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Equity Compensation Hedging

Share Based Compensation Expense

To align shareholders and management, equity compensation is a large part of all-in pay and for retention purposes. Companies will generally use a combination of stock units and stock options.

Stock units such as restricted stock units (RSU’s), deferred stock units (DSU’s) and performance share units (PSU’s) represent one share in the company that will be paid out under certain conditions.

For RSU’s and DSU’s, these will vest over certain time periods – either 3 years or upon retirement/termination (for Board of Directors). Accordingly, as significant shareholders of the corporation, the hope is that management will act in the best interests of the broader shareholder base. The number is fixed.

PSU’s are different in the way that a number is assigned a multiple based on whether or not key performance indicators (KPI’s) are met. So for instance, this may be:

100,000 PSU’s
1) Performance of Technology stock versus S&P 500 and versus S&P Technology Index
0% if underperformed Indices by 5% or more
50% if underperformed indices by 0-5%
100% if outperformed indices by 0-10%
200% if outperformed indices by over 10%

100,000 PSU’s
2) Annual Growth in Daily Average Users
0% <10%
50% Above 10%
100% Above 50%
200% Above 100%

250,000 PSU’s
3) Growth in Cloud Computing Market share
0 50 100 200 and so on

There will usually be multiple criteria in the PSU calculation and may be over 3-year performance measurement horizons to detract from short-term thinking. As PSUs are lucrative, investors should be cognizant of when they may want to bend accounting treatment a certain way – but that is beyond the scope of this article.

Accordingly, there is no fixed number to be paid out, but in addition to meeting performance indicators that are ideally aligned to management, as the payout will be based on the then share price, managers will be incentivized to act in the best interests of their fiduciaries.

Agency Problems in Corporate Compensation and Hedging Considerations

When these are not aligned with real shareholder objectives, this can cause agency problems between management and ownership. As discussed in corporate governance classes, simple examples include having PSU KPIs include revenue only (where management can boost revenue at the expense of costs and end up depleting net income and cash flow, which is what truly matters to shareholders) or cost only (converse of the previous example) or deleveraging as an isolated context (can just sell off core and valuable assets to pay down debt).

Management is usually less amenable to engaging in equity compensation hedging discussions as less sophisticated treasury staff may perceive it as “right way risk“. This makes sense on the surface as when the stock price is going up, things are generally going well and the corporate can afford to suffer higher payouts. Likewise, when the stock is doing poorly, it could be that the corporate is haemorrhaging cash and can ill-afford to have an additional tax on operations.

Regardless, equity compensation hedging allows for corporates to fix their equity compensation costs, which generally have far more upside than downside. As an example of confidence, Microsoft used to sell puts on their own stock in the Bill Gates era, boosting earnings as the share price continued to boom. A corporate that is confident in the execution of their plan is the best candidate for share based comp hedging.

Additionally, there may be a stock which is doing really well but may not have cash flow – so if share price is flying for reasons other than performance, the company may well take a hit just from equity price volatility.

How to Hedge Share Based Compensation Expense

Stock units are generally cash settled or at the option of the holder (where an investment banker would assume that this implies cash settlement). This is opposed to physical settlement where the holder is granted stock when it vests. As such, the cash outflow is more punitive from a cash flow perspective and accordingly more easily hedged.

As you may surmise, since the stock moves either up or down, an equity swap (or total return swap as highlighted in the CFA curriculum) is the appropriate instrument to fix the amount paid upon vesting. A corporate may also look into options.

PSU’s are far more difficult to structure a hedge for because the amount to be hedged is not known, even if there is some confidence pertaining to the KPI metrics.

Stock options can be hedged by buying similar stock options from a market maker. The options you will see in the 10-K are basically the company writing call options for staff, with the premium being part of the compensation. This can be offset easily by purchasing options with the same strikes and maturities from an investment bank.

These products can also be used on convertible bonds and other equity-linked instruments. Of course, there are a host of equity derivative strategies that corporates can use beyond this.

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