The Age of Alignment Part II: Getting Strategy-Driven Performance Measurement Right
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Transcript of The Age of Alignment Part II: Getting Strategy-Driven Performance Measurement Right
ADVANCING EXEMPLARY BOARD LEADERSHIP
The Age of Alignment Part II: Getting Strategy-Driven Performance Measurement Right Compensation Series
March 12, 2015
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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.
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Click the buttons below to access additional resources
Housekeeping
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Housekeeping
Click below for a copy of the slides
Slides are also available at
pearlmeyer.com/AgeofAlignmentPartIIMeasurement
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You will automatically receive 1 NACD skill-specific
credit for your participation.
Credit may be applied to NACD Fellowship
programs. Contact [email protected]
for more details.
The replay and slides will also be available early
next week at NACDonline.org/webinars and
pearlmeyer.com
Housekeeping
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
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Developing Strategically Aligned Pay Programs
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• 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
Hallmarks of Strategically-Aligned Pay
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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
Performance Measures are a Critical Link Between a Stated Business Strategy and Management Execution
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• 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
Understanding How a Company Creates Value Allows Identification of Strategy-Linked Performance Measures
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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&D Distribution
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
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
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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
Ma
rke
t to
Bo
ok
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
Ma
rke
t to
Bo
ok
Once Centerpiece Financial Measures are Identified, “Balance” Them Appropriately Based on Strategy
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• 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
Plan35% X X X X
Cash Long-term
Incentive Plan15% X X X
Performance-
vested Restricted
Stock
15% X X X
Other 5% X X
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
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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%
YO
Y C
ha
ng
e
Sales GM$
ABC Department Stores
-40%
-20%
0%
20%
40%
60%
80%
100%
YO
Y C
ha
ng
e
Sales GM$
123 Department Stores
-50%
0%
50%
100%
150%
200%
250%
YO
Y C
ha
ng
e
Sales GM$
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
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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.
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The Goal-setting Process is Changing and Compensation Committees are More Involved Than Ever Before
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• 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
Goal-Setting Should Incorporate Multiple Perspectives on Performance Expectations
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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 Estimates Variance of Results
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
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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
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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!
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ADVANCING EXEMPLARY BOARD LEADERSHIP
Questions
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.
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Fellowship programs, please contact:
Lori Whitehand, Fellowship Program Manager
Phone: (202) 572-2084
Email: [email protected]
To learn more about NACD Fellowships, visit us at
NACDonline.org/Fellowships.
NACD Credit and Fellowship Information
ADVANCING EXEMPLARY BOARD LEADERSHIP
Thank You