Letter number 67 of April 2012


News : A few thoughts about compensation policy

Management compensation is a sensitive subject (particularly when performance is poor) and any news on this topic is taken up by the press. Some examples include the activist shareholder protests at Citi, Barclays and Deutsche Bank or the announcement by the L’Oréal CEO that they were going to phase out the granting of stock options in favour of free shares.  These have all provided much food for thought on the matter.

Getting back to basics, we’ll remember that there are four key types of compensation:

• fixed salary,

• variable compensation (profit-sharing linked to the firm’s results, bonuses linked to the achievement of individual results),

• miscellaneous compensation and perks (company car, complementary retirement scheme, etc.) and,

• compensation that is directly linked to the performance of the share (mainly free shares and stock options).

Over and above the moral aspect of compensation, which is to reward people for their work (and risk-taking), setting compensation must meet the following objectives:

• initially, to attract people who appear to be the best placed to do the job;

• to hold onto them, while their performance is satisfactory;

• to ensure that their personal interests tie in with those of the shareholders.

Our aim here is not to hold forth on the absolute levels of compensation that we see on the market, but to look at the different types of compensation and to ascertain whether they meet their stated objectives. 

The last objective we highlighted is governed by what in finance we refer to as agency theory.  This theory raises the fact that the various stakeholders in the firm may have diverging interests.  For example, managers may seek to pursue personal goals (size of the company, risk limitation, personal profit, etc.) that differ from those of shareholders (maximisation of the value of the share)(1).  Accordingly, a good compensation system will ensure that the manager is driven by the key aim of maximising the value of the company over the long term.

The traditional incentive used to encourage managers to "do their jobs well", is the bonus.  The bonus is the variable portion of compensation, paid annually in cash.  Bonuses are determined on the basis of performance during the past year.  Theoretically, it is paid if given objectives, in terms of both quantity and quality, are achieved.  The variable nature of the bonus is certainly an incentive, but its underlying principles contain a certain number of faults.  Firstly, there is a tendency to institutionalise the bonus, and its variable nature becomes, to some extent, theoretical.  Also, defining goals and targets is a complex business.   They have to be sufficiently precise in order to be measurable and directly dependent on the management actions, and at the same time guarantee the maximisation of value over the long term rather than the short term. 

In order to provide even greater incentive, a product was developed which became widespread in Europe during the 1990s – stock options. This instrument, granted as part of compensation, in a certain way, enables the firm to index compensation to the performance of the share, as it is an option to buy.  Accordingly, it has the advantage of providing a great deal of leverage, providing the manager with the prospect of making very high gains if the company’s share price were to rise nicely.  It also, theoretically, provides a great deal of incentive, as its value could be zero in the event of under-performance of the share.  Explained like that, stock options would appear to be the ideal panacea.  But are they?

Let’s take a look at some of their main drawbacks.  The first drawback of stock options is that their value can be very much disconnected from the relative performance of the company.  In periods of stock-market euphoria, the value of stock options can rise dramatically, even for companies that are managed in a rather mediocre way.  On the other hand, during times of economic gloom, the efforts and efficient policies of some managers will not be rewarded by an increase in the value of their stock options, even if value has been created. 
In other words, because the change in a share price does not reflect the performance of the company over a past period, but rather a change in investor perception of its future, a bias is introduced.  For example, in 2012, around 40% of Eurostox 600 companies have share prices that are lower than in 2000, while most of them have created value for their shareholders by generating a higher ROCE than their cost of capital.  This just can't be seen in the share price over this period, as it was anticipated during the previous period.   This may well be one of the reasons why the managers of L’Oréal waived their right to stock options and opted for the allocation of free shares. 
Since the payment of dividends has a negative impact on the value of stock options, companies that have granted stock options run the quite high risk of seeing their management adopt a very "cautious" dividend policy, preferring to reinvest in order to increase value, rather than to reduce it by paying dividends.  At the worst, they could resign themselves to carrying out share buybacks.  It goes without saying that the principle of “action, reaction”, is universal and also applies in finance.

