With Volatility and Rising Interest Rates, Will Some Performance-Based Equity Awards Be Worth the Greater Cost?

The price of the most common performance-based equity award is increasing for US-listed companies. Approximately half of companies that use performance-based equity awards have some portion tied to relative total shareholder return (rTSR). Typical designs are earned based on company shareholder return (stock price growth plus reinvested dividends), often over a three-year performance period. The target award level generally is earned for performance at or around median, and the number of shares ultimately earned can be above or below target for performance above or below median.

The appropriateness of rTSR as a performance measure is a topic for another discussion. Instead, this post is about how the current inflationary environment, US monetary policy, and market volatility are converging in a manner that impacts the Monte-Carlo and Black-Scholes models, or those that are most often used to calculate the accounting cost of a rTSR award. We observe that these forces are converging in a way that will increase these awards’ theoretical value (i.e., the grant date fair value or GDFV), perhaps materially. This matters because the GDFV is the compensation that is disclosed in the Summary Compensation Table of proxy statements and what is incurred over the performance period as stock-based compensation on the income statement. It’s a function of accounting rules and not a shift in companies or grant participants perceiving a higher likelihood of a payout.

To fully understand this, it is important to recognize some of the high-level key relationships that drive the theoretical value of these awards. For equity awards valued with Monte-Carlo and Black-Scholes accounting models, the GDFV (1) rises as interest rates rise, (2) rises as volatility rises, and (3) is fully recognized regardless of the performance achieved.

The math implies that the award is worth more when the markets are volatile and interest rates are higher and accounting rules require the cost to be treated like an option (i.e., the cost is established today and not adjusted up or down based on the actual performance achievement at the end of the period). This is in contrast to internal or financial performance conditions, such as earnings or return measures, in which the cost can be reversed if the performance goals are ultimately not met.

How big might this problem be? Our client experience and experimentation with the model tells us that the cost of an award made today might be 10 to 30 percent higher than the same award made one year ago. Additionally, there will be extreme outliers in certain niche situations—think a more than 40 percent increase in accounting value per unit. While technically correct, these changes in value do not translate to a more valuable, or certain, award in the real world. Implications include the following:

• The “real” probability that the award will finish “in the money” is basically the same across industry-specific comparator groups because all companies being compared are subject to the same macro forces.

• Stock-based compensation expense goes up. It is often explained away as a non-cash cost that is backed out by shareholders, but it is arguable whether or not analysts and investors will be more forgiving of this expense in the future as the cost of equity increases alongside debt rates.

• Reported compensation in the proxy goes up. For an executive who earns 70 percent of their total pay in equity, and 50 percent of that is in rTSR awards, a 20 percent increase in rTSR cost will increase pay by 7 percent without any other change. Proxy advisors and many large shareholders prefer this rTSR design. Presumably, they account for this accounting-driven force in their analyses of pay levels, but it is entirely subject to their perspective of “appropriateness.”

• The potential range of share prices at the end of the performance period is wider. Volatility means higher highs and lower lows. For rTSR plans, which measure returns from point to point, the program becomes riskier, also with higher highs and lower lows. The value of performance-based equity can already be a risky proposition for recipients, and more risk (and the underlying formulas to illustrate “value”) makes the award feel like a day at the casino.

So, what should compensation committees and management do? The answer is always about preparation and discussion, but here are two considerations:

• Address award valuation and award design at the same meeting. Do not wait until design is approved. Have any valuation inputs changed? What would sample disclosure look like for last year’s awards under the new inputs? What is the impact on budgeted stock-based compensation expense? Does a different valuation change opinions about the appropriateness of the award?

• Consider performance-based long-term awards that are less dependent on “theoretical value” accounting calculations. If the objective is simply to manage reported compensation and income statement cost, performance awards whose cost does not vary with macro assumptions may generate outcomes that are more aligned with actual performance and company fundamentals over time. These metrics may also be more navigable during periods of heightened market volatility, given the point-in-time risk associated with three-year market measurement periods.