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Global Governance Advisors

What are Peer Groups and Why are they Important?

Posted by Brad Kelly on Mar 25, 2019 9:00:00 AM
Brad Kelly
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In 1864, Herbert Spencer’s book, Principles of Biology, introduced the world to the phrase “survival of the fittest.”  This phrase then sparked the ongoing argument surrounding competition and whether it is ingrained in human nature. So, it can be argued that if there is an opportunity to compare one thing to another, it is second nature for competition/comparisons to arise. In essence, once there is more than one of anything it is natural for competition/comparisons to surface.

Within markets and economies, objective comparisons between organizations naturally help determine which firm is the most productive, most profitable, fastest growing, etc. and for any organization that is keen on understanding and monitoring its performance, appropriate peer groups are the most logical way to assess were it stands in the marketplace.

Peer groups are commonly used to benchmark performance in a myriad of areas such as:

  • Revenue/Earnings/Investment Returns/Profit
  • Asset levels/market capitalization/size
  • Market share/growth rate
  • Productivity/product development/outputs
  • Human capital Recruitment/Retention
  • Compensation salary/incentives/benefits

However, if the peer group is inappropriate or poorly constructed, it will most likely lead to a skewed or distorted view of your standing/performance in every area you are monitoring.

First and foremost, peer groups must be comprised of organizations that are similar to the one you are assessing. Simplistically, you should always focus on comparing apples to apples.

1 apples

This means that your peer group should always be comprised of organizations that are similar in size, sector, and, if interested in geographic competition, similar location or areas of operation. Likewise, if you are assessing compensation levels, the positions within these organizations must be similar in scope and responsibility level.

Trouble with comparisons often stem from inappropriate comparators included in peer groups. Similarly, you should avoid comparing apples to oranges at all costs.

Although this can be tempting, because bench-marking data can always be skewed in your favor by including the right “poor performer” or “high payer”, no matter what you may assume, the “oranges” will always stick out which inevitably leads to future problems such as:

  • Setting compensation levels either too high or too low
  • Increased stakeholder, government and media scrutiny
  • The need for sudden corrective actions with incumbent employees
  • Heightened public relations problems and activist investor targeting

1 apple

An obvious example of this could be when a manufacturing company includes financial services companies in their peer group solely because they operate within the same geographic location. The outcome of such a practice will most likely push the assessed median compensation levels higher and inappropriately lead a board to think that they might be underpaying their Chief Executives and Senior Leadership Team. Or conversely, mature companies could include smaller “early stage start-ups” in their peer group which could make their productivity or output levels appear comparatively high – which could help justify higher incentive payouts.

As a best practice, at times it may be appropriate to set multiple peer groups. If you are looking to expand into a new market (sector/location) or expand through acquisition, it would be appropriate to establish an “aspirational” peer group to help your board and executives best understand how this change will most likely impact things such as your performance expectations and compensation levels. Far too often, organization make changes first and then only later suffer from sticker shock in terms of what their new peers pay their employees or set as performance outputs. In these cases, it would always be helpful to establish this new peer group and investigate the impacts as part of your due diligence and preparation.

Alternatively, it is also a best for publicly traded companies to proactively set up alternative peer groups that mirror the groups used in their Institutional Shareholder Services (ISS) and Glass Lewis assessments. Far too often, companies are caught off guard by the algorithms used by these groups to pick comparators that do not match the group you’ve thoughtfully established. Actively monitoring your ISS and Glass Lewis peer groups will enable you to preventively deal with any potential criticisms that may result from these alternative comparisons.

Overall, well thought out, well structured peer groups will always help you objectively set targets, assess performance, ensure you are paying fair and competitive compensation levels and proactively enable you to deal with external criticism. Given the usefulness and importance of properly compiled peer groups, maybe its time you follow this best practice and get your apples in order!

Topics: GGA, Executive Compensation, Peer Groups