Goyder's extraordinary Coles cash-in

After 82 per cent of Wesfarmers' shareholders voted to accept proposed mid-stream changes to Richard Goyder's incentives arrangements, he is going to receive extra compensation that under the existing scheme he isn't entitled to. In principle that's bad governance, but Wesfarmers was confronted with some unusual circumstances.

Goyder's existing long-term incentive plan was put in place before Wesfarmers' $19 billion acquisition of the Coles, Target, Kmart and Officeworks businesses in 2008 in the lead-up to the financial crisis.

The key hurdle within the plan was a 12.5 per cent return on equity. Given that, in 2007, Wesfarmers had returned just over 25 per cent on equity of about $3.5 billion, that wouldn't have appeared too steep a hurdle.

Then, of course, Wesfarmers acquired the rundown Coles retail businesses, funding it largely by issuing, directly and indirectly, shares. The first tranche was issued directly to Coles shareholders during a period when Wesfarmers was trading around record levels and then, as the crisis emerged and grew, the group subsequently deleveraged by raising deeply-discounted equity from its enlarged shareholder base.

As a result of the Coles acquisition and the way it was ultimately funded, Wesfarmers' ordinary capital base exploded from less than 400 million shares to nearly 1.2 billion and its shareholders' funds from around $3.5 billion to more than $25 billion.

Not surprisingly, despite earnings that have continued to rise and which are now two-and-a-half times what they were pre-Coles, Wesfarmers' return on equity collapsed from that remarkable pre-crisis and pre-Coles level to less than eight per cent, with obvious implications for Goyder's incentive arrangements.

One might normally say to Goyder in these circumstances: "Bad luck mate, it was your call to buy Coles and issue all that equity and smash your ROE and you've got to live with that."

In fact, that helps us understand the dilemma the Wesfarmers board must have faced as they contemplated what would inevitably be a controversial move to change the arrangements to deliver Goyder up to $6.7 million of shares that he wouldn't otherwise be entitled to.

But the acquisition of Coles has, at the level where it really counts – the businesses themselves – been a stunning success.

The rehabilitation of the food and liquor business might still be a work in progress but the speed at which Ian McLeod and his team have turned Coles around and the extent to which they have forced the once-dominant Woolworths onto the back foot has been staggering. The rivalry of Kmart and the growth in Officeworks is highly encouraging and Target, while hit hard by the downturn in department store retailing generally, remains a very attractive business.

There is no argument that Goyder and the teams he appointed to rebuild those brands have added a lot of value for Wesfarmers shareholders, with the prospect of considerably more to come. His direct reports, operating with very different incentives to his, are raking in remuneration that is in some instances multiples of his own.

Had he not acquired Coles, or perhaps had he funded it differently, Goyder personally may have been better off. It is difficult to argue, however, if one takes a long-term view of its shareholders' best interests, that Wesfarmers shouldn't have made that acquisition.

Part of the problem for Goyder is that the 'E' in Wesfarmers' ROE was inflated by the way the Coles acquisition was accounted for and the fact that he was initially issuing shares at prices that were pumped up by the equity market bubble that developed in the lead-up to the crisis.

The Coles businesses are in Wesfarmers' books at the valuations provided by that pre-crisis share price but, because the businesses themselves have made such progress, he can't, under the accounting standards, adjust the values to more realistic levels.

The Wesfarmers board can't allow Goyder's subordinates to receive big incentive payments and their boss none for any protracted period and the directors would also be aware that the accounting for the Coles acquisition and the nature of the key performance metric in his incentive arrangements disguises how well Goyder has performed.

The two biggest proxy advisers recommended shareholders vote in favour of the changes to the incentives, in order to bring his incentives into line with his team's, although one expressed concern about changing a scheme after hurdles for incentives weren't met. The Australian Shareholders Association and the Australian Council of Superannuation Investors, however, voted against the change.

Because the board stated that it would give Goyder cash in lieu of the scrip he may otherwise have received in the event the proposed arrangements were voted down, the vote was more of a vehicle for protest than a way of preventing Goyder from receiving incentive payments in future – although ultimately, only a handful of shareholders dissented.

Changing incentive schemes mid-stream to be able to award incentive payments that haven't be earned under the scheme is generally very poor policy – indeed it would generally be regarded as outrageous.

There are, however, a number of unique and aberrant circumstances that have created the situation Wesfarmers has found itself in and that help explain why a highly respected board decided to ignore governance norms and bring the structure of their CEO's remuneration arrangements into line with those of the executives he recruited and oversees.