We have previously highlighted the importance of ESG in the investment decision process and Whitman’s focus on Governance. Extending this theme, this article outlines the changes we would like to see regarding executive remuneration for UK listed smaller companies.
We would first like to thank Roger Lewis, Head of Responsible Investment at Downing, for encouraging Whitman to produce this article together and his valuable input.
Financial incentives act as a catalyst, encouraging individuals to pursue the behaviour associated with the promised reward. As investors, we entrust the board of each company to recruit, retain and incentivise key executives to sustainably grow the business and be aligned with the success of the business strategy.
Executive remuneration should be fair, balanced and understandable. Whilst we want to reward management teams, soft targets should be avoided. All remuneration schemes have an economic cost through dilution and diminished shareholder returns. We spend considerable time understanding management incentives as this gives a good indication of the level of growth the executive management team believe is achievable – after all, a rational CEO is unlikely to agree to a target that they thought was unrealistic.
Executive renumeration is a highly emotive topic – there is no simple solution or one size fits all. Over the years various corporate governance codes, such as the QCA[1], have been introduced and as there are already a number of excellent guides for executive remuneration there would be little value in Whitman developing its own remuneration policy.
However, we remain concerned about the misalignment of the level of executive pay versus company performance. For example, the average CEO remuneration of the largest 100 AIM companies (AIM 100) has increased by 5.8%[2] over the last three years to £783,600[2] (this includes base salary, bonus, pension and other benefits such as options), even though the value of the AIM 100 index declined by 34%[3] over the same period. We believe greater shareholder alignment can be achieved by adopting the following ‘common-sense’ rules:
Rule 1. Removal of rewards for failure
We expect boards to ensure there is no reward for failure and one way to create alignment with shareholders is to link the exercise price of share options or LTIPs (long-term incentive plans) to the share price at the date of award rather than the more commonly accepted practice of issuing options with a ‘nil cost’ exercise price. If options are to be issued below the share price, this should only be on the basis that executives are committing their own capital – i.e. some form of matching principle with management forgoing salary/bonus in return for shares on, for example, a 2 for 1 basis.
Rule 2. Employee Ownership
Executives should have meaningful share ownership as it is one of the best ways of aligning management and shareholders. This should be achievable as AIM executives receive attractive base salaries (the median AIM 100 CEO base salary in 2023 was £363,100[2] or the equivalent to over ten times the median annual earnings in the UK[4]) and bonuses (the median AIM 100 CEO bonus, when paid, in 2023 was £294,300[2]). Simply put, without committing their own capital, management have a one-sided bet that could encourage undue risk taking. It is for this very reason we prefer founder led or owner managed businesses where they have ‘skin’ (equity) in the game.
Rule 3. Long-term strategy pursuit v short term personal benefit
Share options should be exercisable after 5 plus years, rather than the standard three years after grant, as it is unlikely that the financial benefit of any investment is realised within a shorter timeframe. This creates a greater longer-term focus and reduces the possibility that the executive team will request a further incentive after three years have elapsed. Once the terms have been agreed, performance criteria should not be retrospectively changed.
Rule 4. Removal of complexity
Over recent years, incentive schemes have become more complex. The number of targets has increased and there is often a myriad of schemes, raising the possibility that at least one KPI will pay out. We believe the targets of any long-term incentive plan should be limited to two or three key measures with the maximum payout linked to ambitious or stretch targets. Using remuneration consultants – which can incur material cost – is unnecessary and should only be done under exceptional circumstances.
Rule 5. Greater disclosure
The performance metrics and vesting terms should be announced to all shareholders at the date of the award as otherwise there is an arbitrage of information with the largest shareholders, who are typically involved in setting the incentive scheme, benefiting from the lack of disclosure.
Rule 6. Binding shareholder vote
The QCA[1] guidance (which is adopted as the corporate governance code by 93% of AIM companies) should be updated to be in-line with the UK Corporate Governance Code (adopted by companies on the Main Market) so that executive remuneration is subject to a binding rather than advisory shareholder vote to approve the directors’ remuneration. A strong vote against sends a clear signal to the board that they need to consult more with shareholders before making pay awards.
As long-term shareholders, Whitman takes stewardship and voting rights seriously and wants to support remuneration proposals whilst meeting the fiduciary duty of our clients. Remuneration policies should be designed to promote long-term sustainable success. Whilst we recognise the importance of incentives, executive remuneration has increased during a period when shareholder returns have been negative. Remuneration creep needs to be reversed and pay policies need to be greater alignment to shareholder performance.
Sources
[1] Quoted Companies Alliance Corporate Governance Code (2023)
[2] BDO AIM 100 Directors’ Remuneration Report, March 2024
[3] London Stock Exchange, 31/12/20 – 31/12/23
[4] Office for National Statistics, Employee earnings in the UK
