Long-term incentive plans – ASX listed companies and performance rights

Peloton Corporate

This paper is intended to provide insights as to how Performance Rights are employed by ASX-listed companies as an essential component of remuneration.

Remuneration committees, CFO’s, executives and shareholders will all benefit from an understanding of this now widespread tool.

The key points for long-term incentive plans

If you don’t have time to read the whole paper, here are the key takeaways:

  1. Long-term incentive [“LTI”] plans are a key reward and retention tool for senior executives
  2. Many LTI plans employ performance rights (zero-exercise price options) which vest if the company achieve a mix of absolute and relative financial objectives (e.g. EPS growth and TSR) or “performance hurdles”
  3. Careful consideration is required as to the selection of the vesting performance hurdles
  4. LTI plans which consistently fail to result in vesting will work against the retention objective
  5. A trusted adviser is often engaged to set, test and evaluate the performance hurdles and LTI plan outcomes

What are performance rights?

Performance rights are a near-ubiquitous tool in the remuneration toolkit of larger ASX-listed public companies.

A performance right is effectively a zero-exercise price option which results in the issue of ordinary shares (equity) in the issuing company upon satisfaction of performance hurdles.

The recipient is not required to pay a subscription price for the shares as the issue of the shares is a reward to the employee (usually a member of the executive team – what remuneration reports will typically refer to as Key Management Personnel [“KMP”]).

How are performance rights used?

Performance rights are part of the regular remuneration of KMP.

KMP remuneration typically has three components:

  1. A fixed, base salary – recognising the day-to-day role and responsibilities of the KMP. This component is often 50-75% of total remuneration, depending on seniority of KMP
  2. A short-term incentive [“STI”] – akin to an annual bonus and usually paid in cash in return for the successful achievement of performance objectives (e.g. sales and profitability growth, team management and other objectives of the position description). This component is often 20-30% of remuneration
  3. A long-term incentive [“LTI”] – intended to provide a reward consistent with the return enjoyed by shareholders with the clear objective of focusing the attention of KMP to align their performance with that enjoyed by shareholders. The LTI is often constructed to deliver 20-50% of remuneration and might vary across the seniority of KMP

As an equity-based scheme, the LTI plan must be approved by shareholders in the annual general meeting [“AGM”].

Managing director LTI plans are also expressly subject to shareholder approval.

In addition to a copy of the LTI plan rules, shareholders are typically presented with the gross value of shares which might issue based on the share price at the date of the AGM and the total number of shares which might issue if vesting hurdles are met.

The LTI plan is typically quite detailed and, whilst appearing to be reasonably prescriptive, discretion is also usually provided to the remuneration committee to vary certain elements of the plan.

Why are performance rights used?

From a shareholder perspective, one of the most beneficial reasons for utilising LTI plans is the alignment of interests between KMP and shareholders. LTI payments are linked to achieving outcomes that should drive shareholder returns, including financial outcomes (e.g. share price growth, earnings growth, returns achieved) and corporate outcomes (e.g. launching new products, entering new markets, acquiring new technology).

The longer-term nature of LTI plans encourages longer-term strategic thinking and value creation.

Successful LTI plan outcomes for KMP typically mean shareholders have enjoyed outstanding outcomes. For example, if performance rights vest under a typical TSR-based vesting hurdle it means shareholders have enjoyed a dividend and share price increase in the top 50% of peer group returns.

With an equity interest in the company, a successful LTI plan will reduce turnover in the KMP team.

This is a “soft” benefit of LTI plans which can also have significant financial benefit through reduction in recruitment costs and the productivity of a stable KMP team.

From a KMP perspective, a key benefit of the use of performance rights in an LTI plan is that the tax consequence for the recipient is deferred to the vesting date – typically three years, but this can vary.

They also enable a member of the KMP to significantly enhance their remuneration package through the delivery of positive outcomes.

The shares issued under an LTI plan are usually subject to escrow conditions which prevent the KMP from selling the shares for a period of three years (subject to the exercise of the discretion of the remuneration committee for purposes such as the payment of tax on the vesting of the shares).

Further, a universal vesting criteria is that the KMP remains employed by the company at the end of the performance period.

However, there is often a remuneration committee discretion to relax this condition under specific circumstances (e.g. in the event that a KMP stands down due to health reasons, a CEO contract expires prior to the end of the performance period, or a change of control).

Each of these factors contribute to LTI plans acting as an incentive based retention tool for KMP, encouraging longevity of employment and strategic planning.

An LTI plan also enables companies to remunerate KMP without the need for any cash outlay, supporting its cash flow position.

What are vesting hurdles?

Vesting hurdles are performance measures which must be met over the performance period (i.e., the life of the LTI plan).

Instead of merely granting equity to KMP, the imposition of vesting hurdles is an encouragement for the KMP to support the company in achieving certain measurable objectives.

The use of measurable performance criteria avoids the need for the remuneration committee to consider whether less objective objectives such as ESG outcomes have been achieved.

Financial measures also benefit from having been audited and are therefore less contentious.

