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January 25, 2018
Home run

This was closely followed by predictable calls for all long-term incentive plans (LTIPs) to be abolished. They produce perverse outcomes, the critics say. They don’t incentivise; the size of the awards is determined by the share price at the time of the award; remuneration committees don’t police them properly; and outside events bring in lottery-type features.    

There are elements of truth in all of these.  But what’s really going on?

 

One LTIP fits all?

Persimmon’s LTIP, which dates from 2012, was a one-off, very different to those in most other companies, so it’s perverse to lump them together. But there’s no denying that the outcome is extraordinary. That has been confirmed by its two leading advocates: Nicholas Wrigley, Persimmon’s chairman, and Jonathan Davie, who chaired the remuneration committee. They were the ones who consulted Persimmon’s main long-term shareholders, who duly approved it. On reflection, they never dreamed that the options would be so lucrative and they should really have capped the payouts.  And for that error, they both resigned. 

 

Who says incentives incentivise?

In its 2012 annual report, Persimmon said that the aim of the awards was “to ensure that the whole senior management team is incentivised to meet the group’s long-term objectives”.  The intention was to return 620p per share to shareholders between 2013 and 2021 – and the completion of this “capital return plan” would be evidence that it had successfully achieved its strategy. Five years on and it’s plumped up its shareholders’ pockets – that target has been raised to 925p and there’s still four years to go. So by that definition of 'incentivised', the LTIP worked embarrassingly successfully. 

But 'incentivise' could also mean 'motivate'.  Did Persimmon really mean that the whole of its top team needed to be motivated? If so, there’s a problem. Most evidence suggests that in senior knowledge-type jobs, there are far more powerful motivating factors than money – like tough but achievable challenges, the freedom to act autonomously and the respect that success earns. But that can’t be what Persimmon meant. According to Persimmon, the plan was really “designed to align the executive directors’ interests with the company’s long-term financial performance and with the interests of shareholders”.  So: not for motivation, but to keep the top team’s focus on their contribution to its strategy and to provide them with a financial vested interest in keeping with what would be delivered to shareholders. Shareholders can’t complain at that.

 

Size matters

In October 2012, Persimmon granted its chief executive, who was at that time Mike Farley, a 10-year option over 4,832,000 Persimmon shares. The share price then was £6.20, so the face value of this award was £30m. Not money in the bank, but what it would have cost him to buy the shares. At first sight, had the share price not budged, this option would have been worthless. But these options carry a rather cunning kicker…

But first, what was the expectation in 2012? This was four years after the financial crisis, when UK housebuilders had to slash the value of their land banks. Those with too much debt had gone bust. Housing demand was being held back by lack of mortgage availability, relatively high mortgage interest rates and the need for high deposits. Potential buyers worried about job security in a flatlining economy.  In Persimmon’s 2012 annual report, Mr Wrigley wrote that going forward he expected house prices to be stable. Persimmon’s margins might increase because of its strong forward order book, but at a slower rate than that recently experienced. So: steady as she grows. 

Three months after this award, Mr Farley decided to retire and in April 2013 Mr Fairburn took over. He had already received an option on the same terms as Mr Farley, but a second one was granted on his appointment and then a third one two years later to take his total shares under option up to the same number as Mr Farley. The cost to him of these options was determined by Persimmon’s share price at the time of grant.     

       

Persimmon award to Mr Fairburn

 

Number of shares

Initial option price

Initial cost to exercise

Initial award

17-Oct-12

 2,416,000

£6.20

£14,979,200

Promotion

19-Apr-13

 2,174,400

£11.09

£24,114,096

Performance

26-Feb-15

 241,600

£16.84

£4,068,544

Total

 

 4,832,000

  

 

The number of shares that Mr Fairburn could buy would be in proportion to the special dividends paid to shareholders. The aim was to return £6.20 by 2021. If, for example, only £3.10 was returned, he would only be able to buy half of them. And just to avoid any window-dressing, these returns have to be financed out of retained earnings, and only if Persimmon has no debt. 

