The evolving sophistication of “mid-market” companies in the United States is demonstrated by the fact that executive compensation plan structures among many mid-cap companies have started to mirror that of top performing, large-cap companies.
One of the biggest findings from Gallagher’s recent research¹ into incentive plan structure among the mid-market was that among these companies, performance-based awards now approach 50 percent of the total long-term incentive (“LTI”) award value. This demonstrates that these companies adopt the LTI trends of the country’s largest companies, but with some lag time.
Gallagher’s Human Resources & Compensation Consulting Practice looked at how a sample of mid-market companies structured both short- and long-term incentive plan design in the three-year period from 2014 through 2016. This 100-company sample was selected at random from the Russell 3000 universe and included companies across multiple industry sectors with revenues between $1 billion and $5 billion (nonfinancial companies) or assets between $1 billion and $10 billion (financial companies).
Additional key findings from Gallagher’s mid-market research, which are further detailed in this article, are as follows:
- Performance-Based Awards Partially Replace Appreciation Awards and Restricted Stock: Aside from the LTI mix, performance-based awards have gained ground in prevalence on both appreciation awards and time-based awards, though many companies continue to use a “blended approach” of granting two or more types of LTI.
- Performance Measures Grow in Tandem: Almost all performance measures for long-term incentives grew in popularity from 2014 to 2016, with the exception of cash flow. Income measures continue to be the most popular, followed by total shareholder return (“TSR”), though the gap between these two measure types is closing.
- STI Plan Design is Stable: In general, short-term incentive (“STI”) design trends have been relatively stable over past three years, with a few notable exceptions.
Various factors have facilitated this mid-market momentum toward top company trends, which include:
- More Active Investor Oversight: As a result of increased regulation and public concern, boards (via the Compensation Committees) are reaching out to shareholders for their feedback. Investors are very focused on incentive plans and the relationship to the value of their investment.
- CEOs and Boards are More Comfortable with Concept of Performance-Based Awards: The increase in the use of performance-based awards can be attributed to the fact that more CEOs have come to view them positively -- they now realize they can actually earn more than they would with other equity awards types (e.g. appreciation awards or time-based awards) if target performance is exceeded. This is mutually beneficial for the company and executive.
- Compensation Committee Advisors and Members Cross Pollinate Performance Plan Design Ideas Among Companies: Other factors include more active investor oversight (as a result of regulation), the use of compensation committee advisors to help guide pay decisions at public companies, and an increasingly homogenous board of director talent pool that has independent directors moving freely between companies of all sizes.
More Mid-Market Companies are Using Performance-Based LTI Awards
Equity or LTI compensation plays an essential role in the compensation of executives of all public companies. The three most commonly issued LTI awards are appreciation awards, restricted stock, and performance-based awards. There are advantages and disadvantages associated with each award type, as described in Figure 1.
Among the top 200 U.S. companies by market capitalization, performance-based LTI awards first averaged 50 percent of LTI grant value back in 2012². The mid-market is catching up, with performance-based awards making up 48 percent of the total LTI grant value in 2016, up from just 39 percent in 2014.
This trend demonstrates that mid-market companies adopt the LTI trends of the country’s largest companies, but with some lag time. Following the trend of large companies, as performance-based awards have increased in the mid-market, both appreciation awards and time-based restricted stock/units have declined (from 26 percent and 35 percent in 2014 to 20 percent and 32 percent in 2016, respectively). See Figure 2.
This shift towards performance-based awards reflects a greater desire for pay-for-performance alignment and rewards with a big potential upside within the limit of 162(m) tax-deductibility. It also reflects more active investor involvement that has stemmed from Say on Pay (“SOP”) and resulting shareholder outreach. Today it is very common for companies large, mid-sized, and even small to engage their shareholders and ask what they can do to improve their executive compensation programs. This outreach, combined with the annual say-on-pay scorecard, pushes all companies toward performance-based incentive plans.
