Aligning Interests: (no freeloading on my tab!)
Fat salaries. Big bonuses. Plummeting share price. Sound familiar?
That an article discussing the benefits of aligned interests should even need to be written deeply concerns and somewhat surprises me.
Nevertheless, it's clear from our experiences that there are plenty of companies where the interests of the executives and the interests of the shareholders are in direct and lopsided conflict.
It boggles my mind that investors would put up with such situations, but it seems that many people out there are either unconcerned that the managers and directors looking after their money don’t care about their goals or are simply too busy speculating to notice.
So, though it pains me to my value investing roots to prepare this article, here are our thoughts on where investor interests and attention should be (in our humble opinion).
"Show me the incentive, and I will show you the outcome." - Charlie Munger, Berkshire Hathaway
There are many factors we consider when looking to invest in a company. No doubt, the basic matters such as balance sheet strength, return on equity, and competent management rank highly, but even when all of those factors are in place, a conflict of interest between the incentives for the management team and the interests of shareholders can see an otherwise attractive investment opportunity devolve into an expensive ‘learning experience’.
It should go without saying that a management team and investors should make all possible effort to ensure that their interests are aligned, but shockingly it is far less common than one would expect.
Where investors are concerned with positive long-term outcomes, strong balance sheets, return on assets, return on invested capital, and primarily an increasing share price, many managements incentive schemes (both short term and long term) stunningly disregard some (or all of those factors) in lieu of more ‘inventive’ measures of success.
We’ve seen management teams align their incentive schemes to revenue, or market cap growth, we’ve even seen some propose that the management team be rewarded for product growth.
In each of those circumstances, we’ve seen time and again, management teams sacrifice balance sheet strength (via leverage), long term share prices (with dilutionary capital raisings), and margins (in search of wider and less profitable products). None of that behaviour suits shareholders, but all too often, the powers that be, who create long and short-term incentives get lost in the excitement of a good story or an exciting ‘opportunity’ and forget that the only role a management team should be playing is that of enriching the company’s shareholders.
Now it’s important to note that even a perfect alignment of interests is not a guarantee of success. There have been plenty of companies with the best of intentions that have failed. However, we would suggest that over the long term, misaligned interests are a guarantee of failure.
How to align interests:
There is no one-size-fits-all approach, but broadly speaking there are a few basic things a board should look to do.
- A good place to start is to incentivise success.
- Stock options provide a good start but are imperfect in their implementation of alignment. That is, options will certainly encourage the team to strive for a higher share price (assuming the options are priced at a premium to the prevailing share price) but by themselves, options do not provide alignment to the downside (protect capital).
2. An improvement on our first point is to align management interests with shareholders by insisting that they become shareholders.
- Managers who own significant amounts of stock in a company are going to be motivated to both protect their capital and generate attractive returns over the long term. Colloquially referred to as “skin in the game”, we most often see directors with significant stakes in a company when they used to be the founder. Having been a founder also (often) further aligns management interests with shareholders as the founder is not only financially committed to the business but also emotionally (though that can come with risks as well).
3. Once we’ve seen management align their interests to both the upside and the downside of the company, we also like to see the directors consistently increase their stake in the business.
- Consistent and considerable increases in management's stake in the business indicate both an ongoing commitment and confidence in the operations of the business.
- Manager selling is also an indicator - but not in the same way that buying is. There is no reason other than confidence in the business to buy, but there can be many reasons why a manager might need to sell, many of which are unrelated to business operations. Still, selling is something we pay attention to, and when it appears out of character, we seek to understand the reasoning.
If we can find a competent team that is prepared to support the company and align their interests with shareholders, it is one of the best indicators we can find for positive outcomes. A great example of this in practice is National Tyre and Wheel (NTD.ASX).
National Tyre and Wheel is a Queensland based business that, through its 28 different distribution centres spread over 3 countries, distributes tyres across a range of industries and sectors as diverse as emergency services, agriculture, off-road adventure driving and industrial vehicles (such as forklifts). The Board and Senior Management have been working together for over 30 years, well before the company was listed on the ASX.
Key things that I like about the structure and alignment of interests within National Tyre and Wheel include:
- Good governance is promoted when the Independent, Non-Executive Chair of the company is also a member of the Board’s Audit and Risk Committee as well as the Remuneration Committee.
- The Independent, Non-Executive Chair is also the owner of over 200,000 shares in the company (~$1.40 p/s at the time of this article).
- Both Executive Directors (that is, Directors with management responsibilities as well) have material ownership in the company – the CEO and MD has 2.7M shares and 350,000 options and the second Executive Director has over 27M shares.
- The Chair of the Audit and Risk Committee and also the Remunerations Committee are both Independent, Non-Executive Directors (both of who have between 280,000 and 403,000 shares in the company). It is noteworthy that both Independent, Non-Executive Directors own shares in the company because they choose to do so – they were not allotted any shares under either a short term or long term incentive plan.
- Senior Management remuneration is tiered in a sensible way over time. For example, in 2021 approximately 66% of Senior Management’s remuneration was by way of cash and salary, 30% was via cash payment under a short term incentive plan and 3% was via a share-based program under a long term incentive plan.
- The metrics used to determine both short and long term incentive payments are based on an increase in earnings per share, derived from audited financial statements and anchored against net profit calculations (after tax and excluding amortisation).
Some other questions investors should be asking:
There are no perfect solutions, but there are some simple steps we can take, and some indications we can look out for.
- Do the short term and long term incentives align with the corporate goals?
If the company is consolidating, incentives should reflect that. If the company is growing, then the incentives would be reflective of that.
- Do the incentives attract and retain good employees and prevent bad leavers from taking advantage?
It's worth offering highly attractive incentives to entice and retain quality staff. At the same time, it’s important that those benefits are earned.
- Are the employees and Board being remunerated with shares?
If the company’s employees and Board are confident in the outlook of the business, receiving part of their salary in equity is enticing.
- Is corporate culture a consideration when remunerating the team?
A toxic culture may achieve seemingly good outcomes in the short term but could have catastrophic consequences in the long term.
Again, there is no guaranteed method for ensuring success, but knowing that the management team are working towards the same goals that we investors seek, and that a loss to investors will be equally felt by the management team is as good an indicator of the quality and prospects of a business as any we’ve been able to identify.
How we align our interests.
At Collins St Value Fund we take these lessons to heart. We expect the directors of the companies we invest in to align their interests with ours, and we expect nothing less from the investors who have entrusted us to look after their capital.
As such the team have meaningfully invested in the fund and have done so on the same terms as all our investors. Additionally, the fund only receives a fee when our investors profit (focussing our attention on both genuinely protecting the downside and maximising the upside) – there are no fixed management fees skimmed off the top of investors capital as we believe, that in the Australian equities context, they incentivise little more than asset gathering, rent-seeking, index hugging and, ultimately, mediocrity.
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Michael is the MD and one of the founding partners of the Collins St Value Fund. The Collins St Value Fund is one of the best performing Funds in Australia - having ranked among the top 10 performing funds across all Australian Equity mandates by...