Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Leveraged buyout wikipedia , lookup
Private equity secondary market wikipedia , lookup
Short (finance) wikipedia , lookup
Early history of private equity wikipedia , lookup
Private equity in the 1980s wikipedia , lookup
Investment management wikipedia , lookup
Capital gains tax in Australia wikipedia , lookup
Mark-to-market accounting wikipedia , lookup
Hedge (finance) wikipedia , lookup
Southern Employee Benefits Conference Beyond Stock Options Long-Term Incentives in a Volatile or Protracted Bear Market Copyright © May 7, 1998 Overview: Stock options have become the dominant form of long-term incentive compensation today. More companies use options than any other form of long-term incentive. The value of option grants continues to increase. Levels of participation have expanded. Long-term incentives now make up a major portion of total pay. Overview: Stock options have become the dominant form of long-term incentive compensation today. Prevalence of Long-Term Incentive Plans Phantom 3% 5% Stock Restricted Stock More companies use options than any other form of long-term incentive. The value of option grants continues to increase. Levels of participation have expanded. Long-term incentives now make up a major portion of total pay. 1986 1997 21% 28% 48% Performance Plans 37% 89% Stock Options 0% 87% 20% 40% 60% 80% Percent of Companies 100% Overview: Stock options have become the dominant form of long-term incentive compensation today. More companies use options than any other form of long-term incentive. The value of option grants continues to increase. Levels of participation have expanded. Long-term incentives now make up a major portion of total pay. 222,000 1993 262,500 1995 313,500 1997 0 100,000 200,000 300,000 400,000 Median Expected Value of Long-Term Incentives ($300,000 Base Salary) Overview: Stock options have become the dominant form of long-term incentive compensation today. Prevalence of Long-Term Incentive Plans More companies use options than any other form of long-term incentive. The value of option grants continues to increase. Levels of participation have expanded. Long-term incentives now make up a major portion of total pay. 1.27% 1988 1.69% 1991 1.8% 1994 2.4% 1997 0.0% 0.5% 1.0% 1.5% Workforce Eligibility 2.0% 2.5% Overview: Stock options have become the dominant form of long-term incentive compensation today. Prevalence of Long-Term Incentive Plans 1989 1997 0% 20% 31% 24% 37% 26% LTI Bonus Base 21% 40% 60% 80% Percent of Companies More companies use options than any other form of long-term incentive. The value of option grants continues to increase. Levels of participation have expanded. Long-term incentives now make up a major portion of total pay. Benefits 8% 7% 46% 100% Overview: Stock options have become the dominant form of long-term incentive compensation today. “[T]he proliferation of stock-option grants, combined with the rise of cushy retirement deals, sign-on bonuses, and ironclad severance packages for CEOs, have made a mockery out of many attempts to truly link pay to performance. “The upshot: Good, bad, or indifferent, virtually anyone who spent time in the corner office of a large public company in 1997 saw his or her net worth rise by at least several million.” Source: Business Week, April 20, 1998. Impact: Heightened scrutiny by shareholder groups and the press. Heightened interest in LTI alternatives. Overview: The pros and cons of management stock options. Pros Direct alignment of management and shareholder interests. A truly long-term perspective. Better appreciation and understanding of value drivers. Cons Not line-of-sight. Can’t differentiate management performance from industry fortune. Lack stimulus during economic downturns. Perceived internally and externally as a game of chance. The Challenge: Making long-term incentives work in a volatile or a protracted down market. The Prevailing Methods Design cash-based long-term incentives to address stock option deficiencies. Design better stock options. The Challenge: Making long-term incentives work in a volatile or a protracted down market. The Prevailing Methods Design cash-based long-term incentives to address stock option deficiencies. Improved metrics. Almost all metrics are variations on the same theme... The Challenge: Making long-term incentives work in a volatile or a protracted down market. RI = Operating Profit - Opportunity Cost of Running the Business – – – Sales Cost of Sales Overhead EBIT Tax on Operations NOPAT The return (or expectation) foregone by not investing in a comparably risky portfolio of projects—the weighted cost of debt and equity capital. Opp. Cost = Cost of Capital x Beg. Capital An Integrated Measure of Performance: Residual Income Residual Income = NOPAT - c* x Beg. Capital Residual income can also be expressed as: RI = (Return on Capital - Cost of Capital) x Beg. Capital Residual income introduces four powerful incentives: Improve efficiency, and thus returns. Grow, but only if new investments can earn the cost of capital. Redeploy capital from underperforming operations. Manage risk, and therefore the cost of capital. Value Proposition: Residual Income Drives MVA Value Value PV RI C PV NOPAT C PV CF3 MVA PV RI3 PV RI2 PV RI1 Capital PV CF2 PV CF1 Discounted Free Cash Flow Discounted Residual Income The discounted present value of a company’s expected residual income is its market value premium or discount