The newly appointed Chairman of a large listed Australian company was looking to bring about a significant change in culture. Over the previous ten years the business had grown dramatically in terms of revenue and people numbers, but the performance of the business for shareholders was lacklustre, with the group’s Total Shareholder Return and its Price to Earnings multiple both amongst the lowest of its peers.
Conversations with some of the group’s largest institutional owners confirmed the Chairman’s instinct that the focus needed to move to value. We were asked to review the group’s cash incentive program in this light and develop recommendations for change that would not only help achieve the cultural shift under way, but send a strong signal to investors that the business was taking a new direction.
How we responded
We worked with the Remuneration Committee and the Head of Human Resources to review the existing cash incentive program and make the case for change. Interviews with executives from across the group showed that many were dissatisfied with the existing program that used the budget to set incentive targets and an all or nothing pay-off structure. These combined to encourage dysfunctional and value impeding decision making: negotiations around budget were drawn out and frustrating and if performance was well short of target or comfortably over target, the plan was effectively ‘dead’, with marginal gains or losses unrewarded.
To bring a greater focus on value for shareholders, we proposed financial performance should be measured based on growth in Economic Profit – ie investing funds at good rates of return would be rewarded, investing at low rates of return would not.
But to address the dysfunction noted by managers we also suggested incentive targets be set on a three year basis, independently of the budget process, reflecting shareholder expectations.
To reinforce the importance of returns and value for shareholders, we recommended reassigning some of the compensation mix used for long term, equity based incentives to the new cash program – the equity program was seen as a lottery by many managers and we felt the business could get greater value from its incentive spend by tying a greater portion of rewards to measures within the control of managers.
But to encourage a longer term perspective we also recommended the introduction of a deferral element for cash rewards, with deferred rewards subject to loss if performance was not sustained.
Following extensive consultation with management, the Board decided to adopt our recommendations. Institutional investors have been supportive and management has been quick to put in place a greater focus on working capital management, freeing up significant cashflow for the reduction of debt.
The change to measures of performance has sparked a broader question within management ranks about the causes of the Group’s current low returns on capital and what will be required over the medium term to improve returns. We are currently working with management to review investment approval and capital allocation processes.