Typical performance hurdles

Whilst there are clearly many financial outcomes which might be used as performance hurdles, it is customary to employ a handful of familiar measures:

  1. Return on assets or return on assets growth
  2. Earnings per share or earnings per share growth
  3. Return on equity or return on equity growth
  4. Total shareholder return (dividends plus share price growth divided by opening share price for the performance period)

Most of these measures rely on easily-accessible data but some require some careful consideration (e.g. are dividends measured at the date of declaration or payment to shareholders?).

It is possible that less objective measures will see the light of day in coming years. With the pervasiveness of ESG investing by large institutions it is likely that some will seek to ensure KMP are aligned to issues such as carbon footprint, gender diversity, indigenous employment etc.

It is a good idea to consult with proxy advisers and key shareholders to obtain input to LTI plan design or changes.

Absolute or relative performance?

The performance hurdles can either be based on an absolute or relative performance.

For example, a performance hurdle could be established which requires the achievement of 20 cents per share of earnings by the end of the performance period. This is an absolute measure of performance.

Similarly, a performance hurdle which requires 20% growth in EPS over the performance period is an absolute measure.

A relative measure benchmarks the company against a carefully selected set of peer stocks. For example, a relative performance hurdle may require that the company’s TSR must be greater than the 50th percentile of a peer group (more on peer groups later).

An absolute performance measure essentially address the question “has the company achieved its own targets?” whereas a relative performance measure addresses the question “has the company out-performed its peers?”.

There are nuances to the use of either relative or absolute measures. For example, in a buoyant market, should KMPs receive LTI remuneration for positive EPS performance, even if they performed worse than all of their peers?

Conversely, should a KMP receive no LTI remuneration for a negative EPS outcome, however the broader market is in the midst of a significant downturn, or say, a global pandemic?

How many performance hurdles are employed?

Most ASX-listed companies employ two performance hurdles – usually a combination of an absolute performance measure and a relative measure. However, there is no golden rule as to whether a mix of absolute and relative measures should be employed – it is a matter of judgement for the remuneration committee.

Apart from a little more administration, there is no reason why more than two performance hurdles could be employed – arguably introducing the possibility of using (e.g.) critical ESG measures.

Performance hurdle scaling

Most companies recognise that financial performance is likely to occur across an acceptable range and that no single number in that range can be precisely determined three or more years from the vesting date.

A common scaling of performance is to allow 50% vesting at the bottom end of a likely range through to 100% vesting at 75% achievement of the performance hurdle.

For example, a performance hurdle might be constructed along the following lines:

  1. In the event the company achieves a TSR ranking below the 50th percentile, no performance rights vest.
  2. If the company achieves a TSR ranking at the 50th percentile of the comparator group, 50% of the performance rights to which the hurdle applies will issue
  3. On a linear basis between 50th and 75th percentile the performance rights that vest rise from 50% to 100%
  4. If the company achieves higher than 75th percentile TSR, 100% of the performance rights will vest

Allocating vesting between performance hurdles

It is almost always the case that LTI plans equally apportion vesting between the performance hurdles.

For example if two performance hurdles are employed, 50% of vesting depends on each of the performance hurdles.

Peer or comparator groups?

If a relative performance measure is employed in the LTI plan vesting hurdles, it is necessary to establish who the company is compared with.

It is tempting to nominate one or two or even a handful of companies which the board thinks are reasonably comparable to the issuing company. However, this is often fraught due to the lack of truly-comparable companies.

For example, a company which provides consumer and commercial credit might, prima facie, be comparable to the big 4 banks plus a few additional financial services companies. Whilst appealing to be directly benchmarking against a universe of peers defined in that way, once the relative size of business units are considered (wealth management, international operations etc.) it can quickly become apparent that the performance of those “peers” could easily out-perform or under-perform the company for reasons that are unique to those companies and, in fact, are not really comparable at all.

One give-away of this is the variability in (e.g.) the cost of capital or share price volatility that each of the “peers” presents (a topic for another paper).

A further challenge with the use of a small, select peer group is what is sometimes called “survival bias”.

That is, the performance outcome might be materially impacted by the takeover or merger of one or more of the peer group during the performance period.

This is a sound reason for employing a peer group comprising at least 30 companies. A larger peer group also avoids material changes in the relative ranking of the issuing company, which can have a large effect on LTI vesting.

The other end of the spectrum in the choice of peers used in relative performance measure is to consider a universe of comparable companies represented by the ASX300 or the S&P Index that the company occupies (e.g. Materials, Financials, etc).

Yes, takeovers and other de-listing reasons may reduce the size of (e.g.) the ASX300 from a universe of 300 to 295, but the impact of exclusion of a handful of index constituents is unlikely to materially impact the performance outcome (unless the issuer is line-ball with the hurdle – in which case the remuneration committee might exercise its discretion, make a captain’s call and declare “we got there”).

Shareholder response to the LTI plan

The risk of a “strike” against the remuneration report keeps many directors awake at night.

This is a reason that many companies will design an LTI plan that has been widely accepted by proxy advisers and organisations such as the Australian Shareholders’ Association [“ASA”].

That is not to say there is limited scope for departure from the norm, rather it requires consultation with those major shareholders, proxy advisers and ASA well before the AGM notice of meeting is prepared.