to book value (“MVA”). A company’s discounted residual income plus its level of capital employed will always equal the discounted present value of expected Free Cash Flow. Residual income is the only integrated measure of growth and profitability which relates directly to stock value. The Challenge: Making long-term incentives work in a volatile or a protracted down market. The Prevailing Methods Design cash-based long-term incentives to address stock option deficiencies. Improved metrics. It all boils down to... Adopting a metric which works well with your company. Conceptually simple. Difficult to manipulate. Economically rigorous. The Challenge: Making long-term incentives work in a volatile or a protracted down market. The Prevailing Methods Design cash-based long-term incentives to address stock option deficiencies. Improved metrics. Improved implementation. Focus on controllable, company-specific value drivers. Line-of-sight. Improved Implementation: Making performance measures “line-of-sight” Price Revenue Volume NOPAT Tax Operating Expenses Cost of Goods Sold SG&A EVA Raw Materials Labor Other Cost of Debt Cost of Capital Cost of Equity Plant & Equipment Capital Charge Fixed Capital Capital Employed Legend: High Impact Medium Impact Low Impact Property Inventory Working Capital Receivables Payables Other Good Will Intangibles The Challenge: Making long-term incentives work in a volatile or a protracted down market. The Prevailing Methods Design cash-based long-term incentives to address stock option deficiencies. Improved metrics. Improved implementation. Focus on controllable, company-specific value drivers. Line-of-sight. Make calibration and targetsetting truly long-term. Understand corporate culture and “process.” Help build value-creation coaches. The Challenge: Making long-term incentives work in a volatile or a protracted down market. The Prevailing Methods Design cash-based long-term incentives to address stock option deficiencies. Design better stock options. What would we like to see? Real capital at risk. Management rewarded for its distinctive contribution to share value. Meaningful incentives during downturns. A strong aversion to repricing. Design Challenge 1: Measure good management, not good luck. Contention: Commodity price movements and stock market activity explain the vast majority of most companies’ stock price performance. Example: The Specialty Chemical Industry 10% % Change in S&P 500 20% % Change in Methanol Prices 10% 0% (10%) % Change in Ethylene Prices (20%) 0% 20% (20%) 5% Sample: Dow Chem Co Georgia Gulf Corp Lyondell Petrochemical Co Olin Corp Union Carbide Corp 0% (5%) (10%) R2 0.637 80.0% (15%) (10%) (5%) 0% 5% % Change in Market Value 10% 15% Design Challenge 1: Measure good management, not good luck. Contention: Commodity price movements and stock market activity explain the vast majority of most companies’ stock price performance. Impact: Less than one-fifth of most industries’ stock market performance can be traced to contributions by management. Conclusion: During downturns, conventional stock and cash-based incentives are viewed as lottery tickets. During good times, conventional bonus plans perpetuate the impression that stockholder returns relate mainly to good management. Over time, even sub-par performance will be rewarded. Design Challenge 2: Eliminate the Perception Gap in Bear Markets. Contention: Conventional stock options lose much of their power to motivate if the stock is under water, despite retaining significant economic value. $40 Option Value Exercise Value $30 Option Value at Grant Value of Stock Option Perceived Value at Grant $20 Option Value Today $10 $0 Perceived Value Today ($10) $40 $50 $60 $70 $80 Underlying Stock Price $90 $100 Design Challenge 2: Eliminate the Perception Gap in Bear Markets. Contention: Conventional stock options lose much of their power to motivate if the stock is under water, despite retaining significant economic value. Implication: 1. There is often a wide gap between management’s perception of a stock option’s value and its economic substance. This is especially true for companies beset by industry cycles. Reason: 2. Managers focus on exercise or conversion value, not option value. During downturns, stockholders receive a severely diluted motivational return on the high cost of previously granted options. Design Approach 1: Tinker with the options themselves... but don’t confuse this with repricing. $120 1. Index against industry performance. Portfolio of 5.6 at-themoney indexed options is worth just one out-of-the-money $80 option, but ... Option Value $100 Slope: 5.4 Specifically: Exclude value gains (or losses) attributable to the S&P or industry. Impact: $60 Slope: 1.0 $40 The difference in upside (and downside) potential is enormous, thus greatly amplifying incentives. $20 Creates options where the difference between option value and exercise value (and thus the perception gap) is small. $0 $40 $60 $80 $100 $120 $140 Stock Value Slope: 0.97 ($20) ($40) 1 Standard Option 1 Indexed Option 5.6 Indexed Options Justifies issuing more options as a consequence. Design Approach 1: Tinker with the options themselves... Indexing options exploits the perception gap to comparative advantage. Perception Reality $40 Option Value $30 $40 Indexing means more control over destiny—thus greater option value. Slope: 1.0 $30 $20 High covariance with index means much closer relationship between option value