This time, Weir all in this together

Other executives no longer valued their share awards and the risk was that key people might leave. The directors decided to scrap the performance conditions. Although their main shareholders indicated broad support for replacing performance-based pay with lower, unconditional share awards, some got cold feet.  By the annual meeting in April 2016, the share price had fallen sharply and the motion was defeated. Three months later, the chief executive announced his resignation. 

The company was Weir, which designs and manufactures highly-engineered products, especially valves and pumps, for the energy and mining industries. The point of the article ('Weir not in this altogether', Jul 2016) was to illustrate that the rise in executive pay is far from universal. Weir’s problems were not caused by its pay structure, but by the nature of its business. When the price of oil fell, exploration companies cut back their operations, and demand for many of Weir’s products slowed to a trickle. 

In the long run, the peaks and troughs might even out, but in the short term, this highly cyclical structure presents investors with a quandary.  What will next year’s profitability look like? The gearing of cyclical companies such as Weir to the capital expenditure of the mining industry (and to market conditions in power, oil and gas industries) makes future performance hard to predict.

Jagged

Given this, what can the executive team truly be held responsible for? This was what Clare Chapman, who now chairs the Remuneration Committee, needed to know.  The previous long-term share plan was determined by outcomes (share price performance, dividends, earnings per share and return on capital employed). But expectations had been first set too low and then too high. In eight out of the last nine years, either 0 per cent or 100 per cent was paid out, rather than something in between (see the table below).

This boom-or-bust pattern could suggest that there was too narrow a range between the minimum and maximum targets, but Ms Chapman saw it differently. She concluded that since it is impossible to predict where commodity prices will go next, it is also impossible to set realistic three-year performance conditions for Weir. Trying to tailor them for every eventuality would only make them more complicated. Her solution? Keep it simple. Scrap the performance conditions and award fewer shares.

Massive effort

Weir’s executives backed the idea. Hardly a surprise. Few people relish uncertainty, so performance conditions tend to be unpopular. Under the new scheme, executives will now get the whole of the award, regardless of how Weir performs.

As has been noted before, because performance-based share awards are called 'Long Term Incentive Plans' (LTIP), it is often assumed that they incentivise. That’s debatable. Their real purpose is to expose executives to similar risks to those faced by investors. Ms Chapman argues Weir will still achieve this by paying in shares and requiring senior executives to hold on to them. What has been lost is the amplification. The number of shares transferred to executives will no longer increase if Weir beats future expectations. Nor will they be reduced if Weir disappoints.

This plan is similar in concept to the one rejected before. Ms Chapman was reported as saying that to get it past Weir’s shareholders proved to be “far harder than it should be”. She tempered this by adding, “Weir’s largest shareholders tend to be long-term holders of our stock and well informed about our business. Their conversations with us about our pay reforms brought real insight.” And typically, some with highly diversified portfolios “find it difficult to engage with individual companies or refuse to do so”. Reading between the lines, the lengthy one-to-one meetings with individual institutions took an enormous amount of time and effort. Each concession would have had to be run past them all again, with the process repeated until the majority with voting clout broadly agreed.     

Across the fund industry, views differ considerably. Some large institutions, such as the Norwegian oil fund (the largest sovereign wealth fund in the world), Hermes, M&G, Old Mutual and more recently BlackRock are open to new ideas on how executives should be paid. But others, as Ms Chapman put it (no doubt choosing her words carefully), “have fixed views on how executives should be paid”.

Back to basics

The “fixed views” might be because they expect directors to tie executive pay to the company strategy. Some see this as useful test of the quality of management because coming up with a robust strategy can be a real challenge. The steps are easier said than done:

1. Define the long-term strategy, including what success will look like in a few years time. 
2. Determine the stepping stones needed to achieve it, and incorporate these into each executive’s performance conditions. 
3. Monitor progress, measure the outcomes, and pay people accordingly. 

