The Age of Alignment Part II: Getting Strategy-Driven Performance Measurement Right
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The document discusses performance measurement in corporate governance, emphasizing the need for aligning compensation strategies with business goals. It outlines the importance of identifying relevant performance measures, setting realistic targets, and ensuring accountability in incentive plans. Key takeaways include the necessity of adapting performance measures to company-specific contexts and the involvement of compensation committees in the goal-setting process.
The Age of Alignment Part II: Getting Strategy-Driven Performance Measurement Right
- 1. ADVANCING EXEMPLARY BOARD LEADERSHIP The Age of Alignment Part II: Getting Strategy-Driven Performance Measurement Right Compensation Series March 12, 2015
- 2. 2 Meet The Presenters Michael Ng is a consultant in the Boston office of Pearl Meyer & Partners with more than 12 years of experience in strategy, human capital and executive compensation consulting Greg Lau (moderator), is managing director of the board of directors practice for RSR Partners, a member of the board of the National Association of Corporate Directors (NACD) and an NACD Board Leadership Fellow. Matt Turner is a Managing Director in the Chicago office of Pearl Meyer & Partners, specializing in executive compensation strategy, incentive plan design, tailoring of performance measures and assisting Compensation Committees in setting shareholder-focused performance targets.
- 3. 3 Click the buttons below to access additional resources Housekeeping
- 4. 4 Housekeeping Click below for a copy of the slides Slides are also available at pearlmeyer.com/AgeofAlignmentPartIIMeasurement
- 5. 5 You will automatically receive 1 NACD skill-specific credit for your participation. Credit may be applied to NACD Fellowship programs. Contact Fellowships@NACDonline.org for more details. The replay and slides will also be available early next week at NACDonline.org/webinars and pearlmeyer.com Housekeeping
- 6. Today’s Discussion • Review of the key takeaways from December • Identifying strategy-driven performance measures • Mapping those measures to incentive plans • Practical concerns with performance measurement • Setting performance goals • Questions 6
- 7. Developing Strategically Aligned Pay Programs 7 • Business and leadership strategy drive program design • External practices and views inform program design External Perspectives and Optics Pay / Performance Alignment Market Practices Business Strategy Leadership Strategy Compensation Philosophy & Strategy Compensation Program Design Implementation and Communication Business Results Understand Key Drivers Understand Context Concept in Practice •Conscious deviation from market norms •Drive competitive advantage •Create value proposition differentiation
- 8. Hallmarks of Strategically-Aligned Pay 8 1. Balances Driver and Outcome metrics • Driver or “Lead”: strategic imperatives • Outcome or “Lag”: financial results 2. Balances Alignment and Accountability • Alignment: line of sight; ability to influence • Accountability: absolute; relative 3. Considers both “What” and “How” • What are the results (measurable) • How the results were attained (discretion) Metrics Goals
- 9. Performance Measures are a Critical Link Between a Stated Business Strategy and Management Execution 9 • Maximize shareholder value • Company-specific path to value- creation taking into account – Market economic; competitive position – Company strengths, weaknesses, opportunities and risks • Specific/relevant financial measures, balancing growth and returns • Operational measures tied to business strategy Goal Centerpiece Financial Measures Corporate Processes Operating Decisions Incentives Planning & Resource Allocation Reporting Strategy Driver Measures
- 10. Understanding How a Company Creates Value Allows Identification of Strategy-Linked Performance Measures 10 Revenue Growth Value Creation Economic Profit Market Share Return on Invested Capital New Products Cost of Capital Capital Efficiency Quality New Markets Operating Margin Capital Deployed Innovation R&DDistribution Costs Working Capital Pricing Stock Price vs. Free Cash Flow and EBITDA ($100) ($50) $0 $50 $100 $150 $200 $250 $300 200620052004200320022001200019991998199719961995 $20 $25 $30 $35 $40 $45 $50 $55 $60 FCF EBITDA Price
- 11. Case Example 1: Specialty Chemicals Manufacturer • Company wishes to implement a LTIP that reinforces business strategy (replacing a simple mix of stock options and restricted stock) • Continued market growth at economically profitable return levels, capitalizing on the Company’s strengths – Manufacturing excellence and innovation – Top level, tailored customer service 11 ROGA (Cash Returns) vs. M/B Ratio y = 4.30x + 0.77 R 2 = 0.43 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 0% 5% 10% 15% 20% Return on Gross Assets MarkettoBook RONA vs. M/B Ratio y = 5.72x + 0.55 R 2 = 0.68 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 0% 5% 10% 15% 20% Return on Net Assets MarkettoBook
- 12. Once Centerpiece Financial Measures are Identified, “Balance” Them Appropriately Based on Strategy 12 • A properly balanced performance measurement framework will – Emphasize profitable growth/returns, consistent with strategy and market economics – Include a mix of lead and lag measures to ensure appropriate line-of-sight – Map measures to the right incentive plans based on timeframe and participant profile Growth Profitability ROI Stock Price/TSR % of Target Individual Top Operating Gross NI Working Absolute Relative Plan Type Total Pay "MBOs" Line Income Margin Margin ROIC Capital Growth to Peers Annual Incentive Plan 35% X X X X Cash Long-term Incentive Plan 15% X X X Performance- vested Restricted Stock 15% X X X Other 5% X X
