Recent research suggesting that performance-related share schemes for top managers may increase their pay but do little to increase shareholder value. This week’s FTdynamo column looks at the imperfect use of PRP-share schemes.
Recent research suggesting that performance-related share schemes for top managers may increase their pay but do little to increase shareholder value should come as no surprise.
The UK research has shown that that shareholder value in FTSE 350 companies that use long-term incentive plans (LTIPs) for managers is no higher than the average. Of the 309 companies studied, 150 had LTIPs only, while the others had share option schemes or a combination of both. LTIPs provide executives with substantial numbers of free shares if the total shareholder returns (TSR) – share price plus dividends – are higher than that of similar companies after a set period of time.
According to the study, sponsored by the Leverhulme Trust, LTIPs raised the average pay of chief executives by 21.5 per cent in 1997-1998 at an average extra cost of more than £185,000 for shareholders. But companies that offered LTIPs but not share options schemes raised TSR by 20.71 per cent in 1997-1998 compared with the overall average of 20.74 per cent.
According to the study, LTIPs do not increase chief executives’ commitment to increasing shareholder value because, since they link reward to the TSR of similar competing companies, they may encourage chief executives to concentrate solely on outperforming their rivals.
This is yet more proof that the move to link executive performance to the interests of shareholders has badly faltered. The reason executives are given LTIPs and share options is to overcome the so-called “agency problem” – the concern that managers will drive a company in their own interests rather than those of shareholders, for whom they are supposed to act as agents. Linking executive pay to share price or giving them share options is supposed to align the interests of both managers and shareholders.
In fact, this has not always happened. Managers still like to run a company the way that suits them. And the indifference in the past to managerial performance by institutional investors such as pension funds, by far the largest body of shareholders, has done little to discourage them.
This can result in a number of managerial actions that do not work in shareholders’ overall interests. These can include misguided mergers and acquisitions, divestments, and an increasing trend for companies to take on debt to buy back their own shares. While this can, indeed, boost the share price it also weakens a company’s balance sheet. And the fact is that most buy-backs happen to provide shares for executives.
As Winston Churchill once said about democracy, the public company may not be the best system for wealth creation but it beats any alternatives. But the agency problem remains. The organization that can really come up with a system that aligns managers with shareholders – and other stakeholders as well – may well have re-invented the company. But don’t hold your breath.
FTdynamo features writing and research from leading business schools and management consultancies.