Weir says it has scrapped performance conditions because external events prevent long-term targets from being meaningful. Yet it claims it has a strategy. Part is to “grow the businesses faster than our end markets”. That’s a relative. It need not correlate with external factors.  In the annual report, the chairman also refers to “our strategy to produce increased value for our shareholders”. How much of an increase would make Weir a success over the next five years? The 'fixed view' brigade might consider that if Weir makes this sort of statement, it ought to be able to rate how it does by measuring the outcome.

Backstops

What about rewards for failure? To avoid these, Weir has brought in backstops. Over the next five years, if Weir cuts its dividend or breaches its banking covenants, the remuneration committee will review whether the award should be cut or possibly forfeited. The same goes if there is a major failure of corporate governance or if ROCE (the return on capital employed) falls relative to its cost of capital.

In the event, Ms Chapman won the day at Weir’s annual meeting last month. The new pay policy secured 92 per cent shareholder approval. Weir’s annual bonuses are driven by its short-term strategy (under the headings, “people, customers, technology and performance”). But for a group that has failed to say what long-term success will look like, loyal shareholders seem to be taking a lot on trust.

Suspiciously smooth?

A characteristic of performance-based pay is that its outcomes are leveraged on company results. Better-than-expected results can magnify pay outcomes; disappointing ones can reduce them to zero. And, as Weir demonstrated, it’s not easy to find the right metrics. The overarching principle is that better designed share plans should improve long-term results for all stakeholders. 

The jagged outcomes of Weir’s share awards are in contrast to the consistent payouts to Pascal Soriot, chief executive of Astra Zeneca. Both have raised questions about whether the performance conditions were appropriate. The table below shows that Astra’s chief executives have consistently received close to all of their potential annual bonuses. Mr Soriot’s proportion dipped in 2016, but last year, it was back to 87 per cent. ISS, which advises fund managers on how to vote at company meetings, is suspicious. Of course, the explanation could just be that Mr Soriot is a star performer. ISS is pressing for the performance targets to be made more challenging.  

Nor is ISS happy about the rather curious performance conditions in one of his share plans, which dates from 2014. This investment plan only required the dividend to be held at $2.80 and the dividend cover, based on “core” earnings per share, of 1.5 to be maintained. That’s just about been achieved, but the calculations, which are borderline, rely on adjustments to the published figures. ISS questions these adjustments and implies that the remuneration committee could have used its discretion to trim the payout.  

Opinions are divided. Another proxy adviser, Glass Steagall, sees no problem.  It advised shareholders to support the company at its annual meeting on 18 May.

Horses for courses

The evolving view seems to be that restricted shares are appropriate for companies that struggle to forecast future performance because of the powerful influence of external events. The much smaller Kenmare Resources, which is hostage to the volatile mineral sands market, has also switched to a similar share plan to Weir’s.

But where forecasts can be made with confidence, performance-based pay still seems more appropriate. Ms Chapman also chairs the remuneration committee at Kingfisher where, so far at least, the more traditional LTIP still applies. 

That makes the decision by another retailer, Pets at Home, to drop its performance conditions somewhat puzzling. The only safeguard to its new scheme is that total shareholder return (calculated from share price with dividends reinvested) must not fall over the next three years. But, unlike Weir, Pets at Home is more defensive than cyclical. A major challenge is strong competition, particularly from the internet. It seems odd that its directors are effectively asking shareholders to believe that they cannot, with any confidence, say what a successful Pets at Home will have achieved in a few years' time.

Ms Chapman believes that Weir was “an important test case for pay reform”. She hopes that it will “inspire other companies to pursue reforms of their own”. The risk is that companies might duck defining how they measure their long-term success, and so won’t think through their strategy properly. Ditching performance conditions could become too much of an easy way out.

Weir’s chief executive: LTIP outcome (percentage of the maximum received): 

AstraZeneca’s chief executive annual bonus outcome (percentage of the maximum received):