Executive Remuneration as an Investment Criterion; M&C Saatchi
And HICL Infrastructure Company Limited
The Subsidised Mineowner, Trade Union Unity Magazine 1925, courtesy Wikipedia
The bosses of the FTSE 100 have seen their remuneration increase from 11 times median wages in 1980 to 116 times median wages in 2010. But, as Brian Bell and John Van Reenen of the LSE's Centre for Economic Performance note (Firms Performance and Wages: Evidence from across the Corporate Hierarchy, Discussion Paper 1088, revised May 2012), this is in line with the phenomenal increase in the share of the UK's national income that goes to the top 1% of earners. Furthermore, they estimate that corporate executives account for only 3% of the top 1% of earners in the UK. Financial service executives with more than 40% dominate, while lawyers, accountants and management consultants are all represented in higher numbers than corporate executives are.
The question for shareholders is whether there is any relation between executive remuneration and shareholder returns. Bell and Van Reeden come up with some interesting facts based on an analysis of senior executives and employees at 400 large publicly quoted UK companies between 2001 and 2010.
· There is a positive, statistically significant relationship between senior executive pay and shareholder returns. This is also true of lower level management and 'workers', though the relationship declines to very small numbers at the bottom of the corporate hierarchy.
· CEO remuneration is more sensitive to increases in shareholder value than declines. Therefore, a 10% increase in shareholder returns leads to a 38% increase, on average, in a CEO's cash bonus, while a 10% decline leads to only a 7% average decline in a CEO's cash bonus. And the average cash bonus for a CEO is 31% of his or her total remuneration. 35% of a CEO's remuneration is derived from base salary and the remaining 34% comes from long-term incentive plans.
· The relationship between executive remuneration and shareholder performance is strongest where institutional shareholders have a big share in the company.
· They note that "Low ownership firms [where institutional shareholders are weak] strongly reward positive returns with higher pay but require no pay penalty for negative returns."
Bell and Van Reeden do not touch on the issue of criteria used by remuneration committees to set executive pay. Companies, such as Vodafone, that make large impairments for goodwill and intangibles (they often overpay for acquisitions and other intangible assets) often exclude impairment charges from their profit benchmark. In other companies, where outside shareholders are weak, senior executives sometimes help themselves to what they want irrespective of their company's performance.
The case of M&C Saatchi
After being ejected as Chairman of the advertising agency, Saatchi and Saatchi, Maurice Saatchi, his brother Charles and three other senior Saatchi executives founded a new advertising agency M&C Saatchi. The company was listed on the Alternative Investment Market and it has been a success. Maurice Saatchi left to pursue his interest in contemporary art and the remaining four executives control the company.
For the outside shareholder M&C Saatchi has an unusually problematic corporate structure. A significant rise in the company's share price leads to both a sharp reduction in its accounting profits and a large capital distribution to its four founder directors. And it is worrying that the directors focus on the company's 'Headline results' that exclude some very important accounting charges, including the perverse repercussions of its corporate structure.
In its 2012 Annual Report Charles Saatchi reports that 2012 had been the best year ever for M&C Saatchi. Then on page 10 the CFO adds:
Leaving our improved trading performance aside, the reduction in profit before tax of 38% to 9,881k pounds and basic earnings per share of 75% to 3.89p was in the most part caused by the increase in our share price from 1.165 pounds to 1.805 pounds that caused a 6.9 million pound accounting charge for minority put options (2011: 2.0m pound credit) and the 1.6 m pound write off of our Spanish associate."
This extraordinary state of affairs requires an explanation. Saatchi's 'philosophy' begins with "A federation of entrepreneurs, built through start-ups and owner managers." Saatchi puts this into financial practice in two ways:
1. Saatchi has minority shareholdings in 19 companies that own put options on Saatchi shares. These put options become ever more valuable as Saatchi's share price rises or less valuable as its share price falls. In 2012, the share price rose by 55% and the charge against profits was 6.9 million pounds. This was the main reason why earnings per share declined by 75% in 2012.
