Skin in the game

Of course, the Gekko character was portrayed as the archetypal 1980s asset-stripper, hardly an exemplar for corporate responsibility, but he may have had a point. The question of incentives is fundamental to the study of economics, but it has been cited as the primary catalyst for the executive decisions that brought the western financial sector to the brink. However, there’s an obvious difference between executive equity holdings brought about by share incentive schemes, and those derived from a private outlay on a director's part. Investors, therefore, would be justified in wondering how many directors have their own financial capital tied in to the fortunes of UK public companies - or "skin in the game" - to use a term coined by Warren Buffett.

Compensation culture

If a gulf exists between the rhetoric of remuneration committees and the scepticism of retail investors, it's because the issue of director share ownership is generally herded under the broad heading of 'Compensation and Incentives'. This is perhaps understandable, given the relative growth of executive pay over the past 30 years, and the role that executive share options have played in it. Adjusted for inflation, from 1978 to 2011, average compensation for chief executives in the US increased by more than 725 per cent; a rise substantially in advance of stock market growth and well up on the 5.7 per cent in real income growth for workers over the same period. During the first decade of the 21st century, the base salary of chief executives increased by an average of 2.6 per cent a year, as opposed to a 10.6 per cent growth in the value of executive share options - therein lies the rub.

Predictably, the big investment houses have led the way, with executives and leading traders in the financial sector accounting for 58 per cent of the expansion of income for the top 1 per cent of earners from 1979 onwards. The growing inequality in the UK was brought home by a report produced by the Fair Pay Commission in the wake of the global financial crisis, which highlighted the fact that top executive pay at Barclays (BARC) had ballooned to a level 75 times that of the average worker, as opposed to a multiple of 14.5 in 1979. Over the same period, the salary for the bank's chief executive had increased from £87,323 to £4.37m - a rise of 4,899 per cent - nice work if you can get it.

It's pointless dwelling on the morality of this issue; it should be irrelevant where investors are concerned. What matters is whether the increase in director remuneration - primarily delivered through share-based incentive schemes - has been mirrored in corporate performance. Conclusions from academic research carried out on this issue tend to be equivocal, at best.

But ask any director if he or she needs to be handsomely incentivised above their standard pay award for essentially doing their job, and the answer will almost certainly come back in the affirmative. What is undeniable is that the negative consequences arising from poorly conceived incentive programs have taken on even more significance given the prevalence of non-cash payments. An executive share option scheme that ensures management is comprised of like-minded individuals with a stake in the company seems to be a wholly pragmatic and desirable aim - at least intuitively. The trouble is that incentives tend to change depending on whether or not your in-house stake has been doled out to you, or whether you’ve forked out your own cash for the privilege.

Skewed incentives

In theory, executives who hold equity in the companies they manage have a greater incentive to build economic value, but the maximum benefit attainable from many executive incentive share schemes is often tied to share price and earnings performance. Contrary to the prevailing orthodoxy, improvements in these areas aren't necessarily reflective of a company's trading prospects, or even its underlying financial performance. If management's annual pay structure is tied to earnings growth, then surely the incentive dictates that short-term strategies to boost the bottom line, whether real or through accounting artifice, will hold sway. The reality is that many chief executives in large public companies receive so much of their annual compensation in shares that they do not receive meaningful incentives from variation in their annual pay, which makes it unlikely that anything other than changes in the share price and/or earnings motivates the executive.

In the worst excesses, such as the Enron affair, the allegation that management engaged in fraudulent practices primarily due to the perverse incentives on offer is a compelling notion - particularly if you were a minority shareholder. However, although intuitively it's easy enough to form a relationship in this area, the academic research on the relationship between accounting manipulation and executive incentives has produced mixed conclusions. An appraisal of recent research in this area by Professor Brian Larcker of the Stanford Business School reveals that while some studies have identified a higher prevalence of restatement, these have been contradicted by others. Certainly, independent directors should be aware of the potential for self-gain through the manipulation of accounts, particularly when executives hold a substantial number of options.

However, if an individual has actually paid for their stake in a company, then surely they would be far less likely to take decisions on an expedient basis that could impair a company's value over the long term, as it would inflict corresponding damage to an executive's personal wealth. Although Professor Larcker's analysis suggests there is no clear academic consensus on the relationship between executive equity ownership and corporate performance, there is some evidence to suggest a correlation exists between an increase in ownership at the boardroom level and rising market valuations. However, some analysts believe that particularly large ownership positions (in the range of 25 to 50 per cent) might allow for management entrenchment or misuse of corporate assets for personal benefit. Managerial entrenchment occurs when managers gain so much power that they are able to exploit the company to further their own interests, often at the expense of other shareholders. If you take the view that the pursuit of shareholder value is a long-term concept, rather than a short-term manipulation of earnings, it should be possible to design executive incentive schemes that are aligned with long-term value creation for investors.

