The vast majority of share-based long-term incentive plans operated by UK listed companies include performance targets which need to be sa...

The vast majority of share-based long-term incentive plans operated by UK listed companies include
performance targets which need to be satisfied before the award vests. This is the case for both market value option plans and performance share plans (or LTIPs) which deliver free shares to participants. Whilst it is not possible within the confines of this article to set out all the questions that need to be answered before a decision can be made we have set out below the key issues that we think should be considered:

· Why have performance targets?
· What measure to use?
· What period to measure performance over?
· Practical issues to consider.

In many of the issues it is a question of finding the right balance amongst a range of possibilities. In others it may be a simple “yes” or “no”. However, the answer will be different for different executives and companies not only because they have different business models but also because they are trying to achieve different objectives.

Why Have Performance Targets?
You might think that the answer to this question is so obvious that it should be unnecessary to even ask it. The “standard” response is that companies want to ensure that vesting of the awards is linked to strong financial performance of the company. However, when one delves a little deeper one often comes up with slightly different responses.

Keeping Shareholders Happy
If the performance target has only been put in to “keep the shareholders happy” then it is likely that the company will want to tread a well-trodden path of least resistance.

For example, for companies that had an option plan it was very common for a performance condition of real growth in earnings per share (“EPS”) of two per cent per annum (or most recently three per cent per annum) to have been adopted. Cynics might suggest that this was nothing to do with what the company thought might be achievable in terms of EPS growth (or for that matter what shareholders thought might be achievable) but rather because this was the approach adopted by the guidelines issued by the Association of British Insurers (“ABI Guidelines”).

Similarly, for companies that had an LTIP it was very common for a performance condition of comparative growth in TSR against all the companies in an index (FTSE 100, FTSE 250, FTSE SmallCap or FTSE All Share) with no vesting below median performance and 100 per cent vesting for upper quartile performance.

Keeping Executives Happy
There are still companies out there for which the real objective is to ensure that the award vests and hence executives are rewarded. In these circumstances the target is typically set as being one that is almost certainly going to be achievable. Although when stated as boldly as this one might say this is just completely inappropriate behaviour, to some degree this thinking has merit. There is after all no point in setting a performance target that will never be achieved. Hence companies are increasingly looking at setting graduated rather than cliff edge performance targets where a proportion of the award vests at a relatively low level of performance (that should be attainable) but with 100 per cent vesting at what should be a fairly stretching target. (More on this later.)

Driving Corporate Performance
Having dealt with the publicly unacceptable but in some cases real underlying objectives behind the decision as to what performance target to adopt, we can now move into the issues that remuneration committees should be focusing on.

How can the performance conditions used for the company’s long-term incentive plan both drive the performance of the participants in a way that will help the company meet its business objectives and ensure that the participants receive an appropriate level of reward for any given level of performance? The practical answer to this of course is that it is unlikely that such perfection can be achieved.

For example, it is almost certainly the case that there will not be any one measure of performance that can be met at the cost of all other possible measures. However, dealing with this problem by having, say, 10 different targets derived from the company’s business plan will probably not be the answer either. The evidence suggests that if the intention is for the plan to act as an incentive and to influence behaviour rather than simply to act as a reward mechanism for, say, growth in share price, then the target(s) need to be relatively simple and understandable i.e. there needs to be “line of sight” between the target(s) and what the participants are expected to do. The danger of keeping it simple is that the participants act as the performance target appears to be driving them (i.e. ensure that it is met in full if at all possible). This is unlikely to produce an optimum result for the shareholders.

Many years ago I assisted a company in putting in a plan designed to help the company really drive EPS growth over a three year period. If very stretching targets were met then the participants would do extremely well. This was a one-off award and therefore the danger, as highlighted to the board, was that achieving the target might become too important in the overall scheme of things. I was therefore disappointed (but not surprised) to hear some years later that when any strategic decision was considered over that three year period the key issue that the board focused on was “what would be the impact on EPS in year X” rather than “would this decision benefit the company/shareholders over the medium to longer term”.

What Measure to Use?
For most companies that simply wish to follow “normal market practice” this has been an easy question to answer. If you have a market value option plan you have a real growth in EPS target and if you have an LTIP you have a comparative TSR target. The “logic” being that option plans reward participants for growth in share price provided that the underlying performance of the company has been sufficiently good as measured by real growth in EPS whereas LTIPs typically reward participants for delivering better shareholder return than is delivered by comparator companies (although in many cases these plans have an underlying EPS target). However, even this simplistic approach is under challenge as companies struggle with the impact of the change to International Accounting Standards and the introduction of IFRS 2/FRS 20 (accounting for share-based payments).

EPS or TSR Targets?
For future awards, which is what this article is concerned with, the key issues are that EPS will become much more volatile in the future and, at present at least, many companies do not yet have a good feel for how EPS performance will be affected over the medium term by the changes. Hence, remuneration committees may feel slightly nervous about using EPS targets going forward.

The other related issue is the impact of IFRS 2/FRS 20. EPS targets are what are described in the new standard as “non-market based performance conditions”. In summary, the impact of this is that the performance condition is not taken into account in determining the amount to be charged to the profit and loss account over the vesting period in respect of the award. Rather, the ultimate charge reflects the actual level of vesting (with charges over the life of the award reflecting the expected outcome). This is likely to mean that the amount of the charge from year to year will be very volatile thus adding to the volatility of the EPS charge itself. This can be contrasted with “market based performance conditions” such as a comparative TSR target where the performance condition is taken into account in determining the amount to be charged to the profit and loss account over the vesting period in respect of the award. Once the quantum of the charge is determined it is not adjusted for actual performance. This will mean that the charge will be more certain from the outset but that it will tend to be relatively high for poor performance (with low levels of vesting) and relatively low for strong performance (with high levels of performance).

