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Omar Malik

Omar Malik

Portfolio Manager

  • Incentive structures too often prioritise the maximization of short-term metrics over generating long-term shareholder value

  • At Hosking Partners we advocate for incentive systems that encourage management to act like owners

  • Companies such as portfolio holding Tiny demonstrate what this can look like in practice

Under the analytical framework of the capital cycle, management incentives play a key role. The capital allocation decisions made by a company’s leadership – for example about capital expenditure and acquisitions – determine the denominator in the calculation of return on capital. When a long-term investor buys shares in a company, they outsource future investment decisions to the current management team. Management incentives influence behaviour generally, and capital allocation in particular. Not only can they ensure that optimal investment decisions are made, but they are also useful for revealing to investors the ways in which management is likely to exercise the discretion it has been given to manage the company’s balance sheet.

Despite this opportunity to optimise outcomes, incentive structures often exacerbate behavioural weaknesses rather than aligning the interests of the management team with those of the company’s owners. They may be tied to excessively short-term metrics (for example, sales) or performance metrics which exclude consideration of capital deployment (earnings per share being the obvious example). Such incentives ignore the long-term consequences of today’s decisions and instead privilege growth over return on capital, which in the long run is the key driver of shareholder returns. At Hosking Partners, we believe that incentive arrangements promoting long-term share ownership best focus management on the true drivers of value because when interests can be broadly aligned between management and shareholders, this raises the likelihood of intelligent capital allocation. When management already own significant equity, and share the interests of minority shareholders, so much the better.

Such alignment is often the exception rather than the rule. The challenge comes when analysing companies where equity ownership is diversified, and executives are hired without skin in the game. In these situations, boards’ remuneration committees typically engage consultants to implement “industry best practice”, leading to standardised incentive packages. These arrangements often include an attractive base salary, an annual cash bonus set as a multiple of their base salary based on short-term key performance indicators (KPIs), and annual equity grants through stock options or performance-based long-term incentive plans (LTIPs).

Even when annual bonuses are designed thoughtfully, they may place too much weight on short-term financial metrics. This serves to distract management from their task of long-term value creation. Temptations arising from this might include costly acquisitions or the deferral of necessary investments. To compensate for this, more companies include return on capital as a key performance indicator to encourage better capital allocation. Even this is not wholly perfect, however, as it may be distorting to focus solely on a single year’s return, especially in capital-intensive industries where assets have long useful lives. Although metrics based on a combination of the income statement and the balance sheet are intended to promote an all-round approach, if schemes are not devised carefully then company leaders can achieve generous bonuses by focusing on just a few KPIs at the expense of the rest. We advocate for longer measurement periods and multi-year phasing of benefit awards to promote strategic thinking.

Despite being strong believers in the importance of share ownership by management, we are wary of equity grants to management as we do not believe they align with shareholders' interests in the way that is hoped. Often little more than ‘lottery tickets,’ these grants reward management on the upside, which may be the result of factors beyond their control. Such awards can serve merely to transfer costs from the income statement to shareholders, boosting profits but diluting returns. LTIPs may not be much better, as we find they frequently award high payouts even when performance lags corporate targets. Gifting equity, whether by share grants or via LTIPs, is an inadequate way of replicating the effect of an owner putting their personal wealth at risk in owning a share of an enterprise. There is a chicken-and-egg challenge here – what to do when management have not yet got to a position where they been able to acquire an ownership interest which is meaningful in relation to their own circumstances?

We are drawn to companies that have addressed this principal-agent dilemma thoughtfully. Although no perfect solution exists, we find several schemes worth remarking on. Notable examples include Tiny Ltd (held in the Hosking Partners portfolio) and Constellation Software (not held). At these companies, the founders align closely with public shareholders, forgoing base salaries and bonuses in favour of significant equity stakes. However, other senior managers, also critical in capital allocation but without the same level of prior ownership, have a different arrangement. Their compensation includes an industry-average base salary and an annual bonus based on return on capital and revenue growth in their segments. Constellation Software states, “The objective of our annual incentive bonus is to reward employees for working towards our goal of increasing shareholder value. We believe that shareholder value is created by managing two financial components over the long term: profitability and growth.”

Using more than one metric helps reduce the risk of manipulation. Managers at Tiny receive no bonus if the ROIC falls below a certain threshold. Importantly, at both Tiny and Constellation the annual bonus is paid in cash, with the requirement that a large portion (40-80% across both companies) is used to purchase shares in the open market. At Constellation Software, these shares are held in escrow for a minimum of four years.

Such an incentive arrangement emphasises key metrics for value creation and promotes long-term thinking by requiring managers to invest a significant portion of their compensation in company shares. Executives at Tiny and Constellation Software only do well if the share price appreciates, in stark contrast to the norm at many public companies where executives are able to enrich themselves regardless of shareholder outcomes.

Well-designed incentives do not automatically guarantee good share price performance, and poor incentives do not necessarily lead to shareholder value destruction. But incentives are nevertheless important as they make clear which outcomes management teams are being asked to prioritise, and this shapes their behaviour. A company’s board of directors, elected by shareholders, puts in place these incentive arrangements and it is vital that we, as shareholders, advocate for and support good incentive systems in our portfolio companies. We recommend that boards start from first principles rather than relying on standard practice, with the aim of creating simple incentive schemes that encourage management teams to act more like owners.

17 May 2024

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