The Canary in the Coalmine
London 13th March 2023
Silicon Valley Bank was closed by regulators and the FDIC took control on 10th March 2023 (Wall Street Journal)
My family came from ‘Up North’, an area of England that, depending upon your level of southern-ness, could start as far south as Harrods, but for me was Durham. Hartlepool to be exact. That’s flat caps, Newcastle Brown Ale and coalmining.
I mention coalmining because it struck me, as I read about the collapse of Silicon Valley Bank and Signature Bank in the States, that this was a canary moment. Canaries were used down the mines as the earliest indicator of a gas leak, so that one cough from the canary started a mad rush for the exits. The regulation of banking is (we are led to believe) more sophisticated than it was at the time of the Great Depression and Great Recession, but one does feel a slight edginess amongst the miners, to say the least.
I raise the subject of the canary because it has great relevance to incentive compensation design. It will most likely signal the beginning of yet another economic cycle, just as the failure of Boo.com did on 18th May 2000 and just as the downfall of Bear Sterns, Lehman Brothers and our own Northern Rock, did for us on 22nd February 2008. As before, apparently nobody saw it coming! See below:
‘Silicon Valley Bank celebrates being named to Forbes magazine’s list of "America’s Best Banks" for the fifth straight year’ [@SVB_financial – 6th March 2023]
The design of incentives grew in sophistication during the ‘90s from a time when almost nobody other than BP plc had a long-term incentive. In 1995, for example, HSBC’s CEO Willy Purves [“the banker’s banker”] was granted just one times his salary in share options in return for delivering £3.6billion in profit.
The situation today is that nearly 100% of the FTSE100 have long-term incentives. The sophistication came from choosing increasingly complex performance requirements. If you define success as simply growth, all you need to measure are headline figures such as volume, revenue, or fees. But more likely, your shareholders will want to know if their company is adding value, and herein lies the complexity. If value is simply your market capitalisation, you can measure achievement towards your goal by tracking Total Shareholder Returns (‘TSR’). However, amongst many problems with TSR [see earlier Blog], though, is the problem that it’s really a measure of the stock-markets’ perception of future expectations. If you want to give the management team ‘line-of-sight’, you need to measure growth in Economic Profit (‘EP’) – that’s net operating profit after tax less a charge for capital. Quite a mouthful.
EP is to all intents and purposes the own label version of the branded measure Economic Value Added (‘EVA’). It captures growth, as well as the capital required to achieve that growth, and allows management to set goals out into the future which are real, achievable and which they can deliver through mechanisms they can control, unlike TSR (which is really out of their hands).
“You cannot walk into a Board Room and demand more TSR”
So, EP became the ‘go to’ modern performance measure for incentive compensation design.
Which is where the canary in the coalmine comes in. Economic Profit is notoriously difficult to manage through economic cycles, because the assumptions required for assessing the ‘charge for capital’ also require assumptions about the cycle, and the average across cycles.
I published the following about investors and the use of so-called long-term incentives, in 2005:
“For an investor, the long-term extends beyond one economic cycle. That’s probably seven years or longer. During the 3655 trading days of the bull market from 1990 to June 2002, investors could have achieved annual growth of 11.1%, if you were fully invested. But if you missed the 10 best trading days, you achieved only 8.3% and only 6.5% if you missed the 20 best trading days. Investors don’t know when to get out, so they must stay in (the market)
For as long as Long-Term Incentives have been in place (since ~1990, in the UK), they haven’t really been long-term incentive plans at all. More like Medium Term Incentive programmes
This disconnect, between what the investor is looking for and how the executives are rewarded lies at the heart of the tensions played out in public over executive pay. No investor really begrudges high pay for really high performance. The problem of corporate governance and directors’ remuneration is that they suspect, rightly in many cases, that high performance isn’t sustainable in the long-term. Their long-term.”
Well, that’s Northerners for you!