Keith McLachlan at Element Investment Managers often says that how a CEO is incentivised matters — because that is where their focus will be.
This is not really about their base salary but the bonus structure, and the details will be in the annual report. Some companies offer great detail about the structure, others are a little vague; that in itself should be a concern.
The first point is: if they achieve their targets, what is the actual payment? It is seldom cash, usually it will be shares and, as an aside, this is why directors and CEOs are generally net sellers of shares in a company. The shares will either be given at zero value or they will have a price, let’s say a million shares at R10 each. This means the share price needs to be above R10 for that incentive to have any value. And here’s the first clue about what will matter to the CEO, the share price.
But the real issue is how do they earn that bonus? It’ll usually be two or three key metrics over a period of three to five years.
In simple terms higher growth off the existing equity of the company earns the incentive
It could be as simple as growing headline earnings by an annualised amount, or getting revenue to a certain level. These are nice and easy and from this we’re able to determine exactly what the CEO will be focusing on.
But often there are more tricky incentives. For example, the board may determine it wants a higher return on equity, so it makes that part of the incentive structure.
Here things can again get tricky. Equity is assets less liabilities, essentially the NAV of the company, and the focus is expected to be the return on that equity. So in simple terms, higher growth off the existing equity of the company earns the incentive.
But CEOs can also tweak the equity side of the equation. They could raise debt to pay a special dividend. The extra debt increases liabilities and, as the cash is paid out as a dividend, the assets don’t increase. Thus equity falls and, assuming the same return as in previous years, the actual return on equity will look a lot better with a lower equity number.
Sure, that’s an extreme example but it shows how the incentive can be manipulated to the CEO’s benefit.
A last word of caution is changing incentives. This almost always happens in the CEO’s favour — which means they win regardless and there is no real incentive.
We saw a lot of this during the pandemic and maybe that was a fair response to a global lockdown. Otherwise, chasing the structure is always a red flag.
So do the digging into the annual report. Find out how the CEO is being incentivised. Then try to see how they’re going about it. Last, make sure you’re happy with what the company is trying to achieve.
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