Don’t Let International Peers be Foreign to You
Performance shares earned based on Relative Total Shareholder Return (RTSR) are the most prevalent form of performance equity in the global marketplace. Selecting appropriate peer companies has always been a critical aspect of RTSR plan design, and as more companies compete globally, a greater number of companies are selecting international peers. The inclusion of international companies in an RTSR plan raises a fundamental question: how should TSR be calculated for a company that trades in a different currency?
Significant currency fluctuations (e.g., Hungary in 1946, Zimbabwe in 2007, Switzerland in 2015, and most recently with Brexit) can cause equity prices to increase (or decrease) dramatically, but these price swings may not be indicative of actual performance. A stock price may drop if the strength of the currency in which it is traded surges, or spike if the value of the currency plummets, even if the value of the company itself is unchanged. Therefore, to tighten the alignment between pay and performance, it is critical that we calculate TSR with currency fluctuations removed from the calculation.
Broadly speaking, there are 3 alternatives to consider when calculating TSR for international peers:
- Alternative 1 – Keep all stock prices in local currencies: This approach is the easiest administratively, but unfortunately it is also the least theoretically accurate. Comparators advantaged by inflation will appear to have high TSR and will be unfairly rewarded for stock price appreciation that is not necessarily indicative of value delivered to shareholders. (Note: There could be rare situations in which revenue of an international peer could be domiciled in a foreign jurisdiction and could already be affected by currency fluctuations, and the fairest solution would be to keep in the local currency.)
- Alternative 2 – Convert all stock prices to a common currency: This approach introduces an additional step to the calculation of Total Shareholder Return but is also the most theoretically accurate. Calculating TSR based on currency-converted stock prices is also aligned with the guidance provided by IVIS in their most recent Principles of Remuneration, which states that “Where TSR is used as a performance criterion and the chosen comparator group includes companies listed in overseas markets, it is essential that TSR be measured on a consistent basis. The standard approach should be for a common currency to be used. Where there are compelling grounds for the calculation to be based on local currency TSR of comparator group companies, then the reasons for choosing this approach should be fully explained.”
- Alternative 3 – Use ADRs for international peers (for US companies only): If international peer companies are traded on American Depository Receipts (ADRs), then the ADR prices can be leveraged for calculating TSRs. This approach will capture the historical currency fluctuation. On the downside, not all international securities trade on ADRs and may not mirror the international currency. Further, ADRs also may differ from global stock prices because ADRs will also reflect the market’s expectation of future currency changes.
The use of international peers in RTSR plans is growing in prevalence, and we anticipate that trend to continue going forward. Our general recommendation is to leverage Alternative 2 (convert to a common currency), supplemented by Alternative 3 (use ADRs) if and when appropriate. This decision will require some judgment in advance of the grant date by your compensation committee to ensure that the appropriate global security is selected as your comparator.
If you would like to talk further about international peers, please contact one of the Infinite Equity consultants.