The following case studies provide some interesting examples of managerial moves by insiders with high personal stakes - we leave it to you to determine if these incentives have worked in the broader interests of shareholders.

Berkeley Group - aligned incentives

Tony Pidgley, founder and chairman (4.27 per cent)

The question for incentives for Tony Pidgley could be altogether spurious. As a self-made man and Barnardos boy, he turned Berkeley Group (BKG) into one of the UK's biggest housebuilders in a little under 20 years, and has even fended off attempts by his son to wrest control of this business. That said, long-term shareholders in Berkeley will be in no doubt that their interests and those of Mr Pidgley have been closely aligned for some time.

In 2004, Berkeley said that reduced capital requirements would enable the group to return 1,200p a share to shareholders in cash over the following six years to 2010, a total of over £1.4bn. Pidgley & Co repeated the trick again in 2011, targeting another return of £1.7bn by September 2021, including £548m for payment in dividends by no later than September 2015. That's about 1,300p a share. Berkeley has financed this largesse effectively by leveraging the value of its land bank, providing a template for industry peers such as Persimmon. It's clearly been a win-win situation for Mr Pidgley and Berkeley's shareholders. Last IC view: Buy, 2,235p, 19 June 2013.

Soco International - follow the leader

Rui De Sousa, chairman (2.65 per cent)

Rui De Sousa, long-standing chairman of Soco International (SIA: 374p), has built a stake in the frontier oil and gas explorer that is now worth around £33.4m. He originally acquired his interest in Soco through an entity called Torobex, and has subsequently built up his holding through a combination of incentive awards and on-market cash transactions - but it hasn't all been one-way traffic. While there's no doubt that the chairman is totally committed to the business, he has tended to be quite adept at buying Soco on the dips and selling on the rips. Nothing untoward in this, of course, particularly given that seasoned oil campaigners such as Mr De Sousa tend to be rather unsentimental about making a quid - Soco appears unfazed by environmental concerns surrounding its activities, although some shareholders can be a bit precious about this sort of thing.

The good news is that a number of the directors had been building up their holdings ahead of a capital return to shareholders later this year, which has been made possible by the successful (albeit delayed) expansion of its Vietnamese production and a net cash position of $329m (£210m). Last IC view: Hold, 385p, 12 March 2013.

Dunelm Group - keeping it in the family

Will Adderley, executive deputy chairman (31.2 per cent)

Home-grown incentives don't always work in favour of minority shareholders, but in the case of Dunelm Group (DNLM: 903p) they most certainly have. Around half the group's shares are still held by the founding Adderley family, with son (and former chief executive) Will providing continuity on the board.

Late last year, the homewares retailer initiated a return of around £66m to shareholders on the back of a large - and growing - cash balance. The return was done through a share scheme under which shareholders receive a pro-rata bonus issue of a newly created 'B' class of shares.

The return of capital was equivalent to 32.5p a share and came on top of a £20m ordinary dividend of 10p a share for Dunelm's 2012 June year-end. Add that to another £42.2m of surplus cash that was returned to shareholders in 2010 and, although the company hasn't shied away from its capital commitments, it's clear that management isn't prepared to just sit on excess capital. The Adderley family members have been the most obvious beneficiaries of the shareholder returns, but there are few minority shareholders who would see it as anything other than enlightened self-interest. Last IC view: Hold, 832p, 10 April 2013.

Dunelm Group: excess capital has been finding its way back to shareholders.

Redrow - more than just money at stake

Steve Morgan, chairman (34.7 per cent)

Last year, Redrow (RDW: 226p) boss and major shareholder Steve Morgan pumped nearly £19.4m of his own cash into the business and underwrote a share issue that took his stake past 30 per cent. Mr Morgan had been trying to wrest-back outright control of Redrow, a company he originally set up as a small civil engineering business with the help of a £5,000 family loan. The business floated in 1994 before Mr Morgan stepped down as chairman in 2000. He returned to the company in 2009 after it posted its worst-ever results and has boosted its performance by focusing on traditional family housing.

So, given Redrow's genesis, and even with the probability of a sustained housing surge in the offing, there's more at stake for Mr Morgan than simply pounds, shillings and pence. Although the indicative offer was deemed "opportunistic" by some institutional shareholders, including Fidelity, they recognised that Mr Morgan's interest was a clear signal of confidence in the fundamental value of the company. Whatever, his motivation, since his return the fortunes of the housebuilder have recovered significantly, and the board has confirmed that dividend payments will resume at the end of this year. IC view: Hold, 187p, 26 February 2013.

Redrow: boss and major shareholder Steve Morgan stepped in to pu the builder back on the road to recovery.