Sharing success: How does a high-growth, privately held company compete with industry giants to attract and retain the best people?

How does a high growth challenger business attract and retain good quality people?  Can the way you pay your people be used to differentiate your business in the market for talent?

In this case study we look at how West Australian based Perth Energy is using entrepreneurial rewards to take on the giant of its industry and how that has led the company to think more broadly about how it measures success, thinks about investment opportunities and sets strategy.

Download the full case study here: Perth Energy case study

Sharing success

In the late 1990s Ky Cao was working for the West Australian government owned power monopoly Western Power, when reform of the industry presented a once in a generation opportunity.

Cao saw the future would be an openly contested electricity market with privately-owned retailers and generators competing for customers, improving service and delivering value.

He left the safety of his job at Western Power to found Perth Energy, relishing the chance to be at the forefront of change in his industry. He raised seed funding from a group of Perth investors and by 2006, the business had revenue of over $8m.

By 2010 Perth Energy had established itself as a leader amongst a small group of commercial providers that competed with the government owned retailer, now renamed Synergy. Cao had also won the support of one of the region’s leading infrastructure investment houses, New Zealand listed firm Infratil, which took a majority stake in the company to help fund the purchase and installation of a $130m, 120 megawatt power station at Kwinana, south of Perth.

As a mark of his achievement, in 2011 Cao was presented with the prestigious Ernst & Young Entrepreneur of the Year award for the Western Region.

Attracting and retaining key people

But as new participants followed Perth Energy’s lead into the industry and the West Australian mining boom continued unabated, the competition for staff presented Cao and the Perth Energy Board with a new problem: how to attract and retain quality people?

“Electricity and gas supply is a relatively complex industry,” Cao explains. “It requires technical and commercial brainpower and experience. To attract and retain good staff and align their interests with those of the company, we needed an incentive scheme that fairly, transparently and efficiently linked company performance to staff bonuses. And it needed to cover short term and long term aspects.”

Rod Jones, a director of Perth Energy and founder of the ASX listed global education business Navitas Limited, suggested Cao contact Juno Partners Managing Director, Justin Bown.

“Justin had helped Navitas put in place a profit sharing program that offered a meaningful reward for staff, but only if gains were sustained over three or more years”, says Cao. “It had also allowed greater variability in employment costs: up when the business could afford it, but well down and acting as a cushion to profits when the business had an inevitable down year.”

Juno Partners was engaged to develop and implement a profit sharing scheme with similar qualities for Perth Energy late in 2010.

“We spent about three months working through all the design considerations with Juno Partners. We discussed a range of options that would allow for rewards to be uncapped, but in a way that ensured only sustained gains were rewarded,” says Cao.

Measuring success

An important part of making the program shareholder-aligned was the choice of metric to measure performance. Juno’s Justin Bown explains, “Most people come to work each day wanting to do a good job, but every employee needs their manager to clearly define what ‘good’ looks like.”

“Justin asked us to think carefully about how we defined good performance”, continues Cao. “Given the capital investment program that lay ahead of us, we chose Economic Value Added (EVA) as the financial metric at the heart of our reward program.”

EVA was developed and popularised by US consulting firm Stern Stewart & Co. in the early 1990s. “It’s profit as it would be measured by an owner,” says Cao, “that is after including a charge for the shareholder’s money tied up in the business. Traditional accounting profit charges for the use of the bank’s money [interest], but not for the use of shareholder’s money. By charging for all the capital tied up in the business, EVA gets staff to think about revenue and expenses but also asset utilisation and working capital management. Other measures like EBITDA don’t do that.”

Cao had come across EVA earlier in his career and the logic of it appealed immediately. “It clearly shows the value a company creates for its shareholders. Our goal was to share the success we had with our staff in a way that aligned their interests with those of shareholders, so sharing sustained growth in EVA made really good sense.”

Owner-like rewards

The ‘ValueShare’ plan was approved by the Board in February 2011. In addition to the use of EVA, it includes other aspects designed to differentiate Perth Energy in the market for talent and align the interests of employees with those of shareholders.

The plan offers uncapped potential – both on the upside and the downside – but with the safeguard that rewards declared in any one year above a pre-set threshold are deferred and settled over time, provided the employee sticks around and gains are sustained.