Say on pay is now a fundamental part in decision making of compensation committees (facilitated by compensation advisors) as the standards of proxy advisers such as Institutional Shareholder Services (ISS) and Glass, Lewis & Co. LLC continue to evolve. Indeed, with SOP voting an annual event for most companies, pay for performance has become a core issue for all public companies, regardless of size. Improving the disclosure of performance measures used, the values associated with those measures, and how they expect to drive performance has been of the upmost importance to avoid unwanted scrutiny.
A faulty incentive design could lead to a failed SOP vote, which in turn may expose an executive and the board of directors to criticism from investors, media and the general public. ISS continues to have strong influence over SOP results because an ISS vote recommendation “for” SOP practically assures significant majority shareholder support. An “against” SOP vote recommendation from ISS most often results from a poor pay-versus-performance relationship. ISS bases its SOP recommendation on three quantitative tests and a thorough qualitative review of various factors relating to performance-based pay, such as the ratio of performance-based compensation to total compensation, the ratio of performance-based equity to time-based equity, financial and operational performance, realizable pay, and the completeness of disclosure and rigor of performance goals.
More Mid-Market Companies Choose a “Balanced Approach” to LTI
With respect to the choice of LTI award types, a number of companies tend to prefer a “balanced approach” that incentivizes stock appreciation, corporate results, and retention.
In 2016, 29 percent of mid-market companies used all three types of LTI awards (appreciation awards, restricted stock, and performance-based awards). Use of all three LTI award vehicles has nearly doubled since 2014, when only 16 percent of companies structured plans this way.
The blended approach of granting a mix of award types provides appropriate incentives for participants to achieve financial targets, and strengthens the linkage between the economic interests of executives and shareholders. A blended approach can also provide the benefits of reduced share usage, reduced expense, increased retention and ownership, and direct motivation on key performance factors.
All three LTI award types have increased in prevalence from 2014 to 2016. Restricted stock awards led the pack at 73 percent in 2016 (up from 65 percent in 2014), followed closely by performance-based awards at 70 percent in 2016 (up from 63 percent in 2014). Appreciation awards have grown at a slower rate, at 58 percent in 2016 (up from 53 percent in 2014). The average number of award types used has increased to 2.00 in 2016 (up from 1.81 in 2014).
While appreciation awards like stock options have been criticized for a variety of reasons including ISS that does not consider them performance based, many commentators view performance awards that measure achievement over three years as midterm incentives.With stock options vesting over three- to five-years and retained beyond that before exercise in many cases, these are more often viewed as longer term. In addition, with retention clauses being added to many different types of equity awards—restricted stock, in particular—these are also viewed as longer term; and retention is increasingly important in these days of declining CEO tenure. See Figure 4.
Income and TSR Measures are Most Popular in Mid-Market LTI Plans
Mid-Market companies are faced with selecting performance measures that are reasonable, aligned with the business plan and investor communications. The selection of performance measures and corresponding performance levels can be one of the most difficult aspects of designing an incentive compensation program.
Because the relationship between pay and performance is often complex, communicating the purpose and design details of the executive performance program is challenging. However, despite changing disclosure rules, the interest in pay for performance continues to grow and will continue to be a focus of the U.S. Securities and Exchange Commission as it reviews proxy disclosures and of shareholders as they vote on executive compensation.
Performance can be measured against a fixed goal (such as an earnings target) or a relative goal (measures compared against a peer group of companies). LTI plans often use relative measures. In addition, performance measures can be segregated into two main categories: market-based (stock price or total shareholder return) and financial-based (earnings per share, return on assets, etc.).
The majority of mid-market companies in the study set LTIs based on income-related measures (64 percent), followed by total shareholder return (or “TSR” at 56 percent). That said, the gap between these two measures is closing, with income measure use outweighing TSR by only 8 percent in 2016, as compared to 15 percent in 2015. This is further evidence of the “trickle down” effect of LTI program trends from top companies to the mid-market (in 2015, the use of TSR in top company LTI plans surpassed the use of income measures³). TSR is commonly used in performance-based LTI plans because 1) it’s based on a measure very important to shareholders (the value of their holdings) and 2), it is self-adjusting and not tied to budgetary or business condition concerns.