Where an EPS target is considered to be appropriate, consideration needs to be given as to what level of EPS growth is required. Companies are increasingly coming under pressure from shareholders and shareholder bodies such as the ABI, the NAPF and PIRC to have EPS growth targets which are at least as demanding as the analysts’ EPS estimates.

Turning to TSR targets, these are becoming more popular not only for option plans but also for LTIPs. The majority of them compare TSR growth with that of a number of comparable companies (either all the companies in an appropriate index such as the FTSE 250 or a group of companies which the remuneration committee selects as being comparable).

Given the costs and complexities associated with identifying a sufficient number of comparable companies and/or of calculating the TSR growth for every company in the comparative group, some companies take a more simplistic approach of comparing their TSR return with that of an index itself looking at the percentage out-performance against that index.

Other Measures
EPS targets are less likely to be appropriate for companies where increasing earnings is not necessarily the main objective. For example, many (but not all) property companies see growth in net asset value as being a better guide as to the underlying financial performance of the company.
Going forward it is also likely that we will start to see other financial measures being used (particularly in option plans where, for whatever reason, EPS is no longer considered appropriate). These might include measures such as return on capital employed or free cash flow.

What Period to Measure Performance Over?
Of all the issues to consider this one is probably the most straightforward. To date the vast majority of plans have measured performance, initially at least, over three years. However, whilst retesting (where if the target was not met the performance target could be considered again after a further period or where it was measured over a rolling three year period) was very common, shareholder pressure has almost eliminated this practice.

Although there are still a number of commentators who suggest that three years is not a long enough period if the plan is really designed to be a long-term incentive plan (rather than a medium term one) and a number of companies do have a four or even five year performance period, it is unlikely that a remuneration committee would be criticised for staying with a three year target particularly where a series of annual awards was being made.

Practical Issues to Consider
It is often said that “the devil is in the detail”. This is particularly true of performance conditions for long-term incentive plans where, in most cases, the detail is never seen by anyone outside the company. Detailed issues to consider might include the following:

Cliff Edge or Graduated Targets
Historically most option plans with EPS targets adopted a simple approach of having a “cliff edge” performance target. Either it was met, in which case the option was fully exercisable, or it was not in which case the option lapsed.

LTIPs, which have for many years tended to use comparative TSR targets, tend to have a graduated vesting schedule with, say 30 per cent of the award vesting for median performance going up to 100 per cent vesting for upper quartile performance.

Now it is increasingly common for all forms of plans/performance targets to use some form of graduated vesting condition with relatively little of the award (although typically a higher percentage for options than for LTIPs) vesting for median or acceptable performance increasing to 100 per cent vesting for what is considered to be truly demanding performance.

EPS
When one talks about out-performance, for example EPS growth of three per cent per annum in excess of the growth in the retail price index (“RPI”), what does this actually mean? Is that simply total growth of nine per cent more than the growth in the RPI or is it compound growth of three per cent per annum above the growth in the RPI (which equates to simple out-performance of 9.2727 per cent)?

Similarly when one talks about EPS growth is this measured by comparing the EPS of the base year (which is normally the year ending prior to the award) with the EPS of the last year of the performance period (and then calculating an annual rate of growth) or is it measured by taking the average of the growth in EPS for each year in the performance period? Care needs to be taken with the second approach where EPS falls and then rises (or vice versa) as some “odd” results can occur.
Continuing with EPS growth, consideration needs to be given as to which EPS figure to use, for example basic, diluted, adjusted (and if adjusted then what is it adjusted for).

Finally, care needs to be taken as to how losses are dealt with. This is less of a practical problem than it used to be as companies tend not to set out the detailed performance condition in the plan rules and therefore if a loss arose in the base year the remuneration can decide how to deal with this when making awards. Clearly, simply deeming the loss to be £nil means that any growth will be infinite when expressed as a percentage! Hence, where the base year is a loss the two most common approaches are either to go back to the last year when there was a profit (although this can still produce an unhelpful result - either a very easy target if it was a very small profit or an impossible target if this was a significant profit and the business has now changed) or to simply set a target (or target range) of EPS to be achieved at the end of the performance period (i.e. not expressed as a percentage growth).

TSR
The main issue here is how to calculate TSR growth. In particular, companies need to decide whether to set this out in great detail including how to deal with all manner of corporate events such as reconstructions, demergers and takeovers or whether to leave it to the remuneration committee to determine.

In addition, companies need to consider when the period over which growth in TSR is to be measured is to commence. Alternatives include the start of the year or the date that the award is made. Companies also need to decide whether to use a spot share price at the start and end of the period or whether to average share prices over a period. Where averages are used they tend to be over one, three six or even 12 months prior to the relevant date.

As with EPS targets, consideration needs to be given as to how to measure annual or average growth rates.

Conclusion
Unfortunately it has not been possible to provide companies with a simple decision tree to follow but by considering each of the above issues, some of which are connected and some of which are not, it is hoped that companies will at least be able to identify whether they need to consider this question further.