The sharing formula is set for three years in advance, providing certainty to the Board and accountability to managers. “I’d seen the crippling impact that tying bonuses to budget could have on the planning process,” says Cao. “You’re basically paying people to lower their forecasts and game the system. We’ve got away from all that, again making the culture more entrepreneurial than our competitors.”

While the majority of rewards are based on the financial performance of the Group, Cao also wanted to recognise the contribution made by individuals. He retained a small pool to reward outstanding achievement by individuals, allocated annually by him as Managing Director.

“The EVA reward is the bigger number, it rightly focuses attention on how we perform as a team,” says Cao, “but the individual reward balances that and allows me to recognise those who have put in a particularly good effort during the year.”

To make the most of the change he had led, Cao recognised the importance of education. “Having designed and gained approval for the new program, we wanted staff to embrace it and understand what they needed to do to grow EVA.” Juno Partners led education sessions that were reinforced by changes to monthly reporting. Cao continues, “I was pleased to see how quickly people picked up on the principles and the way conversations began to give more emphasis to efficient capital management.”

Changes to capex and planning

Changes were also made to the capital expenditure and planning processes. “We began by including EVA in capex proposals and the annual and long term plans we presented to the Board.” Cao says. “And that gave great focus to balancing profit and capital growth. But after a few years we became more focused on the conditions that were necessary for EVA growth.”

“Only about 50% of Australian businesses are profitable from an EVA perspective,” Bown adds. “To grow EVA you have to be investing funds at attractive rates of return, which in turn creates wealth for owners. But because high returns are the path to creating wealth, any business that enjoys high returns usually finds they are quickly surrounded by competitors looking to mimic their offering, but at a lower cost, or with more features.”

“To grow EVA sustainably therefore, you have to think about how to create value for your customers, but you also have to think about how you’re going to defeat the ravages of competition and keep a worthwhile slice of that value for yourself.”

Cao comments, “We started out looking for a way to share our success with our people and we’ve achieved that, but that journey also brought other benefits. It forced us to define clearly what we expect of our people and the company and think through what it is that really drives value for shareholders. It’s been a very useful process.”

A key role in doubling revenue

Cao sums up, “Perth Energy has always been a forward-looking company, not least because we were instrumental to the opening up of the electricity market in WA in the 2000s. This reputation helped us attract high quality staff to the company, which at the time was still a small business.”

“Our retail business grew ten-fold in the five years to 2010 and at the same time our generation arm was in the midst of delivering on time and on budget the Kwinana Swift power station project and soon after a second, $90m, 82 megawatt power station in Merredin, east of Perth.”

“So we had to implement innovative management tools to glide the company’s operation into medium sized enterprise mode. The ValueShare scheme was an important part of that.”

“The results from the first 3-year cycle, which paid out in FY12, 13 and 14, show the scheme working well. We are now into the 2nd 3-year cycle and staff have become very familiar with and supportive of the rationale, intent and transparency of the scheme.”

“The introduction of the ValueShare scheme has played a key role in Perth Energy doubling in size to nearly $300m in turnover, without a hiccup on the HR side.”

Five elements to make managers think and act like owners #1: Reward sustained improvements in profitability

In this series of articles, we’ve looked at some of the most common mistakes that privately held companies make in approaching the question of incentives, and we’ve sketched out the common themes that owners tend to look for in an incentive plan.

Let’s now move to see how those themes can be realised in practice, by including five key elements in the incentive plan design that will make managers think and act like owners.

#1  Reward sustained, multi-year improvements in profitability
Ultimately an ‘ownership-like’ incentive plan must have financials at its heart, as it is sustained gains in financial performance that power the value of a business. Single period spikes in performance are unlikely to grow the value of the business a great deal however – buyers look for high levels of ‘repeatable earnings’. The more reliable the profit flow, the higher the premium buyers are likely to pay for a business.

I’ll discuss how to reward sustained gains in element #4, but it is worth focusing on how ‘profit’ is defined first, because, as we have seen, the most common profit measures, such as EBIT and EBITDA (or Net Profit, Earnings Per Share, Return on Equity and so forth) can actually encourage decisions that reduce, rather than grow, the value of the business.

