The false precision of the 50% discount in UK listed-company pay

The market seems to have settled on an exchange rate for PLC executive pay.

Two pounds of performance shares can be exchanged for one pound of restricted shares. That is the logic of the 50% discount sitting inside many hybrid LTIPs. 

Yet it is often unclear how the 50% figure reflects the risk being exchanged.

The Investment Association’s Principles of Remuneration recognise that restricted shares have a more certain outcome and lower risk profile than performance shares. For a standalone restricted share plan, they expect a significant reduction in award size, typically 50%. For a hybrid, they expect the restricted-share element to be discounted and encourage the remuneration committee to explain its rationale and methodology.

The 50% is familiar. The methodology is usually harder to find. The point is not that 50% is necessarily wrong. Nor is there necessarily one objectively correct discount waiting to be calculated.

The problem, I would suggest, is that a governance convention is often treated as though it has already answered several different other questions: shareholder cost, expected payout, executive value and incentive effect.

And I don't think it has.

A convention is not a valuation

A hybrid makes a genuine economic trade.

The number of performance shares vesting may range from nil to maximum, depending on the measures and targets. Restricted shares are more likely to vest because continued service, rather than stretching performance, does most of the work.

More likely does not mean certain. Restricted shares remain exposed to share-price movements, leaver provisions, malus and clawback and any performance underpin. But one important source of vesting risk has been removed: the number of shares vesting no longer depends on achieving stretching performance targets.

That changes the economic profile of the award. However, it does not, by itself, tell us that the correct adjustment is 50%.

An executive is not a diversified institutional investor. Their salary, career, deferred bonus, existing awards and required shareholding may all depend on the same company. They cannot normally sell or hedge an unvested award. Face value, shareholder cost and the value placed on an award by an undiversified executive are therefore different quantities.

That does not mean shareholders should compensate executives for every element of their personal risk discount. Some exposure to company-specific risk is the purpose of equity remuneration.

It means only that greater certainty has a value and that value will not necessarily be identical in every company. It may depend on the volatility of the shares, the performance conditions and likely distribution of outcomes, the strength of the underpin, the executive’s existing exposure and the probability of remaining employed.

A restricted share in a stable compounder is not the same economic proposition as a restricted share in a highly leveraged turnaround.

Certainty is worth something. But I don't think it should automatically be worth 50%.

And then, of course, there is the separate and harder question of how you price uncertainty (explored further here).

One number is doing four jobs

I think the discount is being asked to answer four questions at once.

The first is cost. What economic value and potential dilution does the proposed award represent for shareholders?

The second is expected payout. How much of the award is likely to vest across a credible range of outcomes?

The third is executive value. What value does a risk-averse, undiversified executive place on the award after allowing for the possibility that it may vest at nil? I have previously written about employees having a cost of capital (explored further here).

The fourth is incentive effect. How does the structure affect retention and the sensitivity of reward to performance?

Those questions are related. 

Suppose a performance share award has a face value of £200 and an expected vesting level of 50%. Holding the share price constant, its expected vested face value is £100.

Replacing it with £100 of restricted shares appears to preserve that figure. But it does so only if the restricted shares are assumed to vest in full. A meaningful underpin, leaver risk and other vesting conditions may produce a different result.

A further gap runs the other way. Suppose the executive holding that £200 award would privately value it, before any conversion, at only £70 - well below its £100 expected value - because bearing risk that cannot be diversified away is itself costly.

A restricted share may carry materially less of that discount, so its face value and its value to the executive may sit closer together. Grant £100 of restricted shares in its place and the swap may not have preserved value. It may have increased it, without anyone consciously deciding to do so.

Even if the expected values match, the two awards still do different jobs. Restricted shares provide more dependable retention across disappointing or mediocre outcomes. Performance shares provide greater leverage to measured outperformance.

Equal expected value does not mean equal incentive effect.

Structural change and higher pay are different questions

The same structure can produce different outcomes

Forterra plc and Aberdeen plc illustrate how the same conventional exchange rate can be applied from different starting points. Forterra left its maximum notional long-term incentive opportunity unchanged and divided it equally, before discount, between performance shares and restricted shares. The restricted-share half was then reduced by 50%. For each £100 of notional performance-share opportunity, the resulting award contains £50 of performance shares and £25 of restricted shares: an aggregate face value of £75.

Aberdeen adopted the same arithmetic from a different starting point. It retained a 350% ceiling for an award made entirely in performance shares. Its hybrid is limited to 175% in performance shares and 87.5% in restricted shares, producing a combined face value of 262.5% of salary, again 25% below the all-performance alternative.

The identical outcomes appear to reflect the conventional 50% exchange rate rather than separate company-specific valuations of certainty. What the disclosures do not establish is whether 50%, rather than 40% or 60%, reflected the risks embedded in either company’s performance award.

Value creation plans expose their payoff curve

A value creation plan is usually treated as the more aggressive relative of the hybrid. Its leverage is explicit, and its potential outcomes may be large.

But the design of a value creation plan necessarily specifies its payoff curve. Nothing is paid below a defined hurdle. Above it, management receives a stated proportion of incremental value. The hurdle and participation rate do not tell us what the award is worth. They do show how value will be transferred across different outcomes.

That is more economic information than a bare 50% conversion convention provides.

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