2. Saatchi awards its four founding directors ten percent of the company's increase in market capitalisation in the year, subject to certain conditions. At the beginning of 2013, this resulted in the four directors receiving shares equivalent to 5.6% of the company's outstanding shares.
As a result, the four founding directors were awarded a large bonus in a year when earnings per share declined by 75%. There is no provision for a claw back should Saatchi's share price fall.
2013 is likely to be a similar, but even more extreme story. Saatchi's share price has risen by 84% since 1 January. This suggests that the charge against profits for put options will be over 14 million pounds. Over the same period, the company's market capitalisation has increased by about 100 million pounds, suggesting a payout to the four founding directors of about 10 million pounds. In 2013, thanks to an incentive plan, the four directors paid about half the going price for Saatchi shares. It is not clear whether there is any similar plan in place for the bonus these directors are almost certain to receive in 2014.
In this scenario, Saatchi would most likely make a loss in 2013 while at the same time rewarding the four founding directors with new shares to the value of 10 million pounds.
The four founding directors currently own 27% of the company. The largest institutional shareholder, Aviva, owns 10%. Institutional shareholders are weak, and the company is run for the benefit of its owner managers. This is not in the interests of outside shareholders.
HICL Infrastructure Company Limited
Viaduct over Kicking Horse Canyon, courtesy HICL website
Most shares have risen sharply these past five years and it is difficult to find suitable companies at a price that allows for a margin of safety. At such times, it is wise to take profits on investments where the price of a share is well in excess of one's estimate of what it is worth. The logical asset class to park the funds is cash. However, with money market funds yielding virtually nothing and bonds still expensive, one must look for better places to invest in for the medium term.
HICL was the first investment company listed on the LSE to invest in infrastructure projects. It is incorporated in Guernsey. The company was floated in 2006 and it now has a market value of 1.55 billion pounds. HICL is 91% invested in the UK in schools, hospitals, roads and public buildings. On average, its contracts have a duration of 22 years and its income is largely indexed to inflation. HICL is unaffected by changes in GDP, though it is not entirely free of market sentiment. Consequently, its shares (in red) were, with the exception of a brief period in late 2008, a safe haven from the consequences of the financial crisis. Its shares perform more like investment grade corporate bonds than equities:
HICL share price and shareholder return versus FTSE 250 and All Share, courtesy HICL website, click to enlarge
At the present price of 130p, the shares yield 5.4% and they are priced at an estimated premium of 9% to net asset value. Demand for HICL shares has maintained a share price premium to net asset value since 2009.
The essence of HICL's business is:
1. To buy into completed PFI/PPP/P3 projects, currently 79. The company avoids the risks of development and construction. It prefers to own 100% of the project.
2. HICL sets an internal rate of return (IRR) of 7% per annum for each project and bids accordingly.
3. Inflation protection. Currently, the company will see an increase of 0.6% in the gross valuation of its portfolio for every 1.0% increase in the UK Retail Price Index (RPI).
4. The company leverages its equity financing, currently by 1.23 times (1.23 pounds of debt for every pound of equity). The average cost of debt is currently 5.7%. Nearly all borrowings are long term and project related.
5. HICL issues new shares when it has exhausted its existing resources and sees an opportunity for further investments. When it does so, the share price premium falls for a short time.
6. HICL uses Infrared Capital Partners to manage the estate. Their advisory fee in 2012 was 1.2% of gross assets. Director fees are limited to 250,000 pounds per annum.
The prudent investor will note:
1. HICL's continuity depends upon its ability to secure new projects at its desired IRR. Of 15 bids it entered last year, it won just three.
2. The company relies entirely on the public sector and a new, Labour government could change the terms of business. However, given that the Treasury is trying to reduce the public deficit and Labour's mission is to increase capital spending, a change of government might prove to be beneficial.
3. If there is a prolonged period of RPI inflation below 2.75%, this will adversely affect the value of HICL's estate. The RPI for the year to October 2013 was 2.56%.
4. An upsurge in bond yields would depress HICL's value to investors.