In other words, it is likely that a company whose growth rate is slowing down, would prefer to allocate free shares in the future, as free shares will always have a value, rather than stock options which may become valueless.  This will be a lot more incentivising and efficient from a management point of view.

The allocation of free shares or “performance shares” is linked to objective criteria which are intended to reflect the effective actions of management and not the variations in the value of the share:  minimum return on capital employed or equity, growth rate of EPS, etc.  The criteria may be non-financial, such as the degree of customer satisfaction, industrial accident rate, amount of market share, etc.  The value of these shares, once acquired thanks to the meeting of economic criteria, obviously depends on the performance of the share but, unless the company goes bankrupt, it is not zero, as is often the case for stock options these days. 

This leaves the difficult task of defining goals and targets.  These are obviously different for each company.  For a comparison of criteria for value creation, see chapter 28 of the Vernimmen.  In the context that is of interest to us, accounting criteria remain the easiest to put into place.

All in all, the phasing out of stock options in favour of free shares results from the convergence of several factors:

• political correctness (as free shares are less speculative and involve those who receive them directly in the capital);

• tax regulations, which in some countries, encourage free shares over stock options;

• stock market context of the 2000s (12 years later, the Eurostoxx 600 index is down 30% on its 2000 level), a lot different from that of the 1980s and 1990s, which were generally marked by stock market euphoria;

• the difficulty for a large group of continuing to achieve growth;

• and, the corollary, the increase in dividend payments.
(1) For more on agency theory, see chapter 27 of the Vernimmen.

Statistics : Working capital in Europe

The ranking of Eurostoxx 50 groups, excluding financial and real estate firms, shows that half of them, at the close of their 2011 financial year, have negative working capital. Accordingly, negative working capital is one of the attributes of a powerful group and you shouldn't be surprised to find a lot of powerful groups among the members of the Eurostoxx 50, which is a club of the elite in the euro zone!   As we've said elsewhere(1) "Working capital is a sign of a power play between the firm, its customers and its suppliers".  So its not only in mass market retailing that we find negative working capital. 

All in all, the Eurostoxx 50 has a negligible 2011 working capital of €11bn for sales of €2000bn, or the equivalent of 2 days sales:

Overall, the situation hasn't changed much compared with the previous year, except in as far as these large European groups have continued to improve their performances in this area - while their sales have risen by 22% since 2009, their working capital has only increased by 3%. There have probably been improvements in productivity (inventories management for instance), but, let's not delude ourselves, arms (of suppliers and subcontractors) have also probably been twisted.   

Over and above the apparent stability of total working capital, we see that groups with negative working capital increased it parallel to their sales, and that those with positive working capital increased it as well.
(1) See chapter 11 of the Vernimmen.

Research : Post merger restructuring

with Simon Gueguen Lecturer-reseacher at the Paris Dauphine University

Empire building is one of the main motivations behind mergers and acquisitions, according to economic theory (1). For reasons of compensation or simply prestige, managers tend to go overboard when extending the boundaries of the firms they run.  A recent article (2) calls into question the empirical truth of this idea, using an original approach. 

This article shows that an acquisition is only the first step in a process of redefining the firm’s boundaries. Accordingly, to measure the long-term consequences, we need to study the disposal of manufacturing plants during the months following the acquisition. 

Maksimovic et al studied the post-merger restructuring of firms and they show that such restructuring is a response to economic efficiency rather than empire building.

The study combines data contained in an annual US survey (3) on the production, employment and expenditure of manufacturing plants and data from an M&A data base on US targets, between 1981 and 2000. The sample may seem to be a bit old for a study published in 2011, but the authors needed a certain distance in order to measure the restructurings in the years following the acquisition (not to mention publication delays!). The period is sufficiently long to cover two full M&A cycles in the USA(4) . The final sample contains close to 1,500 M&A deals.

In the three years following a total acquisition, 27% of plants acquired are sold and 19% are shut down. By comparison, firms in the sectors involved in these acquisitions, but which have not made any themselves, sell 9% and shut down 3% of their manufacturing plants over the same period.