Now comes the clever bit. Buried in the depths of Persimmon’s annual report, there’s a sentence that turns these options on their heads.  It says: “The initial exercise price will reduce by an amount equal to the value of cash returns to shareholders made by the company during the period from date of grant to the earlier of 31 December 2021 or the date of exercise of an option.” What’s that supposed to mean? Simply this: what the shares cost will be reduced by all the special dividends paid to Persimmon’s shareholders:

 

Year

Special dividends

Cumulative return

Target in 2012

2013

£0.75

£0.75

 

2014

£0.70

£1.45

 

2015

£0.95

£2.40

£1.70

2016

£1.10

£3.50

 

2017

£1.35

£4.85

£2.80

 

New target

 

 

2018

£1.10

£5.95

 

2019

£1.10

£7.05

£3.90

2020

£1.10

£8.15

£5.05

2021

£1.10

£9.25

£6.20

 

So, adjust for the number of shares and the shrinking price, and on my calculations, at a share price of £27, his notional gain has gone into orbit:

 

Persimmon award to Mr Fairburn

 

Number of shares

Current option price

Current Gain if share price is £27

2021 option price

2021 gain if share price is  £27

Initial award

17-Oct-12

2,416,000

£1.35

£47,766,658

£0.00

£65,232,000

Promotion

19-Apr-13

2,174,400

£6.24

£45,140,544

£1.84

£54,707,904

Performance

26-Feb-15

241,600

£11.99

£3,626,416

£7.59

£6,203,957

Total

 

4,832,000

 

£96,533,618

 

£126,143,861

 

In fact, he is only allowed to cash in 40 per cent of the award at the moment, so his immediate gain would be more like £39m. But the option allows him to do this at any time. If Mr Farley waits until after the cash is returned to shareholders in 2018, he will be entitled to more shares in this early tranche and at a cheaper price too.  

 

Excess

What the kicker has enabled is the conversion of share options priced at market value into share options that will cost nothing. These nil-cost share options are similar to shares; the difference is that the option allows the holder to cash them in at any time until they lapse in October 2022. 

So yes, this LTIP was influenced by the share price at the time of the award, but the real problem was its sheer magnitude. Even with no increase in share price, the kicker made the initial award worth a potential £3m every year for 10 years. And that’s in addition to the £2m a year from the rest of the chief executive’s pay package.

But expectations were higher by the time Mr Fairburn received his second option. The share price had almost doubled and, since then, it has more than doubled again. This second option too might well become nil-cost. True, nobody expected external tailwinds such as the national housebuilding push or the Help to Buy scheme, but such scenarios should have been part of the planning. 

Mr Fairburn’s gross gain over 10 years now runs at about £126m and every £1 on the share price will push it up by almost £5m more. The criticism remains: why was he awarded so much? And, more importantly, what can be done about it?

 

Stiffened resolve

There is a way out. In its latest annual report, Persimmon says: “a clawback arrangement… allows the company to recover share awards which have vested as a result of an error or misstatement…”  

The company has confessed to an error. That’s why two directors resigned. But it remains to be seen whether uncapped share options fall within the definition of error in the plan rules. Cutting back on their value could result in legal wrangles, but Persimmon’s remuneration committee chairman was paid £68,000 in fees precisely to steer through hard decisions like this.

Curiously, the committee agreed a 3 per cent salary increase for Mr Fairburn in 2017. The least they could have done was freeze his future salary.

 

Exposure

If you’re sitting on substantial options with almost five years to run, what’s your best game plan? As soon as you cash them in almost half will go in tax and you then run the risk of losses on the shares you keep. By holding on to them you shift part of that risk on to the market. But there’s another reason for sitting tight. Cashing them in will spark media outrage, so why not wait until just before either they lapse (or you resign) and get it over with all in one go? If I was Mr Fairburn, I know which strategy I would follow. And that’s why my money won’t yet be on him becoming the highest paid chief executive in the land. 

Paul Jackson