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OPINION

Pressure to conform

Pressure to conform
April 26, 2018
Pressure to conform

Last year Reckitt proved vulnerable to a cyber attack and like-for-like revenues and profits were flat. So is this an example of executive pay being “ratcheted up so high that it is impossible to see a credible link between remuneration and performance”? That’s how Iain Wright, who chairs the government’s Business, Energy and Industrial Strategy select committee, described high pay last year.

In fact, the pedestrian underlying results wereenough to lose Mr Kapoor his annual bonus. What drove 90 per cent of Mr Kapoor’s payout was his leadership of a team that had increased Reckitt’s shareholder value by about £8bn since 2015. The compound growth of Reckitt’s adjusted earnings per share (EPS) averaged 11.5 per cent a year, comfortably above both Reckitt’s peer group and Mr Kapoor’s upper target of 10 per cent. Under his long-term ‘incentive’ plan (LTIP) award of 2015, this entitled him to receive 240,000 shares and exercise an option over 400,000 more. 

 

The optic

The associated rise in Reckitt’s share price (of almost a third) boosted the value of this award to £22.4m (at a share price of £66.67). Too high? The non-executive directors on Reckitt’s remuneration committee thought so. Worried about the optic – how it would look to outsiders – they halved it, neatly getting the total amount he received down to below that of 2016 (£15.25m, after £25.5m in 2015). “A sensible decision,” according to Stefan Stern, outgoing director of the High Pay Centre, as quoted in the Financial Times. But he added, “this clever LTIP has turned out to be completely unsuitable and required them to step in and retrofit it.” A bit harsh, perhaps? Let’s try a checklist:

Was the committee correct to exercise its discretion? Yes, because a lot can happen in three years. Circumstances change. Last year, for example, Reckitt transformed itself by acquiring Mead Johnson and selling Reckitt Benckiser foods. 

Was the original award too high? Implicitly, yes. The LTIP awarded in December 2014 consisted of 240,000 Reckitt shares (worth on award £12.6m) and an option over 400,000 shares at an exercise price of £50.57. The committee halved these – and held down future ones. The latest LTIP awarded to Mr Kapoor is for 100,000 shares (worth on award £6.5m) and an option over 200,000 shares at a price of £64.86.  

Were the performance conditions too easy? Difficult for outsiders to assess. Reckitt deserves some credit for keeping its LTIP simple: the only criterion is EPS. First, Reckitt has to outperform that of its peer group. Secondly, it needs to grow EPS by more than an average of 6 per cent each year before Mr Kapoor becomes entitled to any shares. To receive them all, he has to beat that target of10 per cent. Mary Harris, who recently took over chairing the committee, calls these targets “stretching”. Her predecessor thought the same in 2014.

Were they the right performance conditions? Probably not. True, growth in EPS normally creates shareholder value, but Reckitt is unusual in having this as the sole measure for its LTIP. And this focus can raise ethical issues (see ‘The need to get a grip at RB’, IC, 24 March 2017). The government is impressing on companies that the pursuit of shareholder value must not obscure their “contribution to the wider society”. Ms Harris is reviewing Reckitt’s current policy; expect changes in 2019. 

In general, can EPS be manipulated? Possibly. There are mixed views on the relationship between debt and EPS, with a particular concern about share buybacks. 

 

Share buybacks

Logic suggests that any company buying its own shares will push up EPS – and (if EPS is a performance target) also executive pay. The charge is short-termism – executives can push up their pay by buying shares when they should be investing for the future. But some research suggests the opposite – companies that buy their own shares often report lower, rather than higher, EPS growth. They don’t miss out on investments; they buy back shares because they can’t see any profitable investments to make. The government wants to get to the bottom of this so, a couple of months ago, it commissioned PwC and the London Business School to review the evidence.  

 

Grinding exceedingly slow

This is part of the wider reform of corporate governance that started in July 2016 when Theresa May promised to build an economy that “works not for a privileged few but for every one of us” (honed by Labour into the more snappy: “for the many, not the few”). In November 2016, a Green Paper went to consultation, but by the time of the White Paper in August 2017, the more radical proposals had been ditched in favour of increased transparency. Out went stronger consequences if remuneration reports are voted down; ceilings on pay; and forcing companies to have worker and consumer representatives on their boards. Also scrapped was a move towards executive pay needing an annual binding vote.