A management tool rarely used by remuneration committees is to seek valuations of the LTI plan outcomes prior to a decision on the form and structure of the LTI plan before it is “too late” (i.e. well before the plan sees the light of day in the notice of AGM).

Reporting issues

Whenever equity is employed as part of remuneration the LTI plan will be subject to financial reporting under an accounting standard referred to as AASB2 Share based payments and will therefore be subject to external audit.

AASB2 recognises that the issue of equity to KMP is part of remuneration and should be expensed.

The operation of AASB2 is the subject of a separate paper. However, the key elements are:

  1. An expense is brought to account over the life of the performance period (usually the beginning of the financial year in which the grant of performance rights occurs to the end of the financial year in which vesting occurs)
  2. For non-market-based expense (e.g. arising from EPS, ROA growth hurdles), an adjustment to the expense that was brought to account based on the anticipated vesting is made at the end of the performance period for the actual expense incurred.

These accounting entries are driven by two separate measurements:

  1. Grant date valuation
  2. Vesting hurdle performance assessment (non-market-based components only)

Th first is undertaken in the year of the grant date and the second is undertaken after the end of the performance period.

Grant date valuations

With crystal ball in hand, the remuneration committee (usually with the help of an independent valuer) assesses the likely vesting outcomes and applies the probability of vesting to the share price on the grant date.

In most cases, this process is outsourced to an independent valuation expert for a number of reasons:

  1. KMP undertaking valuations of their own LTI plan is not representative of good governance
  2. Auditors will inevitably prefer the assessment to be undertaken by a respected expert
  3. Rarely will a remuneration committee possess the appropriate skills to undertake this exercise

A grant date valuation can be a complex exercise.

Whilst a performance right is, as we said earlier, a zero exercise price option, the well-known option valuation models do not cope well with the valuation of options which have performance hurdles overlaid on the outcome.

That is, the typical valuation models are best-suited to valuing “vanilla” options and will tend to over-value performance rights.

As a probabilistic view into the future, the achievability of the performance hurdles (both absolute and relative) must be assessed.

Whilst deterministic measures are sometimes employed, we believe a probabilistic view of the potential outcomes (again, both absolute and relative) provides a more reliable estimate of the expense which should be brought to account.

The total AASB2 expense for ASX300 companies typically varies between a few hundred thousand dollars per year to some millions at the larger end of the spectrum (where remuneration is often higher and there are more participants in the LTI plan).

A curve-ball to watch out for is over-expensing the value of the grant.

AASB2 permits adjustment for actual versus expected outcomes with respect to non-market measure expenses at the end of the performance period (e.g. EPS growth which is a company-specific performance measure) but does not permit adjustment of market-based measures (i.e. relative performance hurdles such as relative TSR performance).

Vesting hurdle performance assessment

At the end of the performance period, KMP and remuneration committee alike will be eager to determine whether the vesting hurdles have been met.

To the extent that the performance rights (shares) vest, the KMP will be pocketing a considerable uplift in remuneration.

An inevitable tension arises between KMP and remuneration committee if the company nearly achieves the bottom of a performance hurdle range.

There are often matters requiring some judgement and potentially the exercise of remuneration committee judgement such as whether a comparator company which was removed from an index during the performance period should be included in the assessment of a relative performance measure if it makes the difference between zero and 50% of performance rights achieving the hurdle.

The actual expense (and value to the KMP) is the deliverable from the performance assessment.

As with grant date valuations, the performance assessment is usually outsourced by the remuneration committee to an independent valuation expert to ensure a reliable outcome is obtained.

Is the LTI plan delivering?

Many companies continue to employ the same LTI plan parameters over several years before it becomes apparent that it isn’t achieving the principal objectives of rewarding the KMP or imbibing a sense of KMP partnering with equity holders.

This is often due to a problem in the design of the plan such as the selection of the performance hurdles, failing to assess the potential value of pay-offs from the plan, continually revising the comparator group and many other critical inputs to the design of the plan.

It is good practise to review the performance of the plan over the last few years and consider whether some design tweaks might better achieve the objectives.

Working with remuneration committees, an independent valuation expert such as Peloton can assist in the design and structure of remuneration plans, through for example, modelling potential payoffs/outcomes across a wide range of variables which the remuneration committee might appropriately choose to change before next going to shareholders for approval of the next LTI plan.

Peloton can also undertake a number of necessary valuations for companies that are issuing LTI incentives, including grant date valuations (for the purpose of estimating and recognising an expense on the Income Statement) and performance testing (for the purpose of determining what proportion of LTI incentives have vested in accordance with plan rules).

LTPIThe Peloton Corporate valuation team has been valuing and advising on LTI plans for over 15 years and has seen every variation of LTI plan imaginable. Working with every major audit firm, the systems and processes employed in our grant date valuations, performance assessments and LTI design advice provide comfort to remuneration committees that the outcome is what was both planned and expected. Download our Long Term Incentive Plans booklet for more information.

Contact Michael Churchill on 0412 066 019 or mchurchill@peloton.group if you would like to discuss any aspect of your LTI plan.