- 13. Case 2: Retailer • Current incentive plans had 80%+ based on sales and gross margin dollars • Analysis showed that the measures were highly redundant, both internal to the firm and among peers • Focusing on one measure allowed for increased focus on drivers or “lead” measures 13 Performance Linkage Bonus Dollars at Target - Merchants and Store Mgrs. 43% 47% 44% 8% 33% 5% 20% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Merchants Store Mgrs. Comp Sales Gross Margin $ Income Inventory Turns Expenses XYZ Department Stores -15% -10% -5% 0% 5% 10% 15% YOYChange Sales GM$ ABC Department Stores -40% -20% 0% 20% 40% 60% 80% 100% YOYChange Sales GM$ 123 Department Stores -50% 0% 50% 100% 150% 200% 250% YOYChange Sales GM$
- 14. Sometimes the Tailoring of Measures is Worth Consideration Potential Deviations from Standard Definitions Some Considerations Operating income vs. all “earnings” (e.g., interest income, JVs, discontinued ops) Employee control and influence Actual vs. standard tax rates (or pretax earnings) Same as above; is management of a deferred tax asset part of operations? Non-cash charges (depreciation, amortization, etc.) Unusual period of growth; management inherited goodwill; distortions to investment decisions Effects of exchange rates Employee control and influence; financial vs. operational hedging; distortions to investment decisions Inventory valuation Differences from peers for relative performance comparisons; large swings in actual value of inventory Adjustment of balance sheet values (marking to market; recognizing non-GAAP assets) Distorting investment decisions; protecting brand value Capitalizing R&D or marketing expenses Encouraging investment without undue impact on short-term financial metrics Suspending the impact of acquisitions for a period of time Acquisition strategy with multi-year integration 14
- 15. Once Key Performance Measures are Identified, Understand Their Limitations and Plan Accordingly • Agree ahead of time on how to treat unusual, non-recurring, and non-operational items. Acquisitions and divestitures Unusual swings in commodity prices, exchange rates, interest rates Settlement of lawsuits or government-related items Asset write-downs Share repurchases Changes in accounting rules Windfall gains or losses • Past precedent is instructive. But think through the intent of the measures, as well as fairness and optics. 15
- 16. The Goal-setting Process is Changing and Compensation Committees are More Involved Than Ever Before 16 • Budget-driven • Target-focused • Compensation Committee involved at the end of the process • Multiple performance perspectives • Multiple pay/performance scenarios considered • Early, active involvement of the Compensation Committee Traditional Approach Today’s Required Approach
- 17. Goal-Setting Should Incorporate Multiple Perspectives on Performance Expectations 17 Peer/Comparables Performance Shareholder Expectations Historical Company Performance Bottom-up Budget Company Financial Goals Cost of Capital Multiple Performance Scenarios Historical Perspectives Forward-Looking Perspectives Analyst EstimatesVariance of Results
- 18. Five Goal-Setting Pitfalls to Avoid 1. Relying principally on the company budget process (or any single perspective) 2. Presuming that financial performance relative to peers is as relevant (or more relevant) that stock price performance relative to peers 3. Fixating on year-over-year performance or continuous improvement 4. Not doing a sanity check by modeling the potential outcomes 5. Becoming too anchored to past results or circumstances 18
- 19. Case 3: Natural Resources Company • Historical performance ROIC (and margins and asset turns) = top quartile Sales growth = close to median TSR = close to median • New performance share plan ROIC and sales growth (3-year) • Company plan modest decline in ROIC; aggressive sales growth • Shareholder expectations analysis shows that the plan is consistent with the current share price/market valuation Leads to a valuable discussion of the trade-offs between growth and returns specific to the Company’s circumstances Confirms that the plan numbers are reasonable for incentive goals 19
- 20. Key Takeaways from Today’s Presentation • Performance measures can and ought to be explicitly linked to business strategy and value creation. • Measures and the measurement framework should be tailored to each company’s specific circumstances. • Plan ahead! Avoid surprises with respect to how a measure is calculated and/or what non-recurring events are included in it. • Set goals based on a broad, robust set of analytic inputs – let your Comp Committee members get a good night’s sleep! 20
- 21. ADVANCING EXEMPLARY BOARD LEADERSHIP Questions
- 22. Don’t Miss Our Upcoming Webinar Join NACD and Pearl Meyer & Partners for the next program in our Compensation Series The Age of Alignment Part III: Moving from Theory to Practice To register or check out the archives of earlier webinars in this series, visit NACDonline.org/webinars. 22
- 23. 23 If you have any questions regarding NACD credit or the Fellowship programs, please contact: Lori Whitehand, Fellowship Program Manager Phone: (202) 572-2084 Email: Fellowships@NACDonline.org To learn more about NACD Fellowships, visit us at NACDonline.org/Fellowships. NACD Credit and Fellowship Information
- 24. ADVANCING EXEMPLARY BOARD LEADERSHIP Thank You