VOLUME 31 NUMBER 3 SUMMER 2019 Journal of APPLIED CORPORATE FINANCE IN THIS ISSUE: Columbia Law School Symposium on Corporate Governance “Counter-Narratives”: On Corporate Purpose and Shareholder Value(s) Corporate 10 Session I: Corporate Purpose and Governance Colin Mayer, Oxford University; Ronald Gilson, Columbia and Stanford Law Schools; and Martin Purpose— Lipton, Wachtell, Lipton, Rosen & Katz LLP. 26 Session II: Capitalism and Social Insurance and EVA Jeffrey Gordon, Columbia Law School. Moderated by Merritt Fox, Columbia Law School. 32 Session III: Securities Law in Twenty-First Century America: Once More? A Conversation with SEC Commissioner Rob Jackson Robert Jackson, Commissioner, U.S. Securities and Exchange Commission. Moderated by John Coffee, Columbia Law School. 44 Session IV: The Law, Corporate Governance, and Economic Justice Chief Justice Leo Strine, Delaware Supreme Court; Mark Roe, Harvard Law School; Jill Fisch, University of Pennsylvania Law School; and Bruce Kogut, Columbia Business School. Moderated by Eric Talley, Columbia Law School. 64 Session V: Macro Perspectives: Bigger Problems than Corporate Governance Bruce Greenwald and Edmund Phelps, Columbia Business School. Moderated by Joshua Mitts, Columbia Law School. 74 Is Managerial Myopia a Persistent Governance Problem? David J. Denis, University of Pittsburgh 81 The Case for Maximizing Long-Run Shareholder Value Diane Denis, University of Pittsburgh 90 A Tribute to Joel Stern Bennett Stewart, Institutional Shareholder Services 95 A Look Back at the Beginning of EVA and Value-Based Management: An Interview with Joel M. Stern Interviewed by Joseph T. Willett 103 EVA, Not EBITDA: A New Financial Paradigm for Private Equity Firms Bennett Stewart, Institutional Shareholder Services 116 Beyond EVA Gregory V. Milano, Fortuna Advisers 126 Are Performance Shares Shareholder Friendly? Marc Hodak, Farient Advisors 131 Why EVA Bonus Plans Failed—and How to Revive Them Stephen F. O’Byrne, Shareholder Value Advisors Are Performance Shares Shareholder Friendly? by Marc Hodak, Farient Advisors ince the early 2000s, executive compensation has experienced a secular shift S toward performance shares1—equity awards whose vesting is based on perfor- mance as opposed to time or service. In the past, for example, an executive might have been granted mostly restricted stock units (RSUs) that would vest over a three-year period; they simply had to stick around to get all the shares. Today, an executive is more likely to be granted over half their awards in performance share units (PSUs) that vest at the end of three years; in such cases, the number of shares that actually vest can be more or less than the nominal grant, depending on how well the company performs during that period. Ten years ago, less than half of S&P 500 firms awarded PSUs. Today, as shown in Figure 1, over 80% of them do, and PSUs have become an increasingly larger percentage of the long-term incentive (LTI) mix within those companies. Figure 1 Prevalence of PSUs in LTI Plans in the S&P 500 100 4% 5% 4% 4% 4% 5% 8% 8% 6% 5% 5% 90 1 13 12 19 1 2 0 30 2 3 0 0 3 0 0 1 84% 3 0 76% 9 2 64% 67% 30 58% 2 0 20 10 0 200 2009 2010 2011 2012 2013 201 201 201 201 201 LTI with SUs LTI witout SUs No LTI lan 1 Shares with performance-based vesting are generally awarded as “performance share units,” or PSUs. This article uses “performance shares,” “performance share units,” and “PSUs” interchangeably. 126 Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 This growth in PSUs has been driven largely by the efforts of scale of the portion of granted shares that vest across various influential institutional investors and their proxy advisors to performance levels, from threshold to target to maximum. promote what they believe to be a more shareholder-friendly These plans must be calibrated to yield rewards that make award than restricted stock or stock options, which these sense across the entire spectrum of possible performance investors have taken to calling “non-performance based.” outcomes. Further complicating matters, PSUs increas- However, investors are by no means in complete agreement ingly include additional “triggers” or “governors” designed to about how pay for performance should be implemented in prevent unintended windfalls due to the uncertain relation- companies. Fissures have begun to appear in the general senti- ship between accounting-based metrics, such as earnings or ment about performance shares. returns, and stock price over multiple years. Such complex- Perhaps most notable, in 2017 the well-known Nordic ity makes these plans much less transparent to even the plan sovereign wealth fund, Norges Bank, came out with a widely participants, some of whom have dismissed them as “black circulated white paper that declared a preference for share box” reward mechanisms, thus casting considerable doubt on awards without performance conditions, arguing that the use their actual incentive effect. of complex