Understanding a company’s executive incentive compensation can highlight investment dangers

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There’s nothing like the right incentive to shape behaviour. The person with an upcoming beach vacation is more likely to squeeze a workout into a busy day or look the other way when the dessert trolley comes by.

For advisors and investors to understand a business they’re invested in, it’s important to analyze the firm’s incentive compensation program. This will provide clues on the actions its leaders may take in the future that have the potential to grow shareholder value – or to destroy it.

For example, at Geico, the U.S. auto insurance company owned by Berkshire Hathaway Inc., the compensation system is simple and transparent. It’s designed to create wealth for shareholders.

The incentive program has only two variables expressed numerically, on an X-Y-axis: growth in policies in force and the profitability of the seasoned business. Where they intersect determines the bonus pool for the year. This simple structure incentivizes employees to grow the business’s profitability over the long term.

But just as the right incentives can drive shareholder value, the wrong incentives can derail a business and damage personal and professional reputations.

The notorious case of Valeant Pharmaceuticals is an extreme cautionary example of an executive compensation scheme having unintended consequences.

In early 2008, ValueAct Capital, a small investment firm that was a key Valeant shareholder, recruited Michael Pearson to be its new chief executive officer. Mr. Pearson’s compensation package was designed to encourage him to focus on long-term value creation by giving him exponential bonus payouts for exceptional share price appreciation.

His base salary was a modest US$1-million, and he was obligated to invest US$5-million of his personal funds in Valeant stock. But, based on performance, he stood to make a fortune through the multiplier effect of the incentive program. ValueAct measured performance solely by Valeant’s share price. Mr. Pearson did what he had been incentivized to do – pump up the share price, something he took on with gusto.

By 2015, Valeant Pharmaceuticals had an equity market value of about US$90-billion. From 2015 to 2017, its share price fell more than 90 per cent. What happened? To keep the share price growing, Mr. Pearson pursued deal-making aggressively by buying more than 100 companies, including Canada’s Biovail Corp. He reduced investments in research and development dramatically, cutting costs to the bone. He also raised prices on drugs consistently.

Long story short, by 2016, Mr. Pearson was out. In 2018, Valeant was renamed Bausch Health Cos. Investors, including such large hedge funds as Pershing Square Capital Management, lost billions.

For advisors, understanding both the potential upside and downside of a company’s incentive compensation program should be part of the risk/reward assessment before making an investment.

Here are some of the key factors advisors should consider:

• Is the compensation incentive program too complex?
• What is the balance between financial and non-financial rewards?
• What is the balance between cash and equity?
• What is the magnitude of the rewards?
• What is the time horizon for receiving awards – short, medium, or long-term?
• Are the rewards in alignment with the company’s values and goals?
• Are the rewards in alignment with the business’s maturity? For example, early-stage companies may skew to growth compared with later-stage businesses that skew to optimization and profitability.

Management that’s incentivized only by financial rewards may exhibit a lack of ethics and take shortcuts to achieve their monetary goals. Hard-won business, personal reputations and shareholder value can be collateral damage.

Sharon Wang is senior equity analyst at PenderFund Capital Management Ltd. Inc. in Vancouver.

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