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DealMakers - Q1 2021 (May 2021)


Executive bonuses in the age of COVID

by Guy Addison

Thanks to market outperformance, executive incentives are under the spotlight once again.

Since the global pandemic began in early 2020, global stock markets have rallied heavily. Against this backdrop, governments have gone to extraordinary lengths to support their citizens, from both a healthcare and a stimulus perspective. And with this, a new way of working (from home) has emerged, forcing humanity to re-evaluate how we do business. Despite the good news of a vaccine rollout and buoyant global markets, there remains the concern that we are in for a surge of bankruptcies from both corporates and SMEs, and a wave of industry consolidation. This remains a risk, particularly where the impact of the pandemic is longer lived than expected. Businesses, in general, are nowhere near their pre-pandemic levels of activity and, hence, revenues are strained and budgets under pressure. 

Guy Addison.jpg
Guy Addison

With market indices at or near their high, listed companies’ share prices appear to be in a different basket, compared to their private peers. This has resulted in executives meeting share-price performance targets, whilst their underlying businesses are telling a very different story. 

Volatility and uncertainty in a post-COVID world
Organisations that entered the lockdown on shaky ground will be further weakened and, no doubt, eager to resume trading normally. Many businesses are still coming to terms with the changes that the pandemic has wrought. Whilst many shares are trading at new all-time highs, the underlying businesses upon which such prices are determined are not. Our clients are working harder than ever to build sustainable organisations that can weather the onslaught of the pandemic and emerge on the other side intact. 

It is then ironic that despite executives being at home, they are working longer hours and are more stressed than previously. And yet, their incentives are only based on the movement in share prices – not their activity levels. It appears that Boards are starting to take notice, given the large number of listed companies announcing resets to their existing incentive schemes. There has also been a swathe of ‘ad hoc’ bonuses paid to executives recently, presumably for this reason. Shareholder activists are also highlighting the worrying disconnect between executive remuneration and general employee remuneration. These outcomes highlight a deeply flawed set of incentive structures in need of renewal.   

Frothy markets disconnected from economic reality
There is no doubt that markets have performed admirably since the initial COVID-19 pandemic stunned the world. Fortune Magazine is forecasting a string of new listings, particularly in popular sectors such as technology and healthcare. It makes sense to raise capital when there is just so much liquidity available, but this may be hiding the true economic reality for many listed counters – both new and existing. 

Whilst this may not directly impact new incentive schemes, existing schemes largely predicated on growth in share prices will continue to do well, despite the performance of the underlying business. We question whether this was the intention of the boards that implemented these schemes. Unfortunately, executives are not staying invested in the companies in which they receive share-based awards. Bloomberg has reported on executives selling down their share awards at an alarming pace. This is cause for concern, as the alignment and retention elements of incentives do not appear to be working. Owning a stake in the business should result in loyal management who are working to add value for all stakeholders. We question whether this is happening now? 

Government support driving up share prices
As a response to the COVID-19 pandemic, central banks are engaging in quantitative easing measures to inject liquidity into financial markets, thereby stimulating economic activity. As a result, the money supply continues to rise rapidly, and interest rates are not expected to increase any time soon, even if inflation picks up. In the US, money supply rose 6.7% in 2019, and by more than 25% in 2020; it went up from 1% to 11.7% in the UK and 11% in the eurozone over the same period. 

Commentators and investors have raised concerns that this extra liquidity and stimulus may result in a global equity market bubble forming. As most executive incentives are based on growth in the share price, this means that managers’ wealth is also increasing dramatically, despite many of the companies not recovering financially. 

In addition to the rapid growth in asset values, companies are using the extra liquidity available to repurchase their own shares. Even using external debt to fund share repurchases, as interest rates are so low, it pays to keep buying back stock. Unless company boards are careful, this may result in executives earning their share-based payment bonuses despite their company not actually doing better. This is typical of a warped incentive. 

Given that share prices have disconnected so dramatically from economic reality, it is ironic that executives continue to earn their share-based payment bonuses despite the economy being in such a dire state. Executive incentive structures have adjusted too slowly to the challenges and opportunities presented by the COVID-19 pandemic. Despite the impact of COVID-19 being relatively short-dated, it is having a dramatic impact on executive incentive structures. Certain executives are benefiting handsomely from the disconnect between share prices and their company performance, and other executives are working harder than ever for no relevant reward. We maintain that the structure of incentives will have to change to accommodate the post-COVID world.

We argue that those charged with the governance of organisations should consider the ways that existing structures are being warped, and how to better align executives’ interests with existing shareholders and a broadening stakeholder base. Incentives should only be awarded after careful consideration of underlying company performance. Right now, the widening disconnect between share prices and underlying performance exposes companies to undue risk when it comes to designing incentive structures. 

Finally, we suggest that Long Term Executive Incentives should refocus on the retention and alignment of management with the company they serve. The current environment provides fertile ground for the warping of such incentives, and companies cannot afford to ignore this any longer. 

Addison is a partner at Addison Comline.

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