Compensation peer group composition has been a hot topic with our clients of late due to the impact of a variety of strategic factors, including: industry consolidation, uneven impact of the COVID-19 pandemic on companies, and blurring of lines between industries due to technology and digitalization.
Role of Compensation Peer Group
The compensation peer group is used to inform on the competitive market for executive and non-executive director compensation levels and practices. The companies used for compensation comparisons do not necessarily need to be the same companies that are used for comparing company performance.
Compensation peer groups have historically been developed by selecting industry competitors of similar scope and scale (most commonly revenue and market capitalization); however, industry consolidation can lead to situations where it becomes increasingly difficult for a company to identify a robust number of companies of similar scope and scale that can be used for compensation benchmarking. In these situations, companies might be tempted to expand their peer group parameters to include meaningfully larger or smaller direct industry competitors. While these companies might represent direct competitors for industry talent (particularly below the executive level) or customers, they might not be the most appropriate companies to help establish the market value of the executive jobs.
An alternative approach is to broaden the peer universe and develop a compensation reference group. Compared to traditional compensation peer groups, compensation reference groups typically include more companies from a wider array of industries and might not represent the best group for performance comparisons. Potential reference companies can be screened using a combination of quantitative and qualitative business characteristics that influence executive pay. In the context of administering executive pay, these business characteristics can be characterized as “compensable factors.” These compensable factors are the basis upon which the market value of a job can be established and influence the way in which pay is delivered. Sample compensable factors include the following:
- Quantitative: margins, asset intensity, sales per employee, revenue growth
- Qualitative: global sprawl, technical complexity, place in the business cycle, business type (e.g., business to business versus business to consumer)
Uneven Impact of COVID-19 Pandemic on Companies
The COVID-19 pandemic had an uneven financial impact on industries and companies. For some companies, this created situations in which their financial results and market capitalization diverged from their peers. As companies evaluate the potential impact on their peer groups, it might be appropriate to consider the following approaches:
- Wait and see: Companies could delay making changes to their peer groups until market conditions have stabilized. This provides year-over-year consistency in the peer group and mitigates the risk of making changes to the peer group this year that might need to be undone if the company’s performance and its peer’s performance converge the following year.
- Broaden the peer screening criteria: Generally, peers are screened and selected by evaluating companies within a reasonable size range of the subject company (e.g., 1/3x to 3x revenue). It could be appropriate to use a broader range for key financial screening metrics (e.g., 1/4x to 4x revenue) to address volatile market conditions.
- Use different periods for measuring financial performance: Peer screening criteria is often based on a company’s financials at a point in time (e.g., trailing four quarters of revenue or market capitalization as of a specific date). Companies could consider using supplemental measurement periods when evaluating peers to help normalize for market disruption (e.g., pre-pandemic revenue or projected FY2022 revenue rather than the trailing four quarters of revenue or one-year average market capitalization rather than market capitalization on a single day).
Blurring of Industry Lines
Technology and digitalization of companies’ business models is blurring the lines between different industry verticals. The implementation of a new business model could require a company to recruit outside executive talent with a different skillset and from a different talent pool than its existing executive team. This in turn could require companies to re-evaluate whether or not they have the right definition of the competitive market (i.e., peer group) for setting executive pay. Potential approaches include:
- Broaden peer group to increase exposure to a company’s new end markets and segments (e.g., a brick-and-mortar retailer might include online retailers / ecommerce companies). As companies begin to broaden their peer group, they should avoid developing peer groups that are too aspirational (i.e., including companies that are outsized or overweighting companies that reflect the companies future state rather than current state) and don’t align with how proxy advisory firms or investors define the competitive market.
- Transition from using revenue as the primary financial screening criteria to market capitalization as it should account for differences in business models and characteristics (e.g., margins, growth, etc.) between companies in the same industry.
In addition to reviewing their compensation peer groups, companies might also need to re-evaluate how they apply their compensation pay strategy when recruiting outside executives. In certain situations, companies might need to pay at the 75th percentile or higher of their peer group to attract executives with unique skillsets or critical to executing their evolving business strategy.
Dynamic market conditions and evolving business strategies are having a wide impact on the financial performance and executive talent needs of organizations. Companies need to make sure that their executive compensation peer groups reflect this dynamism and evolution so that they can continue to support the human capital needs of the business.
Matt Lum works with clients across a wide array of industries and within various stages of the business cycle. He has experience in aligning companies’ incentive plans with their long-term strategy, advising on total compensation structures, and comparing pay and performance.
Fiona Blumin works with both public and private clients across a variety of industries. She provides consulting services focusing on all elements of executive and board compensation, specializing in executive compensation trends, director compensation, peer group development, and incentive program design.
Becca Jordan works with both large publicly traded clients and smaller privately held companies across a wide range of industries. She provides consulting services in various areas of compensation matters, specializing in director compensation benchmarking, executive compensation trends, and peer group analysis.