Capital efficiency measures, where results is divided by capital to assess the quality of the company’s receivables, and revenue both grew in usage to 27- and 21-percent, respectively. Common types of capital efficiency metrics are return on capital employed (ROCE) and return on invested capital (ROIC).
Mid-market companies are using more of each type of performance measure in 2016 as compared to 2014 and 2015. The prevalence of performance measures all showed increases, from 54-, 43-, 22- and 16-percent respectively in 2014. Only cash flow showed a decline, from 8- to 5-percent over the same period.
The use of “other” measures remains relatively uncommon at 5 percent in 2016 up from 3 percent in 2014. However, some companies are using performance measures such as milestones (significant events), cost savings, market share and other significant measures that are tied success. See Figure 5.
Number of Mid-Market Performance Measures Continue to Increase
Single measure LTI plans have fallen from 54 percent of companies in 2014 to 39 percent in 2016. In contrast, the proportion using two metrics has risen from 38 percent in 2014 to 51 percent in 2016. The weighted average number of performance metrics used by mid-market companies has increased from 1.54 in 2014 to 1.72 in 2016. While no companies use four or more measures, 10 percent use three, up from 8 percent in 2014. Increased use by mid-market cos. of performance metrics overall for LTIs indicates a growing sophistication in performance measurement for such incentive plans.
Mid-Market STI Plan Design Remains Stable
In general, mid-market STI design trends have been relatively stable over past three years. This stability extends to types of performance measures, complexity of performance measures (as indicated by number of performance measures), and the pay-for-performance curves.
However, there have been some slight movements in the data, which are as follows:
- Increase in the use of capital efficiency measures, with prevalence of 27 percent in 2016 following 22- and 23-percent in 2014 and 2015, respectively.
- The use of income as a measure saw a small decline, revenue stayed around the same, and cash flow, after a bump up to 19 percent in 2015, returned to 16 percent, the same figure as in 2014. Unusually, total shareholder return (TSR) usage increased from 1 percent to 2 percent. Income and/or revenue dominates in most industries, while capital efficiency metrics are most popular in financial companies, which also use measure outside the top five metrics.
- Shifting of the pay-for-performance curve to have a tighter performance threshold, particularly for EPS, which shows an increase in the prevalence of performance threshold of 90 percent of target increasing from 31 percent in 2014 to 43 percent in 2016. A similar increase is shown for capital efficiency.
- Shift in payout range from beginning at zero percent to a threshold of 50 percent. The most prevalent payout range shifted from zero percent to 200 percent in both 2014 and 2015 to 50 percent to 200 percent in 2016. This is a recognition of achieving a minimum performance threshold versus beginning to payout on achieving a minimum goal.
The trends in executive compensation indicate that most public companies, regardless of size, have redesigned their incentive programs during the past several years to ensure there is a link between performance achievement for the company and executive, and performance achievement for shareholders. Indeed, the study of mid-market companies confirms continued increases in the use of performance-vested grants as a means for more closely linking pay to performance. Pay trends that start with large companies are trickling down to the mid-market.
¹ Gallagher’s Human Resources & Compensation Consulting Practice looked at how a sample of mid-market companies structured both short- and long-term incentive plan design in the three-year period from 2014 through 2016. This 100-company sample was selected at random from the Russell 3000 universe and included companies across multiple industry sectors with revenues between $1 billion and $5 billion (nonfinancial companies) or assets between $1 billion and $10 billion (financial companies).
² Source: Gallagher’s 2015 Study of Short- and Long-Term Incentive Design Criteria Among Top 200 Companies (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2916206)
³ Source: Gallagher’s 2015 Study of Short- and Long-Term Incentive Design Criteria Among Top 200 Companies (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2916206)