performance criteria does not necessarily enhance alignment between corporate managements and their share- holders. Other investors have recoiled at the increase in the sheer volume of pay disclosures, which have been largely “ driven by descriptions of performance share plans. In fact, Whether their end-of-year goals were set one year PSUs have evolved to the point of presenting significant struc- tural and economic problems that should cause more investors ago or three years ago is immaterial to the short-term to rethink them. behavior that the plan can drive. Performance Shares Significantly ” Complicate LTI Plans Time-based grants of restricted stock or stock options are easy; if the executive sticks around, the shares or options eventually This complexity has also, not surprisingly, proved frustrat- vest. Notwithstanding their “non-performance” label, these ing for investors trying to evaluate the plans. Working against types of equity awards can effectively align the interests of investors’ desire for “shareholder-friendly” incentive compen- managers and shareholders by directly, transparently tying the sation plans, PSUs, with their exotic features in overlapping personal net worth of the executives to the ups and downs of grant and performance periods, are often the most compli- the stock price. cated parts of today’s compensation disclosures. And since the How effective is that alignment from the shareholder’s inner workings of these plans are often poorly understood by perspective? Empirical studies have shown, with remark- internal as well as external stakeholders, it is almost impossible able consistency, a significant positive relationship between to explain counterintuitive pay results, even when such results management ownership of shares and the enhancement of were intended by the designers of the plan. shareholder value. Indeed, this is one of the most robust results in the peer-reviewed, corporate governance literature—one Performance Shares Turn Out to Be More Costly, Too that has been replicated over several decades of scholarship In a recent study, my Farient colleagues and I looked at LTI covering many different nations and regulatory regimes.2 awards across S&P 500 firms containing significant PSUs Compared to straight equity grants, performance shares versus those containing only RSUs or stock options for each introduce significant complexity into long-term incentives. To year over the ten-year period from 2008 to 2017. During this determine how many of the granted shares will vest, the plans period, CEOs who received a significant portion of their LTI must include performance measures and, for each measure, a awards in the form of PSUs were awarded median grant values that were roughly 35% higher than those for CEOs who 2 McConnell, John J., and Henri Servaes, “Additional evidence on equity ownership received only restricted stock or stock options. Moreover, as and corporate value,” Journal of Financial Economics, 27 (1990) pp. 595-612; de Miguel, Alberto, Julio Pindado, Chabela de la Torre, “Ownership structure and firm value: can be seen in Figure 2, in nine out of eleven sectors, the grant new evidence from Spain,” Strategic Management Journal, Volume 25, Issue 2 date value of LTI awards that included PSUs was materially (December 2004) pp. 1199-1207; Von Lilienfeld-Toal, Ulf and Stefan Ruenzi, “CEO Ownership, Stock Market Performance and Managerial Discretion,” The Journal of Fi- higher than for those getting only RSUs and stock options. nance, Volume 69, Issue 3 (June 2014), pp. 1013-1050. In the case of the average company switching from “non- Journal of Applied Corporate Finance • Volume 31 Number 3 Summer 2019 127 Figure 2 Median of Grant-Date Values of Equity in S&P 500 Firms from 2008-2017 14 it SUs No SUs 12 ) 10 s MM $ 8 ( e u l a 6 V t n a r G 4 2 0 Communication Conumer Conumer ner Financial ealt ndutrial nformation aterial eal tilitie Serice icretionar Staple Care ecnolo tate performance” equity awards to PSUs over the last decade, the are, contributing to this effect—but the basic risk-reward median CEO received an approximately 40% increase in the imperative that comes with PSUs is also almost certainly a grant date value of their award. contributor. The most likely explanation for this increase in grant date values should make perfect sense to any investor—namely, Performance Shares Hurt Corporate Performance that performance shares create greater compensation risk than Even if performance shares cost more, they may be worth it if an equivalent value of time-based equity, especially RSUs, and they lead to better company performance. Given the proven no one should be expected to accept greater risk without the benefits of management share ownership, it seems plausible prospect of a greater reward. Furthermore, our firm’s experi- that alignment may be improved by layering on performance ence in developing offers for senior executives suggests that conditions before allowing stock to vest.