One measure of profit that can be relied on to drive decisions that will grow the value of the business is ‘Economic Profit’. Economic Profit is the only metric that can be measured as easily as EBIT or Net Profit and yet ties reliably to wealth creation for owners. It’s measured like this:

Economic Profit calculation

Most owners know that ‘Profit’ is what is left over from sales revenue once all the costs of running the business have been taken out.  But accounting profit forgets one very important cost – the cost of using shareholder funds.  And by failing to put a price on the equity used to fund the business, accounting profit effectively says it’s free.

Pay managers to grow accounting profit and they will be encouraged to use as much of the shareholders’ money as they can put their hands on, after all its free and if they invest it at just 1%, accounting profits – and their bonuses – will grow.

But by charging for the owner’s capital used in the business at a rate that reflects what could be earned elsewhere at similar risk, managers are encouraged to treat capital like the scarce and valuable thing every business owner knows that it is.

Economic Profit puts into practice what anybody starting a new business has to think about from day one: if I put my savings into this business, will it generate more profit than I could have got elsewhere at similar risk?

For managers on an incentive plan linked to Economic Profit it forces them to think the same way: not just will this decision be profitable, but will it make enough profit to justify the owner’s investment?

In the next article we’ll discuss how to align the payoff profile of managers to that of owners.

The most common incentive plan mistakes made by privately held companies #6: The wrong measures

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

Mistake #6: The wrong measures

Finally, the wrong measures of performance are too often used to determine bonus payments. The most popular financial measures used in bonus plans are pre-tax, pre-financing ones like Earnings Before Interest and Tax (EBIT) or Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA). But these measures ignore a major component of doing business, the capital put up by investors.

Most businesses require capital – money from banks and owners – from day one and every day thereafter as they grow and prosper. But measures like EBIT and EBITDA completely ignore the use of capital and hence give managers no incentive to manage it more efficiently.

For example, for an EBIT of $2m, would you rather put up $10m in capital or $20m? A bonus scheme based on EBIT doesn’t differentiate between these two alternatives and so it’s not surprising that EBIT and EBITDA based schemes often go hand-in-hand with bloated working capital, gold-plated asset purchases, and a preparedness to pay suppliers early to keep them happy.

Under these schemes capital has no cost, so it’s not surprising that it’s used so wastefully.

But you can’t blame managers for responding to the rules of the game that are written for them. The blame sits squarely with the owners and Boards that write the rules of the bonus game without careful thought or research.

Next we’ll look at how these common mistakes can be avoided and instead, an incentive plan put in place that pays managers like owners.

Is your business engineered to create wealth? Part 3: Capital allocation

Most CEOs would prefer to create more wealth for shareholders than less.

But most companies are not ‘engineered’ to create wealth – internal processes often act to hinder wealth creation, rather than encourage it.

In this article we look at how capital allocation processes can fail shareholders and some simple steps that can be taken to drive greater accountability into investment decisions.

The big capital spends, be they investments in new markets, new products or acquisitions, often represent the signature, transforming achievements of a CEO. And for shareholders, they often have a transforming impact on wealth.

So when faced with these opportunities, CEOs need clear, reliable tools to assess investment opportunities. Unfortunately, the tools that they are most likely to use are anything but.

If wealth creation is the goal of the business, then for any investment evaluation tool to be of use it must address the quality and quantity issues we saw in part one of this series as the key determinants of wealth creation.

This rules out using EBITDA and EPS growth, which both fail to capture the funds invested in a business and say nothing of the quality of the business. Sophisticated investors know this and mark down businesses that trumpet EPS accretion, if the investment fails to deliver reasonable returns on capital invested.

Other, more sophisticated tools, like Internal Rate of Return (IRR) and Discounted Cash Flow (DCF) address the draw backs of EBITDA and EPS by forecasting all the capital required for an investment and all the cash that will be generated by it and boiling them down to a single number; a percentage in the case of Internal Rate of Return (IRR) which can then be compared with the company’s hurdle rate, and a dollar figure in the case of Discounted Cash Flow (DCF), showing how much wealth will be created from the investment.

But while IRR and DCF can be used to accurately calculate the wealth impact of an investment decision, they are only ever as useful as the forecasts used and this is where IRR and DCF analysis fall down.

The best users of DCF look to key drivers, such as margins, volumes and inventory turns to assess the reasonableness of forecasts. If the acquisition requires industry best results across all key drivers to create wealth it’s time to negotiate a better price, or walk away.

