A memo from Credit Suisse CEO Brady Dougan yesterday setting out alternative ways of paying a proportion of employee bonuses through a derivative-backed structured note had pulses racing among some in the investment banking community by the evening.
The creation of alternative products for paying bonuses is expected to be commonplace over the next few years. Firms have also reportedly increased bonus deferrals and capped cash bonuses as they battle with lower trading volumes and upcoming regulatory measures that are expected to increase business costs.
Alternative bonus payouts via investment products have emerged over the last few years, but market officials say that such structures are likely to increase, with many being more exotic in terms of underlying and payout. Alternative ways of paying bonuses have been achieved through investments from a pool of collateralized debt obligations and via subordinated notes (DI, 2/26/10). The former was used by Credit Suisse in 2008. They have increased 70% in value since, according to news reports.
Lawyers said they have been working with remuneration committees at investment banks as a way of implementing bonus schemes that reward those employees and businesses that have performed well over the last year, while satisfying some of the calls from politicians to change the way bonuses are paid out in the City. Regulation has also been factored into how bonuses are paid out, as firms look to improve capital ratios as per the Basel III requirements.
“Aligning the performance of the bank with the reward of employees has been an ongoing project over the last year,” one employment lawyer said. Some market officials noted that the creation of alternative products could be construed by some as disguising the amount of cash employees are being paid, but that the objective of aligning the performance of firms with that of employees was being achieved to a greater extent.
What regulators and politicians will scrutinize when products are created is the value of the products, the threshold to which those products are made available and the proportion of those products within bonus packages that include cash and stocks. One lawyer said he expected the coupon to be examined closely as well, including the value of the coupon and the frequency of the payout, and expected firms to be asked to disclose the specifics of such products.
Credit Suisse’s PAF2 structure pays a coupon of 5-6.5% over nine years and is backed by derivatives on 800 entities. A spokesman in Zurich declined to comment on the memo, noting that further details of the remuneration policy will be announced in the firm’s annual review in March.
Memo From Brady Dougan, ceo of Credit Suisse
| MESSAGE FROM THE CEO To all Managing Directors and Directors
2011 Compensation Plan The industry is obviously going through a challenging period. of Some this is cyclical, but some of the changes are structural and here to stay. They are affecting virtually all aspects of our industry.
The Executive Board and I believe it is important to adapt quickly to the new requirements and environment so that we get to a sustainable business model, ideally ahead of the competition. Naturally this entails a lot of challenges and it is not always transparent as to how the different strategies are paying off. But we remain convinced that accelerating our strategic evolution will be a tremendous competitive advantage in the coming years. In addition, for all public companies, and especially for those in the financial industry, the relationship between employee returns and shareholder returns is being scrutinized and criticized.
So, against this backdrop of pretty challenging conditions we have decided to make changes to the compensation approach for our most senior people, Managing Directors and Directors across the Bank. The most significant element is the introduction of the PAF2 instrument – a fixed income structured note – that we announced at our call earlier today. We strongly believe these changes will allow us to: |
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- accelerate our progress in implementing our strategy – particularly the impact the PAF2 structure has on our risk profile |
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- demonstrate to our shareholders and other outside constituencies that we are taking a constructive and creative approach to compensation and ensuring that it also furthers our strategic goals |
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- provide an attractive diversified investment for our most senior people |
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| That is not an easy set of goals to achieve, but we think we have a good solution towards that end.
There are a number of things that will not change from what we announced in November. First, outside the Managing Director and Director population there will be only changes to a small number of employees. Second, there will be no change to the cash variable compensation or the share component of the variable compensation awards. Third, the deferral rate will remain largely the same for everyone outside of Investment Banking. In Investment Banking, however, the deferral rate has been increased from the previously announced rate.
As to the PAF2 instrument itself, we believe it is a good instrument that will support both the Firm’s strategic transition by helping reduce risk and pay a good return for employees in most scenarios. It is essentially a fixed income structured note. The instrument has a stated 9 year maturity but has a call in 4 years. It vests in March of 2012. It pays a coupon of 5% for Swiss franc holders and 6.5% in USD for holders elsewhere, but also carries some risk. The risk comes from a diversified portfolio of derivative counterparty risks. The principal (for both interest accrual and final redemption) will be reduced by the cost of any defaults in the portfolio. The first USD 500 million of losses in the portfolio will be borne by the equity tranche which is owned by the Firm. Losses beyond that, if any, would reduce the principal value of the PAF2 units. The employees’ interest in this portfolio will be overseen by the same group that has managed PAF1 – including Jonathan McHardy and Wilson Ervin.
Instruments such as PAF2 are inherently hard to value. It’s obviously not something that is traded in regular markets so has to be modelled. PAF2’s model value depends on a variety of factors including whether it is priced to its final 9 year maturity or to the four year optional call date. It depends on future market volatility, and whether derivatives exposures are treated identically to other credit risks. But our best estimate today of model value is at a discount to the stated face value. The ultimate value for you as an investor will depend on actual credit outcomes over the life of PAF2.
The portfolio has about 800 different names spread across industries and geographies. It covers about 18% of the credit exposure in our derivatives business. The portfolio is 94% investment grade, and about half is collateralized. Based on an analysis of our historic experience for defaults – including the severe downturn in 08-09 – the notes would have performed well. This is an at-risk investment, but our best estimation from actual experience is that this will pay its interest and principal in full.
PAF2 is a risk transfer from the Firm to employees. The structure results in a reduction in our risk profile, thereby helping to accelerate our strategic goal of risk reduction and capital efficiency. PAF2 represents an effective and real sharing of risk but, nonetheless, we still need to reserve the right to amend this structure in the event of changing requirements. The most likely change would be to amend PAF2 to an instrument that instead of referring to our specific portfolio would reference a public index of credits. In our view this would be just as good for our employee investors. We also need to include a call at market value in case these requirements change so materially that the instrument is no longer effective.
We are organizing a series of meetings held by Jonathan and Wilson to take you through the details of the structure and the key drivers of performance. We hope this will allow you to understand the structure more and answer any questions you have. The first one will be held tomorrow, and will also be available by webcast.
We are trying to strike the right balance and align employees with shareholders. These measures help to put us in a good place and to perform well in 2012. In 2011 we took a number of important steps – the risk and cost reductions which we completed were difficult but necessary – and these have put us in a better place to be competitive in current conditions.
In some ways this is similar to the objectives we had for PAF1, which helped us reduce risk and improve our position in 2009. That program helped the Firm at an important time and also has performed well for employees – PAF1 is up about 70% so far. While PAF2 is different, and future credit conditions may be different, we are trying to strike the same balance of strategic repositioning and fair compensation.
The Executive Board and I are convinced that PAF2 is a good instrument, the right instrument to compensate our senior leaders. We have made good progress reducing risk which puts us ahead of much of the competition. PAF2 helps accelerate our risk reduction effort – it is a very effective risk reduction measure and the right thing to do in the current environment. It provides a healthy coupon, provides a long-term incentive, and it helps the Firm achieve its strategic goals.
This is an important leadership moment – as senior leaders of the Firm we are counting on you to understand the changes in our compensation plan and appreciate the broader context and the benefits to Credit Suisse and our employees.
Brady |
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