Furthermore, there are economic reasons behind this restructuring. The acquiring company holds onto the majority of the plants which are in the same field as its core business, and it holds onto more plants which its productivity in peripheral activities is high. In other words, it is seeking to exploit its comparative advantages. The decision to sell or to shut down a plant only depends on the basic characteristics of the firm and of the manufacturing plant in question, and not on the fact that it belongs historically to the target or to the acquiring company. It is clearly economic logic that holds sway. Finally, Maksimovic et al check that the productivity of the manufacturing plants acquired and held onto increases, while the productivity of the plants sold does not.

These results show that an acquisition should not be seen as an instant deal, but rather as the point of departure for a process of restructuring that extends over a period of around three years (5). Without totally excluding empire building in the short term, over the long term, these restructurings are governed by economic rationality. Accordingly, they result in a better allocation of macro-economic resources. 
(1) For more information, see chapter 34 of the Vernimmen.
(2) V. MAKSIMOVIC, G. PHILLIPS and N.R. PRABHALA (2011), Post-merger restructuring and the boundaries of the firm, Journal of Financial Economics, vol.102, pages 317-343.
(3) Annual Survey of Manufactures, managed by the Census Bureau.
(4) The early 1980s and 1990s correspond to the bottom of the cycle, and the late 1980s and 1990s correspond to the top of the cycle.
(5) The results over 5 years are not fundamentally modified as the main work involved in the post-merger restructuring is completed after 3 years.

Q&A : What are USPPs?

The term private placement generally covers the placement of financial securities (shares or bonds) with a limited number of institutional investors known as qualified investors. The placement can be made with less publicity and information than is normally the case, as the investors are professionals and so, theoretically, do not need to be specifically protected by regulations (1).

Without further precision, and in terms of debt, the term private placement will generally be understood to mean the issue of a bond to a few institutional investors (and sometimes only one).  So it is a means of financing in the same way as a bank loan or a standard bond issue.  

European regulations are generally rather inflexible when it comes to putting in place such operations. There is a small market in Germany (Schuldschein) and in Belgium (placements with individuals). Across the Atlantic though, US regulation makes this type of transaction easy to implement, even though it may take around 12 weeks from the time a decision to issue is made, and the collection of the funds, which includes a road show lasting a few days. 

There are around 50 active investors on this market, mainly insurers and pension funds with a long-term outlook, since the maturity of financings is generally long (7 to 15 years, with 11 years on average). The volume of issues in 2011 was the highest ever, at $46.5bn, a figure that could be beaten in 2012.  Issuers include Americans (37% of the market), Europeans (also 37% of the market), and Australians and New Zealanders (16%). 

So USPPs have become a real financing alternative for non US companies, both large (Veolia, Philips) or medium-sized (Luxottica, Premier Oil). The “bonds” issued are not listed and so do not benefit from a secondary market.  Accordingly, their yield to maturity is often a bit higher than that of a listed bond.

The operation generally consists of an immediate loan at a fixed rate in US dollars, but we have recently seen multi-currency operations, with deferred departure dates and even variable rates. As they are not intended to meet liquidity constraints, the issues (and within each issue, the different tranches) may be modest (and smaller than would often be the case with a standard bond issue).

The placement of a USPP does not require a rating by a rating agency, but the profile of the company must be investment grade. The issue will be rated by the NAIC (National Association of Insurance Commissioners).

USPPs are very attractive to groups seeking to diversify their financings and to gain access to long financings denominated in US dollars, and to do so without having a rating. However, the issuer should bear in mind that the documentation is generally restrictive (covenants are frequent) and that investors are a lot less flexible when it comes to renegotiating the terms of the USPP than would be the banks that are close to the company.   We have seen some strategic transactions abandoned by certain groups as a result of intransigent US lenders (the merger of Italcementi-Ciments Français is an example). Well, you can’t have your cake and eat it...
The strengthening of solvency restrictions on banks is forcing them to tighten up their offers of loans, particularly for loans that are outside their domestic markets.   Since nature abhors a vacuum, loans to companies outside the traditional banking circuit, on the shadow  banking segment, are developing, and the USPP market is a shining example thereof. 
(1) For more see chapter 26 the Vernimmen.