But one key reasonableness test every CEO should ask is, ‘What is the forecast ROCE of this investment, in each year of the forecast period?’ If ROCE forecasts are beyond reasonable upper limits then warning bells should sound.

As the chart below shows, drawing on our research into returns achieved by Australia’s largest companies and summarised in the table in part one of this series, only the top 25% of companies are able to sustain returns 5% or more in excess of the cost of capital over any given five year period. This analysis probably understates how rare high returns on capital are in the broader economy, given businesses that have failed or who are yet to be consistently profitable are excluded from our research.

Figure 1: Returns significantly above the cost of capital are rare

Returns above the cost of capital are rare

 

In my experience, when DCF analysis is recut to include ROCE and Economic Profit data on an annual basis it often forecasts ROCE starting low and gradually growing larger and larger, past the 75th percentile and eventually into the top decile of what companies have historically been able to achieve.

Few companies are able to generate let alone sustain these returns, due to the competitive forces they face. If one player in a market is able to invest and generate such attractive returns, others will follow and unless the investment is made behind, as Buffett would call it, a deep ‘moat’ of a hard to copy competitive advantage, returns will begin to fall, not rise, as time goes on.

Given 75% of companies fail to make returns more than 5% above the cost of capital, the default assumption for DCF analysis should be that returns will revert to the cost of capital over time, in the absence of a very clear and proven set of competitive advantages that will keep competitors, suppliers and even governments at bay.

Equipped with the forecast annual EP Spread of the investment and a thorough knowledge of the competitive forces of the industry in which the business operates, a CEO is in a much stronger position to make career defining capital investment decisions.

The second and important step in this phase is to close the accountability loop for investment decisions. And that comes back to the performance measure chosen by the CEO. EBITDA and similar measures ignore the capital invested in a business and send a signal to all managers that capital is free.

Economic Profit by contrast, constantly reminds managers of the funds invested in their business and the need to generate sufficient returns. By holding managers accountable for sustained gains in EP, the rigour of investment proposals increases: managers know while putting together their forecasts that unless the investment generates and sustains high returns, the Economic Profitability of their business will fall.

As one client put it, ‘EP is like DCF with a memory’.

Is your business engineered to create wealth? Part 2: Performance measures

Most CEOs would prefer to create more wealth for shareholders than less.

But most companies are not ‘engineered’ to create wealth – internal processes often act to hinder wealth creation, rather than encourage it.

In this article we look at one of the most pervasive barriers to wealth creation: performance measures.

As we’ve seen in part 1 of this series, wealth is created when funds are invested at high rates of return and destroyed when funds are invested at low rates of return. But incredibly, the most popular financial performance measures in use today such as Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) and Earnings Per Share (EPS) are silent on the rate of return, or quality of the business. And what’s worse, they actually encourage managers to destroy wealth by investing the money entrusted to them at low rates of return.

Consider a manager faced with an opportunity to add a new customer. If the business
goes ahead with the terms proposed by the customer, the impact on the Group’s financials
will be as follows.

Figure 1: Growing profits, destroying wealth

Growing profits destroying wealth

 

Any of the most popular performance measures, such as sales, margins, EBITDA and even ROCE improve if the manager takes this deal. But in doing so, they encourage him to invest the capital entrusted to the business at 8.2%, less than the 10% that investors could get elsewhere at equivalent risk – that is, these measures will encourage the manager to destroy wealth.

Indeed a manager can grow EBITDA or EPS, two of the most popular measures of performance in use today, by investing funds for a return as little as 1%.

As a consequence, all the creativity and hard work of a management team can unwittingly lead to wealth destruction if the compass that they use to guide decisions is a simple but misleading one, such as EBITDA.

Using EBITDA or any other measure that fails to capture quality and quantity of the business keeps the truth of the performance of the business back from managers and acts as an enormous barrier to the creation of wealth.

CEOs can remove this barrier by replacing EBITDA or similar measures with sustained gains in Economic Profit. Economic Profit is the only measure that captures both the quality of the business and the quantity of funds invested in it.

Figure 2: Economic Profit captures the key drivers of wealth creation

Economic Profit formula

 

Because EP goes down when funds are invested at low rates of return and up when they are invested at high rates of return, it guides managers, through all their efforts during a year, to create wealth, rather than destroy it. And it can be measured right down through the business, sharing responsibility for wealth creation throughout the management ranks.