The failure of drinks distributor Conviviality (CVR:AIM) has highlighted a growing problem with UK smaller companies, namely the misalignment of interests between shareholders and executive management.

I am shocked how large institutional investors are prepared to throw vast sums at small companies embarking on an acquisition strategy yet demand little real financial commitment from executive management of those companies.

To make matters worse, many institutions also seem happy to approve excessive pay packages uncorrelated to ‘real’ returns.

WHY CONVIVIALITY’S INVESTMENT CASE CHANGED

My own firm used to hold shares in Conviviality but were compelled to sell in October 2016 having reassessed its acquisition strategy, management remuneration and their absence of ‘real’ equity ownership.

While Conviviality’s share option scheme meant there was plenty of incentive for management to increase the share price, up until March 2018, the chief executive had never actually acquired any shares in the business, despite being richly rewarded and having plenty of opportunities through numerous fund raises.

I would have expected institutional investors to have demanded real equity participation from the chief executive in the fund raises.

This state of play is prevalent throughout AIM and, I would suggest, increasingly linked to sub-par performance.

It’s worth reflecting that the best performing small companies are generally led by entrepreneurial founders who have made a material capital commitment to the business and retain a large equity stake.

POOR MANAGEMENT ALIGNMENT IN AN EARLY STAGE BUSINESS

ITM Power (ITM:AIM), the energy storage and clean fuel company, has struggled to make much progress since listing in 2004 when it raised £10m at 50p per share. Fast forward 14 years and numerous fund raises later, the share price stands at 32p.

The latest interim results saw income of £4.4m and a loss of £2.9m, bringing cumulative losses to nearly £62m.

The board of directors of this cash-consuming business numbers a seemingly excessive eight people, including four non-execs. Chief executive Graham Cooley has been in place since 2009 and holds approximately 0.35% of the shares.

Directors’ remuneration of £1m in 2017 included £389,000 for Cooley, who has been awarded aggregate remuneration of £1.68m over the past five years. This appears excessive for a loss making business that has raised £42.9m from shareholders over the same period.

I note Cooley acquired 176,470 shares in 2017 at 17p (£30,000) but this is apparently the only share purchase he has made since 2013.

The chief executive’s generous package also seems at odds with the remuneration of other employees, including the chief technology officer, all of whom are the key drivers to the future success of ITM.

I am surprised that a cash consuming business like ITM offers such generous remuneration to a single person, seemingly uncorrelated to the real performance of the business and its share price.

BETTER SHAREHOLDER ALIGNMENT, IF SLIGHTLY ONE-SIDED

Lakehouse (LAKE:AIM), the asset and energy support services group, has had a challenging time since floating on the Main Market in 2015 and subsequently moving to AIM in 2017.

In July 2016, shortly after announcing dreadful interim results for the period ending 31 March 2016, and the share price sinking to 25p, Bob Holt was appointed executive chairman.

The board of Lakehouse believed Holt’s expertise in support services and his track record of turning around underperforming companies would be invaluable to the group.

In connection with Holt’s appointment, the board put in place a revised directors’ remuneration policy and adopted a new share incentive scheme.

STRONG REPUTATION

Holt comes with a good reputation and was instrumental in growing Mears (MER) to a market capitalisation of over £360m (at 3 April 2018).

Although, it’s worth noting that the market capitalisation of Mears has fallen approximately £180m in value since April 2017, which is broadly twice the fall in value of Lakehouse since it listed. A harsh comparison perhaps, but suggestive that Lakehouse’s problems may also be partly sector related.

Holt receives basic remuneration of £225,000 per annum at Lakehouse and the share incentive scheme could see him receive approximately £4.5m in shares should the share price rise above 98.40p by end January 2019.

Two fellow directors are also beneficiaries of the new incentive scheme, although not to the same extent as Holt. It’s not clear how long the directors will need to hold the shares and Holt has not purchased any shares in the company since joining.

While the awards are based on share price performance (which admittedly needs to be pretty spectacular), and therefore ensures a large degree of alignment with shareholders, the performance period is very short and seems to have little regard for the longer-term success of this business.

More significantly, I question how one individual is assumed to be of such high value relative to others in a people business of this nature. If anything, an award of such magnitude surely risks breeding resentment among the real workforce which is essentially working for Holt.

WHY AREN'T DIRECTORS BUYING SHARES?

In similar vein to Conviviality, Restore (RST:AIM), the records management and commercial relocation provider, whose shares my firm used to hold until recently, is another acquisition driven business, however, that’s where the comparison ends.

Unlike Conviviality, Restore has, up to now, been a resounding success under chief executive, Charles Skinner who joined in 2009.

Skinner showed his commitment to the future of the company by acquiring an aggregate £132,000 of shares in 2010 which brought his total holding to 511,415 shares.

I acknowledge this purchase represented a meaningful commitment, however, it’s disappointing to note that since then Skinner doesn’t appear to have participated in any equity raises supporting Restore’s numerous acquisitions, despite being well remunerated.

In May 2016, having been granted just over 2m shares through exercising options Skinner immediately sold 1.6m shares resulting in a holding of just over 1m shares, all of which were now effectively option based.

In 2016 Skinner received 3,518,145 nil cost share options after achievement of performance hurdles, which were a rather modest share price performance exceeding 10% annualised growth in market capitalisation of the company, adjusted for dividend payments and new equity raised.

Upon this hurdle being achieved participants may receive 10% of the value created above the hurdle.

In April 2017 Skinner exercised further option shares lifting his holding to 1,538,560 shares (1.36% of the equity), all now nil cost option based.

I believe the CEO and other executive directors could certainly give more confidence to shareholders by supporting future equity raises, backing the acquisition strategy with their own hard-earned money.

RAISING STANDARDS

In general, it’s about time large institutions stipulated that executive management participate in fund raises, up to an agreed minimum.

Executive management should also be obliged to retain a minimum number of shares, outside any option scheme.

Such an approach would ensure more thought is given to acquisitions, achieve better alignment with all shareholders and hopefully help avoid Conviviality-like disasters.

Chris Boxall,
joint founder of Fundamental Asset Management

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