The Background: Beginning with this proxy season, ISS will use metrics based on "EVA"—economic value added—as part of its pay-for-performance analyses. ISS claims that this use of EVA-based metrics will present a better picture of a company's value creation and permit more meaningful pay-for-performance comparisons among companies, notwithstanding differences in their capital and operating structures.
The Issue: Although EVA is not a new concept and ISS previously calculated it, ISS did not use it in its recommendations, and few companies use it as a performance metric. Further, the EVA-based metrics that ISS will use are subject to many complexities and adjustments that could make comparisons among companies less meaningful. Perhaps most importantly, ISS's EVA-based measurement of company performance as part of its say-on-pay assessment may incent unwanted executive decision-making and could penalize those CEOs who are focused on long-term, sustainable growth.
Going Forward: Companies—including their compensation committees—should study the EVA-based data in their 2019 ISS voting reports, develop their own EVA-based financial performance assessments, and determine whether (and if so, how best) to discuss in their public filings whether EVA-based metrics are an appropriate way to measure company performance. This is an abrupt change in ISS's methodology, and while ISS has suggested that few companies' quantitative pay-for-performance "concern levels" should be modified by this new EVA-based performance assessment, companies and their compensation committee members should anticipate this issue and prepare to respond appropriately.
As the 2020 proxy season unfolds, companies should take note that a recent change in ISS's methodology may impact its pay-for-performance analyses—and ultimately their say-on-pay votes. Specifically, ISS will include in its quantitative pay-for-performance screens a new financial performance assessment based on "economic value added"—or EVA—metrics, rather than the GAAP-based accounting metrics used to date. While ISS's 2019 voting reports included an EVA-based performance assessment for informational purposes, those assessments generally received little attention because they were not used in ISS's pay-for-performance assessments or to determine its say-on-pay voting recommendations.
So why did ISS make the switch to EVA? Some will say that the change was driven by ISS's 2018 acquisition of EVA Dimensions LLC, a firm that measures and values corporate performance based on—you guessed it—EVA. Simply put, EVA is calculated as a company's net operating profit after taxes, less a full weighted average cost of capital charge on total capital. ISS asserts that its use of EVA will facilitate comparisons of CEO pay and performance among companies with different capital structures, operating models, and industries. Further, ISS claims that measuring EVA and tracking changes in EVA are a superior method to analyze and value a company's true economic profit, or value creation (rather than its accounting profit), particularly because EVA adjusts for a company's cost of capital.
Are ISS's contentions correct? There is no guarantee that EVA-based metrics will improve the comparability of company performance—EVA is not a standard measurement, and its computation is more complex than it might seem. Differences in its interpretation and calculation (particularly the cost of capital element) may cause distortions that impede meaningful comparisons between companies. Further, EVA may prove confusing for investors who are accustomed to ISS's use in prior years of GAAP-based measures in pay-for-performance evaluations.
Perhaps more importantly, are EVA-based metrics really a better measure of a company's performance? One problematic aspect is that EVA-based measurements can reward CEOs of turnaround companies even if the expected upswings in the companies' performance have not yet been achieved. The use of EVA can also penalize companies that are investing heavily in the future but not yet realizing the fruits of those investments. Accordingly, the use of EVA to measure performance could incentivize management to pursue projects with quick returns, rather than the multi-year investments that a company may actually need to make in order to realize long-term, sustainable growth.
For this reason, we believe that ISS's use of EVA may actually promote short-termism, rather than the long-term outlook necessary for sustainable value creation—and for a focus on the sustainability issues that are critical in the current environment.
So what should companies do to prepare? Companies and their compensation committees should first analyze the EVA-related information provided in the company's 2019 ISS report (which can also be obtained through ISS's website). Second, companies should compute their own EVA-based financial performance assessments for 2020. Finally, companies should consider whether to disclose any EVA-related information in their 2020 proxy statements in anticipation of the assessment that will be contained in ISS's 2020 report.
Of course, responding to an ISS report before it is issued is tricky—and some companies may instead decide to wait to respond to an unfavorable ISS assessment through supplemental proxy materials. But companies that are forewarned that their 2020 pay-for-performance scores may decline due to ISS's change in methodology may wish to get in front of this issue by communicating to investors that ISS's evaluation is inaccurate or misguided—or that the concept of EVA is not a relevant or reliable predictor of the company's performance, and why.
Two Key Takeaways
- ISS's 2020 pay-for-performance assessments will include a quantitative screen based on EVA—economic value added—rather than previously used GAAP-based concepts.
- Public company compensation committees should assess how ISS measures EVA and determine whether and how it affects their CEO's pay-for-performance analysis. Companies affected by this change in ISS methodology should be prepared to explain why EVA is not an appropriate metric for evaluating company performance.