Aligned Incentives or Dodgy Governance?

– Phill Namara

Prudent investors, when examining a business, will always take the time learn about their operating model, the wider industry, the broader macro environment and sometimes the management team. However, investors are increasingly overlooking the critical influence that corporate governance procedures have upon management’s decisions which ultimately define whether value will be created or destroyed in the long run for the business.

In this article, we’ll explore how a deeper understanding of corporate governance practices can provide investors with an insight into the motivating factors behind key managerial decisions.

The Organisation for Economic Co-operation and Development (OECD) describes corporate governance as: “…a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.”

We can surmise that good corporate governance is all about aligning executives or decision makers with shareholders and stakeholders so that business outcomes are beneficial to all. Good corporate governance is key to creating long-term value for shareholders as it ensures that management are incentivized to think as business owners in terms of strategy and capital allocation.

On the flip side poor corporate governance is all about misalignment between key decision makers and stakeholders, and more-often-than-not, results in the lining of key decision makers pockets with incentive fees at the expense of shareholders.

Unfortunately, public market investors are not privy to the thought-processes driving managerial decision making, and often the best way that we can evaluate or deduce how management will respond to factors affecting the business is to look at their compensation. Hence, it is extremely important to pay close attention to the form of management compensation, as well as any changes to management compensation, as they could be key signal of corporate action.

For example, a specific form of management compensation that investors should pay close attention to are annual equity grants. Typically, employees receive a number of annual equity grants each year provided at a “Grant Date”. Industry standard practice observes this Grant Date occurring several days after the announcement of the Company’s quarterly or semi-annual earnings announcements. However, it is up to the Compensation Committee’s discretion as to when equity is to be granted. As such, the Compensation Committee are placed in a position of power over the executives, as they can choose to grant equity prior to positive earnings announcements (a practice known as “spring-loading”), or they could grant equity after a negative earnings announcement (a practice known as “bullet-dodging” ). This is a controversial practice as it allows employees to potentially book instant profits or allow employees to accumulate stock at lower prices, however it is NOT illegal.

At J.Crew, whilst Jim Coulter, Co-CEO of TPG a global private equity firm, was Compensation Chairman; annual equity grant dates were constantly changing (as seen in the table below). In the filings, it says that equity was granted via “unanimous written consent”, meaning that the Jim had a lot power in dictating how equity would be granted.

Coincidentally, several months after the last date recorded in the table below, TPG lobbed an offer to take J-Crew private, which was heavily supported and lobbied by Mickey Drexler, J.Crew’s CEO, a major beneficiary of the Compensation Committee’s “generous” equity grants.

 

Source: Non-GAAP Thoughts

We leave it as an exercise for readers to determine whether there could have been anything going on behind closed doors. Clearly, there is much value to be gained from analysing a firm’s corporate governance procedures, not just through the microscopic lens of looking to exploit potential earnings upgrades or downgrades, but rather as a measure of the board and management’s accountability and alignment to shareholders.

 

Credit to Mike from Non-Gaap Thoughts for the inspiration.  

 

Phill Namara is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

 

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