Download SKI160217 Risk Adjusted TSR Methodology

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17 February 2016
Risk-adjusted Excess Total Shareholder Return Methodology
Summary
To promote transparency between executive pay and shareholders, it is important that
the methods used to measure long-term performance are clearly explained.
Spark Infrastructure uses risk-adjusted excess Total Shareholder Return (TSR), relative
to the S&P/ASX 200, to determine the percentage of an executive’s Long Term Incentive
(LTI) that will vest. The measure used to determine risk-adjusted excess TSR used is
Jensen’s alpha (𝛼). Alpha incorporates an adjustment for the relative risk of the security,
in the same way that investment markets do.
Specifically, Spark uses a 4-year period over which its risk-adjusted excess TSR is tested
against a peer group. A grant is made on a certain date, and 4 years later, risk-adjusted
excess return is assessed to determine the percentage of the grant that will vest. The
peer group used is the S&P/ASX 200 companies at the date the grant is made. If
companies in this group cease to trade during the performance period, they are removed
from the peer group, as they can no longer serve as a point of comparison.
The methodology below breaks down the process used to calculate risk-adjusted TSR and
the resulting Spark ranking and vesting outcome. As with other forms of TSR
calculations, these calculations use data that is publicly available. This ensures that the
percentage of an LTI that vests is not based on discretion or a judgement call. It is based
on transparent, factual risk and return data and a well-established process.
Rationale for using risk-adjusted TSR measures
Investors know that risk and return are related to each other. In general, if risk is high,
then there is an expectation of higher returns, and vice versa.
Investors in Spark securities generally want stable returns and lower than average risk.
Ideally, Spark’s long-term performance would be benchmarked against a group of similar
companies, with equivalent risk and return expectations. However, because there are too
few of these to form a viable peer group, a broader group of companies is required. The
S&P/ASX 200 was chosen because it is a well-established benchmark in relation to
Australian securities. However, it introduces many companies with significantly higher
systemic risk than Spark. In fact, Spark is ranked below the 10th percentile within the
S&P/ASX 200, based on beta (𝛽), the measure of systemic risk used to calculate 𝛼 .
There are many factors influencing returns, including systemic risk (e.g. economic and
political) and non-systemic risk (e.g. management skills and judgement). If we can
adjust for the systemic risk, then the variability in adjusted returns should be more
strongly related to management performance.
TSR (share price appreciation + dividends), though commonly used to benchmark longterm performance, fails to take into account the riskiness of an investment in a particular
company. For example, two companies could have the same shareholder return, but one
may be much riskier than the other. While it is a common method, it is unfair to deliver
higher reward to executives who achieve returns that put investor capital more at risk
than executives who deliver the same return for less risk. Ranking companies by their
risk-adjusted return, over a specific period, provides a comparison that more closely
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reflects how investment decisions are actually made. That is, when making an
investment decision, an investor will have a requirement for a company return that is
informed by the perceived risk associated with the company.
Methodology
The method uses data that is publicly available, so is transparent. Risk is a concept
central to calculating risk-adjusted TSR. Spark calculates risk-adjusted excess returns
using Jensen’s Alpha (𝛼). The calculation incorporates a measure of a company’s relative
risk called beta (𝛽) and the risk free rate.
The risk free rate is the theoretical rate of return on an investment that has no risk.
Although there is no such thing as zero risk, government bond yields are used for the
risk free rate because their risk is very close to zero.
The risk-adjusted returns formulae are detailed in the following section – The Maths.
The following steps describe the process:
Step 1: Calculate Beta (𝛽)
Beta is the numerical measurement of a security’s risk compared to the entire market.
The market is defined as the peer companies, being the constituents of the S&P/ASX
200. So, if 𝛽 equals 1 for a certain security, then we know that its return moves inline
with market fluctuations. If 𝛽 is greater than 1, the security’s returns are more volatile
than the market. If 𝛽 is less than 1, then the security’s returns are less volatile.
Step 2: Calculate capital asset pricing model (CAPM) required return
Required return is the sum of the risk free rate and a risk premium, based on the
systemic risk of the security. For this calculation, three numbers are needed: the risk
free rate (based on the Australian government bond yield), the average market return
for the period, and beta.
