The state(s) of executive compensatIon

A look at the realities and underlying business factors faced by industries while structuring the executive compensation

The outcomes of the LokSabha elections in India are usually driven by issues that are of national importance, but Assembly Elections are all about challenges and realities that are at a state or local level. Executive Compensation has similar characteristics to show. While at an overall India Inc. level, there are broader debates around pay governance, increasing the gap between compensation of the CEO and the average employee, the questions or issues are very unique at each industry level. The article is aimed at highlighting some of the key executive pay characteristics in the major industries.In some ways our take on the “different state(s)” of executive compensation!

The intent of this article is not so much to delve into the quantum of pay which is available through public data and surveys but to understand the realities faced by each industry and its impact on how executive compensation is structured. While we focus on key industries, we have also included our perspective on the new kid (or beast) on the block called start-ups, which are redefining executive compensation at a different level.

Financial Services is a big state in itself with different constituencies like banking, insurance, mutual funds, private equity etc.The Banking constituency has two large districts, i.e. Indian Private Sector Banks and Foreign Banks with similar pay structures but nuanced differences. The Indian Private Sector Banks, regulated by RBI standards on pay are mostly listed on Stock Exchange(s) and follow the mandated disclosure norms in annual reports. The quantum of increase in fixed compensation and bonus payouts are closely regulated by RBI. Equity-based compensation is, however, not actively governed by regulators and consequently while the media actively tracks cash compensation, it often misses out on the significant pay that is delivered to executives in this sector through stocks. The value of stock-based compensation ranges anywhere between 3-5x of the CEO’s fixed pay on an annualized basis and 2-4x of fixed pay for other Executive Directors. The Indian private banks are by far one of the most aggressive groups of companies on stock-based compensation. The foreign cousins of these Indian banks enjoy similar structure with grants generally made by the foreign parent; however, the quantum of such awards may not be as aggressive.

Another difference is that while the Indian banks have always relied on ESOP’s , the foreign banks have transitioned more towards Restricted Stock and Performance Share programs for delivering long-term incentives. The focus has shifted from rewarding only for stock price performance to ensuring that the bank is delivering fundamental balance sheet performance and is ahead of the competition in capturing opportunities. However, we expect that over the next few years, Indian banks may see a shift on with the adoption of new accounting norms.

The second important constituency is the Insurance business where executive compensation is, in some ways, still evolving. The insurance regulator, IRDA, has taken a leaf out of guidelines issued by the RBI for compensation of Executive Directors/CEO’s.The regulations, however, have some gaps — IRDA guidelines on ESOPs, for example, recommend that it be “kept outside the computation of the total compensation but the extent of ESOP should be reasonable”. It is not clear how IRDAI plans to judge the “reasonableness”. Given that almost all private sector insurance companies are unlisted and will get listed once they achieve a critical mass, it will not be surprising to see companies move to offering ESOP’s to executives based on independent valuation. In many recent cases, we have seen that the listing price is multiple of value used to grant Stock Options resulting in substantial gains to executives at the time of listing although not much time elapsed between ESOPvaluation and IPO. The industry regulatory bodies and SEBI need to critically look at these aspects and provide a governance mechanism around the same.

The third constituency is that of the Private Equity (PE) business, where the structures are well understood at the conceptual level but there is absolutely no visibility on the quantum of pay. At senior levels, PE players are front runners on fixed compensation but significant long-term payoffs are from Carry Plans. Simplistically, this is the part of profit shared with executive after a successful exit on an investment. There are some thumb rules that guide these payouts, but no regulation or even strong market data. According to a recent report by Bain & Co., the deal value in 2015 grew to $23 Billion and number of funds participating in India has grown at a CAGR of 32% in last 3 years. Two out of top 3 factors of increase in deal volume are changes in exit environment and changes in valuation expectations. With a considerable amount of compensation linked with the exit and a typical exit horizon of 5 to 6 years, one needs to see how these players are contributing to institution building and developing companies for the long haul.

There are a few other constituencies within the financial services space such as Non-Banking Finance Companies and Investment Banking/Capital Market businesses, Broking houses etc. But these segments do not yet display challenges that are unique and differentiated – at least not yet!