Another consultation and more than 250 responses later, the Financial Reporting Council is now expected to produce revamped company guidelines this summer. Apart from saying what “contribution to the wider society” actually means, the agenda is expected to restrict directors from serving for more than nine years, to demand more ethnic and social diversity in talent pipelines, and stronger policies to close gender pay gaps. After Carillion (and a more recent example on the Alternative Investment Market: Air Partner), the internal objectivity and the external independence of auditors are likely to come under more scrutiny. On executive pay, the probable focus will be on long-term decision-making and how the evaluation of executive performance (and so pay) can be linked more closely to the business cycle.

 

Paradox or myth?

Behind this reform is the widespread belief, echoed by Mr Wright, that executive pay fails to relate to company performance. But that seems odd. On average, about 80 per cent of top pay comes in the form of shares (90 per cent for Mr Kapoor), which in turn depends on the share price, so how can pay and company performance be out of kilter? 

The government was influenced by research that purported to show that between 2000 and 2013, FTSE 350 chief executives’ earnings grew by 233 per cent, but whatever the measure (market value, EPS, total shareholder return, revenue, pre-tax profits or Ebitda), company performance grew by less than half of this. 

This type of research is flawed, according to PwC. In ‘Paying for Performance, Demystifying Executive Pay’ (February 2017) it identified why: 

  1.  Time periods. Comparing short-term company performance with long-term pay gives misleading results.
  2.  The starting and end points. These are critical. Choosing a starting point that happens to be when stock markets are high is more likely to give you the result that you want.
  3. Confusion of what can be earned with what was actually received. What’s received is much more closely linked to company performance. 
  4. The size of the company. Broadly speaking, for every doubling of market value, executive pay increases by a quarter. So if smaller companies (who pay less) outperform large-caps (who pay more) and the survey just adds the data of every company together regardless of size, total company performance is bound to appear to outpace pay.
  5. Share ownership requirements. The conventional definition of pay excludes these, but forcing executives to own shares is a significant risk for them. Mr Kapoor effectively loses his net annual salary every time the Reckitt share price falls by £1.       

Adjust the research for all of these, PwC says, and executive pay will track company performance more closely. That widespread belief could well be a myth.

 

The tail that wags the dog

Reckitt prides itself on having the most demanding share ownership requirement in the market – its chief executive has to own 600,000 shares, about 40 times his salary. That’s currently equivalent to about £38m – and quite a vested interest to do what’s best for shareholders. 

But it also explains why Mr Kapoor’s pay was set so high. Because: what does such a high requirement imply? That you needn’t even think about becoming chief executive unless you’re wealthy already? Well, not exactly. The incumbent is given eight years to build up this holding, so his or her net income needs to average almost £5m a year. How can any executive accrue that much? From the expected payout of maturing LTIPs, of course. Factor in tax, more for when performance beats expectations, and… to satisfy this share ownership requirement, a pay package of well over £10m is needed. 

Maybe having such a high shareholding requirement isn’t such a good idea after all. No doubt this will also be part of Ms Harris’s review.

 

Worlds apart

Other chief executives who qualified for the £10m-in-2017 club were Bob Dudley at BP (£10m), Nicandro Durante at BAT (£11.4m) and Paul Polman at Unilever (£10.3m). But at about £100bn, the market values each of these companies as three times larger than Reckitt. Double that again (£200bn) and at Royal Dutch Shell Ben van Beurden received £7.8m. Relx is about the same size as Reckitt and its chief executive, Erik Engstrom, received a fraction under £10m. So is Shire, where Fleming Ornskov received £5.3m. 

How Mr Kapoor’s performance over the past three years calibrates against theirs is probably an unfair question, for company characteristics, risk and individual achievements differ. But size matters and, although tax halves these published figures, it’s the sheer scale of high pay that many find hard to fathom. While investors are happy to pay for success, social media bristles with indignation that ordinary workers would take a lifetime to earn what many executives receive in just a few months. 

To appease criticism, companies are holding down pay packages. Executives might receive less in future, but only time will tell how much more remuneration committees have to do to take the sting out of external criticism.