Step 3: Calculate Alpha (𝛼)
𝛼 is calculated by subtracting the CAPM required return from the actual TSR of each peer
company. This is done for every trading day and then compounded over the performance
period.
Step 4: Calculate Vesting
Peer companies (including Spark) are sorted in descending order based on 𝛼 and Spark’s
percentile rank is calculated. Vesting is calculated according to the following scale:
!
!
!
Percentile rank below 51: 0% of LTI grant vests
Percentile rank from 51 to 75: vesting increases on straight-line basis from 30% to
100%
Percentile rank above 75: 100% of LTI grant vests
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The Maths
Table 1: Calculating cap-weighted beta
Variable
Daily return
Daily
cap-weighted
market return
Average
company
returns
Average
cap-weighted
returns
Formula
𝑦! =
Note
Calculate for each trading day (i) in the
performance period for each company in the
peer group. i=1 is the first trading day and
share price0 is the closing price the day
before the performance period.
(𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒! + 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑! )
−1
𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒!!!
!
!!!(𝑑𝑎𝑖𝑙𝑦 𝑟𝑒𝑡𝑢𝑟𝑛! ∗ 𝑚𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙! )
!
!!!(𝑚𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙! )
𝑥! =
𝑦=
𝑥=
Cap-weighted
beta
𝛽=
!
!!!
𝑦!
Calculate for each company, where m is the
number of trading days in the performance
period.
𝑥!
Where m is the number of trading days in
the performance period.
𝑚
!
!!!
Calculate for each trading day in the
performance period, where n is the number
of peer companies, including Spark.
𝑚
!
!!!(𝑥! − 𝑥)(𝑦! −
!
!
!!!(𝑥! − 𝑥)
Calculate for each company in the peer
group. This is the slope of the best-fit line
between daily return and daily cap-weighted
market return, where y is the daily return
and x is the daily cap-weighted market
return and m is the number of trading days
in the performance period.
𝑦)
Table 2: Calculating risk-adjusted excess return (𝛼)
Variable
Average daily
risk free rate
Formula
𝑟=
!
Note
(1 + 𝐴𝑛𝑛𝑢𝑎𝑙 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 ) − 1
Daily CAPM
return
𝑌! = 𝑟 + 𝛽 ∗ (𝑥! − 𝑟)
Daily excess
return
𝛼! = 𝑦! − 𝑌!
Risk-adjusted
excess return
𝛼={
!
!!!
Calculate the compound daily risk free rate
for the performance period, where m is the
number of trading days. The annual risk free
rate is the zero coupon forward rate for the
performance period from the Reserve Bank
of Australia.
This is the capital asset pricing model (CAPM)
return and is calculated for each trading day
in the period for each company in the peer
group.
Calculate for each trading day in the period
for each company in the peer group.
Calculate the compound returns for each
company in the peer group, where m is the
number of trading days in the period.
1 + 𝛼! } − 1
Table 3: Calculating percentile rank and vesting outcome
Variable
Formula/Process
Spark rank
Order the constituents by risk-adjusted excess return and calculate the Spark
ranking from lowest to highest
Spark
percentile rank
𝑆𝑝𝑎𝑟𝑘 𝑟𝑎𝑛𝑘
∗ 100
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑛𝑠𝑡𝑖𝑡𝑢𝑒𝑛𝑡𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑒𝑒𝑟 𝑔𝑟𝑜𝑢𝑝 (𝑛)
0% if the Spark percentile rank is below 51
Percentage
vesting
100% if the Spark percentile rank is 75 or higher
𝑆𝑝𝑎𝑟𝑘 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑖𝑙𝑒 𝑟𝑎𝑛𝑘 − 51 ∗
!""%!!"%
Guerdon Associates Pty Ltd ABN 67 112 483 940
!"!!"
+ 30% if Spark ranking is between 51 and 75
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This document is private and confidential. It is provided for the sole use of Spark Infrastructure. Guerdon
Associates is a professional remuneration adviser. For specific accounting, tax and legal advice we
recommend advice from specialists in these fields.
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