increasing while TSR is declining.
And finally, we have seen examples where activist shareholders challenge the appropriateness of non-generally accepted accounting principles (GAAP) adjustments that are applied to incentive metrics. Activist shareholders will challenge adjustments to non-GAAP metrics especially if they significantly increase incentive payouts. However, we believe that most companies will continue to use non-GAAP incentive metrics because such measures provide management with the best line of sight and investment analysts will continue to rely upon adjusted metrics. We also expect companies to begin enhancing the disclosure of this topic in the compensation discussion and analysis by providing a rationale for using adjustments and, potentially, a reconciliation of actual reported results to adjusted results used to determine incentive awards.
Illustrating lagging relative total shareholder returns While related to pay-for-performance misalignment, activist shareholders also make the point to illustrate the company’s lagging relative total shareholder returns. These common types of relative TSR analyses are typically calculated over the CEO’s tenure and previous one, three and five years. Depending on the circumstances, the company’s TSR results are shown relative to industry peers and a broad index.
Detecting corporate governance concerns It is common for activist shareholders to identify potential corporate governance concerns at the target company. Some of the concerns can be personal in nature and involve criticism of board member background, relationships and experience. This tactic is taken because they want to replace those board members with a slate of their own board members. Other governance concerns expressed by activist shareholders include compensation committee members that approve a peer group that is much larger than the company (so called ‘cherry picking’) and bonuses, despite a lagging stock price. And finally, activist shareholders will cite proxy advisors’ negative comments about the target company. Some of the proxy advisors, can be influential in terms of the weight of their comments and impact on actual voting recommendations.
The impact of activist shareholders on a compensation committee
When shareholder activists get seats on the compensation committee, the executive compensation areas that are commonly focussed on include pay process, pay designs and pay levels. In our experience, the board members that shareholder activists recommend are very experienced and knowledgeable in these areas.
“WHEN SHAREHOLDER ACTIVISTS GET SEATS ON A COMPENSATION COMMITTEE, THE EXECUTIVE COMPENSATION AREAS COMMONLY FOCUSSED ON INCLUDE PAY PROCESS, DESIGNS AND LEVELS”
Pay process The shareholder activists start with a review of the company’s compensation philosophy that drives executive programmes and levels. The compensation philosophy review typically covers a strategic oversight of: compensation programmes (e.g. develop and maintain the compensation strategy/philosophy; review and approve all compensation and benefit plans designed to support compensation strategy), pay administration (e.g. review major organisational changes with CEO; review and approve compensation); and adjustments for CEO and executive officers; ensure competitiveness of executive compensation) and other elements (e.g. oversee executive and director stock ownership guidelines; CEO succession; oversee director compensation).
Next, the peer group used to evaluate executive compensation levels and programme is reviewed. We observe that shareholder activists take a hard line on peer group selection and focus on the following steps. First, they identify a group of similar companies based on industry and size; for size, the focus is on revenue and market capitalisation. Shareholder activists also like to consider enterprise value, which is broadly defined as (market capitalisation + total debt) – (cash, short-term investments). Finally, qualitative factors are assessed to make final adjustments to the peers. For example, companies with founders or ‘controlled’ companies might be excluded.
Each compensation committee has a process to include company management in the design and recommendation of pay levels and programmes. Some compensation committees rely heavily on management to prepare analysis and recommendations while others have their compensation consultant take led on developing materials for the committee.
We observe that shareholder activists prefer to have a balanced approach that includes management and the committee’s consultant working together to prepare analysis and recommendations for the committee.
Pay designs Shareholder activists tend to exert a high degree of influence and change on the company’s incentive designs. When incentives are on the compensation committee’s meeting agenda, we find that shareholder activists are very engaged by asking more questions and challenging management’s assumptions. With the underlying goal to improve the company’s pay-for-performance alignment and accountability, we observe several types of incentive design changes at companies with shareholder activists on the compensation committee.