and conversion value. Slope: 1.0 Slope: 1.0 $20 Slope: 1.0 $10 $10 $0 ($10) $40 $50 $60 $70 $80 1 Standard Option $0 At-the-money option considerably more valuable than out-of-the-money option. ($10) $90 $100 $110 $120 $40 1 Indexed Option Unchanging strike price and longer term to maturity makes conventional option more valuable than indexed option, despite higher starting point.. $50 $60 $70 $80 1 Standard Option $90 $100 1 Indexed Option $110 $120 Design Approach 1: Tinker with the options themselves... $120 1. Index against industry performance 1 Standard Option 1 Leveraged Option 8.4 Leveraged Options $100 2. Reward performance, not longevity. $80 Consider performance options—options which raise the exercise price over time. Because performance options are worth less than conventional options, managers can be offered more such options without diluting the value of stockholders’ investment. $60 $40 $20 Slope: 1.0 $0 $40 $60 $80 $120 $140 Slope: 3.7 ($20) Slope: 0.4 ($40) $100 Design Approach 2: Tinker with capital structure... 1. Make capital structure line-of-sight. Create equity in the business units themselves. Partial public offerings. Spinoffs and split-ups. Letter stock. Restructure business portfolio to reflect core competencies. Design Approach 2: Tinker with capital structure... 28 Large Corporate Split-Ups 1. Make capital structure line-of-sight. 10-Day Gain De-Conglomeratization Quaker Oats Fisher-Price Cooper Industries Cooper Cameron ITT Hartford Proactive De-Integration AT&T Lucent,NCR James River Marriott Crown Marriott Int'l Dole Am. Cyanamid Cytec Castle & Cooke Marriott Roadway Coors The Limited Host Caliber ATX Intibrands Litton D&B Anheuser Busch Western Atlas Union Carbide Campbell Taggart Praxair General Mills Darden Ceridian Control Data GM EDS Baxter AHS Reactive/ Defensive Kodak Eastman Chemical Am. Express Lehman W.R. Grace Nat'l Medical Sears Dean Witter Allegis Hertz Negative 100% 50% 5% 25% Create equity in the business units themselves. Partial public offerings. Morrison cafeterias, hospitals Spinoffs and split-ups. Eli Lilly Guidant Letter stock. Positive Hanson PLC Restructure business portfolio to reflect core competencies. Design Approach 2: Tinker with capital structure... 1. Make capital structure line-of-sight. 17 Large Corporate Split-Ups 365-Day Gain De-Conglomeratization Quaker Oats Fisher-Price Proactive Coors ATX Litton Western Atlas James River Marriott Crown Marriott Int'l Dole Castle & Cooke The Limited Intibrands General Mills Darden Union Carbide Praxair Eli Lilly Guidant Positive Reactive/ Defensive Kodak Eastman Chemical Cooper Industries Cooper Cameron Am. Cyanamid Cytec Ceridian Control Data De-Integration Am. Express Lehman Sears Dean Witter Allegis Hertz Negative 100% 5% 50% 25% Create equity in the business units themselves. Partial public offerings. Spinoffs and split-ups. Letter stock. Restructure business portfolio to reflect core competencies. Design Approach 2: Tinker with capital structure... 1. Make capital structure line-of-sight. 2. Make the stock a management play rather than an industry play. Issue equity-linked debt— pegged to the stock price of competitors. Design Approach 2: Tinker with capital structure... 1. Make capital structure line-of-sight. 2. Make the stock a management play rather than an industry play. Specifics: DECS or Prides issued against competitors. Hybrid debt instruments whose interest payments are linked to the performance of a particular stock—in this case, a market-weighted or equally-weighted portfolio of competitors. Examples: Lyondell, Enron, NationsBank, Netscape, Nextel, Telecom Argentina, plus seven others—each issued for tax reasons, not business reasons. Issuance relatively low-cost and routine. Design Approach 2: Tinker with capital structure... 1. Make capital structure line-of-sight. 2. Make the stock a management play rather than an industry play. Issue equity-linked debt— pegged to the stock price of competitors. Issue commodity-linked debt— pegged to the price of raw materials. The Common Theme: Pay for Performance, Not Luck Inexpensive way for company, and thus its shareholders, to place an extended bet against the competition while investing long in management. Lessens industry risk (and thus beta). Effectively hedges a portion of the equity against all risk except that of lagging behind the industry. Lowers the cost of capital. Although risk reduction for stockholders would be offset by increased risk (and reward) for creditors, the transferred return would be tax deductible. Improves cash flow. Debt service would decline when the market anticipated an industry downswing, and would rise in anticipation of an upswing. Transforms investing in company from an industry play into a management play without shuffling investors. Summary: Getting the most out of long-term incentives. Equity is still the most powerful longterm motivator. Real long-term incentives require real at-risk capital. LTI’s are more effective if made line-ofsight—whether through cash-based incentives, changes in capital structure, portfolio management or better analysis of value drivers. LTI’s are more effective if they differentiate management performance from the economy’s. Summary: Getting the most out of long-term incentives. Bottom Line Long-term incentives are most effective when part of a comprehensive financial and strategic value-based initiative to make managers think and behave like diversified owners.