Corporate America has increasingly relied on share repurchases to fuel earnings per share (EPS) growth in recent years. A study by Reuters found that nearly 60% of nonfinancial, publicly traded companies have bought back shares in the last five years, and share repurchases and dividends exceeded capital spending in 2014.
Critics suggest that the boom in repurchases has been driven by executives seeking to “game” incentives — inflating short-term results to line their pockets. With this in mind, directors need to ask: how should buybacks influence incentives and compensation decision making? We offer four principles to help directors answer this question.
1. Meaningful sustained stock ownership is the best tool to encourage thoughtful capital deployment decisions that drive long-term value creation. Significant ownership mitigates the temptation for executives to use share repurchases to manipulate incentive payouts. A market-competitive equity program with both (i) long-tailed vesting periods and holding requirements and (ii) a culture and ethic of stock ownership will help to align management with shareholders and promote judicious long-term capital deployment.
2. Annual incentive plans work best for measuring operating results. The impact of share repurchases should generally be excluded from calculations of goal setting and incentive payouts in annual plans. Since share repurchases are often opportunistic and not confined to fiscal years, executives have the greatest line-of-sight to performance if buybacks don't figure into incentive calculations. Alternatively, annual incentive plans can exclude EPS as a metric altogether.
3. Long-term incentive plans work best when measuring the company's ability to deliver results for shareholders (particularly in budget-based plans). The impact of share repurchases on longer performance periods requires careful consideration. Many companies include the impact in incentive calculations for multi-year periods to encourage management to execute share repurchase strategies that create long-term value for shareholders.
4. Compensation decision making should fall under a robust board process to evaluate all capital deployment strategies, including share repurchases. This process should relate any findings to the compensation committee to ensure a holistic view of the company's performance and inform program design, pay actions, and the exercise of discretion.
Each company's circumstances vary and these “best practice” principles may serve only as a starting point. Directors need to tailor their treatment of repurchases to the company's nuanced needs. To this end, three questions help translate our principles into sound practice:
1. How do share repurchases fit into the company's capital deployment strategy? Are they a defined and communicated component? Do they just mitigate the dilutive effect of employee stock grants? Are there circumstances that influence buyback decisions on a more discrete basis?
2. Which incentive plan metrics vary with repurchase activity? Of course, any per-share metric is impacted by changes to shares outstanding. To date, EPS has received the most focus as one of the most common metrics among S&P 500 companies. That said, other popular metrics such as ROIC can be impacted when share repurchases are funded from cash and cash is included in return calculations.
3. What is the impact of share repurchases on results and, therefore, payouts? Is it meaningful or just a rounding error? Were the goals—at target, threshold, and maximum—established to be sensitive to varying levels of repurchase activity?
As an example, a company recently divested a non-core line of business that had required greater regulatory capital than the company's core businesses. As a result, the company committed to shareholders to redeploy a large portion of the proceeds as share repurchases over 12 to 18-months.
To align with this strategy, the company determined to include the impact of buybacks in the calculation of EPS for both its annual and long-term incentive plans. The company's finance team then modeled the impact of a variety of scenarios that might change actual repurchase activity and set the threshold and maximum goals to ensure that repurchase variances alone could not drive results to maximum, or below threshold.
Over the course of the year, the board discussed with management the key drivers of over- or underperformance (i.e., operating performance vs. repurchase activity), ensuring transparency between all parties if/when the calculated plan results differed from the committee's view of performance.
It is imperative that boards are both (i) intentional about the manner in which executive incentive compensation is impacted by share repurchase activity, and (ii) transparent in their disclosures to shareholders about the approach taken. Further, active conversations with management help everyone clarify the effectiveness of the company's capital deployment strategies and their implications for compensation decision-making. â–
Mark Emanuel is a senior consultant and Derek Fleck is a senior associate with executive compensation consulting firm Semler Brossy (www.semlerbrossy.com). Mr. Emanuel can be contacted at memanuel@semlerbrossy.com.