Executive pay in this sector shows a convergence to a norm both in design and in quantum. There are again two districts in this ”state”, the Indian MNC’s who are expanding globally and the foreign MNCs focused majorly in India. From an executive compensation perspective, both these constituents show a reasonable mix of fixed and variable pay; and within variable a healthy mix of short and long-term incentives.The long-term incentive structures are also fairly equally divided across ESOP awards and full value awards like Restricted Stocks and Performance Shares. The Compensation approach in this sector displays a clear focus on value creation, and the rewards are not just based on the share price growth but effective implementation of strategy. We see most long-term incentive plans focused on delivering performance on different levers of value creation and there is a priority on lead metrics over lag metrics. These structures help organizations navigate through short-term disruptions on account of factors beyond management’s control (e.g. impact of demonetization of short-term stock price) and keep the focus on strategy execution rather than focusing on means to increase stock price alone.

The Manufacturing state is akin to the Uttar Pradesh – way too many constituencies and discussion on each of them may well be beyond the ambit of this article. This sector, from the executive compensation perspective is still holding on to traditionalist structure i.e. high focus on fixed compensation, relatively low on annual variable and substantially low on LTI. Some firms esp. in the constituencies of automotive, natural resources etc. have shown a progressive approach to executive compensation by defining stronger LTI structures to focus on optimization of resources, innovation in product offerings, improvement and innovation in processes leading to value creation in long run. There is an implicit focus on stock price growth but an explicit focus on institution building which is ready to take on challenges posed even on a global front. What has also helped this sector is that most firms are promoter-driven with substantial stake already in the firm. The idea of these promoters is to ensure that the executives have “ownership” in the firm and not just the share in appreciation in value of shares. This has created a culture of free thinking leading to innovation and not just improving the operating ratios in short run.

IT State is considered as pioneers of stock-based compensation in India with example from Infosys cited even today;although Infosys itself has undergone multiple changes from executive compensation standpoint. We are witnessing a resurgence of stock-based compensation in this sector. The share of long-term incentives in IT companies is getting prominent again with major firms on a cusp of change. From being customized software service providers, these companies are partnering with their clients on various strategic initiatives like digital, robotics and AI which not only requires a change in strategy but also change in mindset on how the business is going to be managed versus how it has been managed in the past. The long-term plans link the payoffs for executives directly with the outcome of execution of new strategy. The IT product constituency in this state mirrors the global plans and we witness an extensive use of full value instruments like Restricted Stock. The ITES companies especially those listed on the US stock exchange continue to be aggressive on stock compensation in executive pay following the trend in listed players in the US.

This new constituency represents the most diverse and imaginative practices towards executive compensation. If we focus on firms where the promoter has got in professional management team including the CEO and is backed up by private equity players, executive compensation in dollar terms has little meaning. While the executives in many cases are open to joining a start-up at the same pay in their previous organization (or even a pay cut in some cases), they are very interested in what percentage of company do they own. It is not uncommon to see the PE-backed firms diluting 2 to 6 percent in favor of the management team with vesting schedules linked to PE exit. The vesting of options in most cases is based on time and performance with PE’s return on investment (Internal Rate of Return - IRR being the performance metric commonly used). The whole approach could be short-term in nature when it comes to institutional building. The focus in many cases is on the return to investors over the investment horizon and not on long-term institution building. This is a classic case of trickle-down effect i.e. the incentives structures in the PE firms reward for a profitable exit and this leads to kind of incentive programs for management in a PE invested firm where the focus is on exit with higher valuation. The pace of value creation and the line of sight to huge payoffs is becoming hard to compete with for established firms and there are numerous examples of executives leaving to join start-ups. 

The approach towards executive compensation is varied across our different states and the underlying business factors and forces will continue to determine the structure of pay. The most important aspect in executive compensation is the governance mechanism around pay structures. The Compensation Committees across different industries need to ensure that the pay structures are not leading to excessive risk-taking for short-term gains and are structured to promote innovation, sustainable institution building and value creation for all stakeholders of the firm and not just investors. As Warren Buffet once said “What we learn from history is that people don’t learn from history”, we really don’t need any other bubble to burst to approach executive compensation from right perspective but only if the custodians of governance mechanisms at micro and macro level do their job effectively.