For annual incentive designs, shareholder activists generally eliminate the use of too many goals, discretion and measuring of individual performance. As a result, the new annual incentive design is based solely on two or three key financial metrics. We have found that shareholder activists gravitate towards return on capital, profit margin, or earnings per share (EPS) metrics to encourage the company to conduct buybacks in order to increase EPS. While difficult to quantify, the new goals are deemed to be more challenging compared to prior goals. If maximum bonus opportunities are outside competitive norms, for example at 300 per cent of the targeted amount, shareholder activists push to bring maximum opportunities to market practice at 200 per cent.
For long-term incentives (LTI), shareholder activists generally want to increase the weight of performance-based LTIs and reduce the weight of time-based LTIs, such as restricted stock units. Similar to annual incentives, the performance-based LTIs will vest based on two or three key financial metrics. Shareholder activists also tend to include relative TSR as one performance-based LTI metric. We typically see a roughly equal mix of stock options and performance-based LTIs with no time-based restricted stock. There are some situations where activists have made very large lump sum grants of performance share units with very challenging stock price goals.
The next pay programme that shareholder activists focus on is severance programmes related to change-in-control (CIC) and non-CIC situations. Key elements that are reviewed include eligibility, cash severance multiples, CIC definitions, excise tax gross-ups and events that trigger cash severance and equity acceleration. In general, we have found that shareholder activists simply want CIC and non-CIC related programmes to be fair and competitive. Their goal is to avoid high value severance benefits for termination due to poor performance (‘pay for failure’) or following a change in control. This is a hot button issue with major institutional investors and their advisers. We do see some companies adopting an emerging best practice to include employing executives ‘at will’ without employment agreements, reducing or phasing out cash severance for termination without cause, reducing cash severance for termination following a change in control, requiring a double trigger for equity acceleration in a change in control, avoiding equity acceleration in the event of a termination without cause and avoiding the temptation to go beyond plan provisions and boundaries at separation.
Pay levels While not at the forefront of making strategic changes, shareholder activists will address pay levels if they are deemed to be above market and not consistent with the company’s compensation philosophy. We have observed instances where target LTI values are well above market (lump sum) and others where LTI grants for the CEO are reduced to be more aligned with market. Some shareholder activists also consider the relationship of CEO pay to other executives. If the CEO’s pay is relatively high compared to other executives, the shareholder activists may view that as a CEO with too much power.
If perquisites are above norms, shareholder activists will likely take steps to align them with market practices.
Strategies to justify executive compensation programmes
Proactive strategies that a company can use to provide justification for potential shareholder activists’ criticism of its executive compensation programme can start in the company’s proxy CD&A. For companies with lagging TSR and operating performance, providing a detailed rationale for executive compensation actions can provide useful context for current shareholders and potential shareholder activists. For example, the following is a forwarding-looking disclosure from a company that took compensation actions to recognise a lower commodity price environment and declining TSR.
Given the current, lower oil and gas environment and the company’s disciplined approach, the committee approved the following compensation actions for the next year: (i) freezing of base salaries for most senior executives, including NEOs; (ii) freezing of annual incentive targets at current levels; and (iii) reducing grant date values of LTI awards compared to the previous year’s grant date values. In addition, the company made substantive changes to its peer group on a prospective basis.
Other reactive strategies to address shareholder activists’ criticism of its executive compensation programme were as follows.
- Management and existing board members need to be open to valid suggestions regarding potential improvements to its executive compensation programme
- Assuming favourable vote results, providing a history of the company’s say-on-pay voting record indicates that existing shareholders approved the executive pay programme
- Showing CEOs realised and realisable compensation over his or her tenure
- If the company’s stock price has been declining, realised and realisable analysis will illustrate that executive pay as a percentage of opportunity also declined
- Conducting analysis of correlation between incentive metrics and company’s stock price can indicate appropriateness of goals and alignment with TSR
- And finally, providing an analysis of goal difficultly can help support incentive plan designs and payout.
