A mention of patient capital in the 2018 Budget (1) made me reflect on how long term thinking is becoming more prevalent in management incentives and employee share schemes.
The 2018 Budget announced a £20 billion plan and task force targeted at unlocking patient capital – i.e. long term investing. Short-term thinking has been blamed for the 2008 financial crisis, and patient capital is arguably both a cause and indication of safer, long-term thinking in finance. Long term investment plans are meaningless if not matched by long terms incentives for management, and here privately owned small and medium sized businesses are leading the way: 4 to 5 year incentives are the default, and 8-10 year incentives are becoming common. The approach of listed companies and our financial regulator lags behind: annual bonuses are still large; 4 to 5 year incentives are common but not universal, 8 – 10 year incentives are mostly just a theory.
What is patient capital?
The UK pensions regulator has been a great promotor of longer term thinking in investment. It defines patient capital as “the provision of long term finance to high potential firms to enable them to reach their full potential” (2).
The UK pensions regulator lists benefits of patient capital to investors, to businesses and the economy: “Patient finance investments offer the potential to benefit from longer term outperformance through:
- investing in an inefficient market – which is (currently) fragmented and underdeveloped
- enabling businesses to up-scale and achieve transformational development
- eliminating short-term financing constraints and enabling management to focus on business development, optimisation of value creation and optimisation of any future business disposal strategy.”
Short term thinking, short term management incentives and the 2008 financial crisis
This is a huge topic, but I think a speech given by Sheila Blair, the Chairman of the US Federal Deposit Insurance Corporation provided a broad ranging and informative view. Her key points were:
- “the overarching lesson of the crisis is the pervasive short-term thinking that helped to bring it about”
- our tendency toward short-termism appears to be biological: when research subjects are presented with real-life decisions involving risk and reward, this activates primitive parts of the brain focussed on greed and fear rather than on long-term implications
- when management incentives vary according to current-year earnings or stock prices, “it creates incentives to maximise short-term results even at the expense of longer-term considerations”.
- “a central cause of this crisis was excessive debt and leverage across our financial system … financial companies proved adept at creating innovative new loan structures and funding strategies in the years leading up to the crisis. But all too often these innovations left participants with badly misaligned economic incentives. The compensation of loan officers, portfolio managers and bank CEOs was typically based on current-year loan volume, earnings or stock price, with little regard for the risks that were building up in the system”.
Listed companies, financial services and management incentives
Leading up to the 2008 financial crisis, huge annual bonuses were the norm and management incentives had a 3 year time line at most – even then the bulk of the value of these long term incentives was weighted to the start of the 3 year period. I remember cowering in the board room of large listed bank as a junior advisor, witnessing the genuine outrage of a bank executive as my supervisor recommended a 5 year time line for an executives’ management incentive: “I don’t give a **** about what happens in 5 years. I make money today, you hold back my reward for 5 years, I don’t want it. It insults me. Who knows what will happen in 5 years?” he memorably said.
Happily, attitudes to longer term thinking have improved.
The British Bankers’ Association, in their briefing on reforms since the financial crisis, reports that annual bonuses are being deferred for 3 years, with consultation on extending this to 5 to 7 years; and that clawback of management incentives currently extends to 7 years with consultation on extending this to ten years (3).
For listed companies, Deloitte reports trends of “increased time horizons …under 75% of FTSE 100 performance share plans, no shares will be released for at least
a period of five years from award, an increase from 60% of plans last year”.
SMEs lead the way on long term management incentives
Granted.co.uk and its parent, the RM2 Partnership, has the largest pool of market data on private SME management incentives, and it’s clear that the trend is strongly in towards longer term thinking.
No company using Granted.co.uk has created a management incentive with less than a 4 year time line, with nearly 50% adopting management incentives with up to a 10 year time line. Companies using Granted are typically early stage, high growth companies adopting simple arrangements. Of the more complex arrangements advised on by RM2, there is a very welcome trend towards 8 year time lines.
Among this positive news, there are challenges. 8 year time lines can work for committed senior employees. There is a tension between this and the higher turnover of junior staff, for whom 8 year timelines have little impact on motivation or retention. It is likely that this will cause a shift in focus of employee share schemes from solely capital growth, to a balance of income and capital growth to mitigate this.
Granted.co.uk is the online platform operated by the UK’s most experienced employee ownership specialist, the RM2 Partnership, helping over 1,200 SMEs set up and administer employee share schemes. For more information on Granted’s service, see here, or create a free account to see if your company is eligible.