The Fundamental Problem With Essent Group

Aug.11.14 | About: Essent Group (ESNT)

Summary

The compensation committee is weak.

The Chairman is strong.

The corporate governance is poorly designed.

Essent Group Ltd. (NYSE:ESNT) could be a very appealing company. The problems facing the stock, in the area of conflicts of interest, are relatively few and all focused around a poorly designed structure for the compensation committee. If those problems were fixed, I think the stock would deserve a premium to its peers. Until those changes are made, and I doubt that will happen, the stock does not deserve to trade at a premium. This piece will be focused on the potential for conflicts of interest. The analysis is largely qualitative and the goal is to identify what potential conflicts, if any, could arise based on the structure. It isn't feasible to predict every problem, but it is possible to foresee many of them. In my opinion, investing in REITs without checking for these problems is like driving with your eyes shut. When something entirely predictable happens you'll hear people saying, "We never saw it coming!"

The table below breaks down some of the most common problems. Some fans of the stock may argue "Every company does that". They don't. Some REITs are better, some are worse, and some are worthy of cringing.

This chart has numbers, letters, and colors. What does it all mean?

Green means I found strong evidence that the potential conflicts were not present or were effectively mitigated.

Yellow means the evidence was insufficient for me to declare that there was no potential problem there.

Red means I found strong evidence that the potential for conflicts of interest was present.

Numbers indicate the page number on which I found evidence. There may be evidence on multiple pages. If the evidence on a single page is sufficient to make a decision, I only list that page. Sometimes it takes multiple pages viewed as a whole to reach the required level of evidence.

The letter K or the word Proxy is listed to let you know if I was looking at the 10-K or the Proxy statement when I found the conflict and recorded the page number.

With that cleared up, I'll move on to the individual findings.

CEO/Chairman

The same person, Mr. Casale, is filling both positions. I'm not a fan of that. I don't think the CEO should be the most powerful member of the board that is supervising him.

External manager structures

The company is internally managed, which is a good thing for shareholders. It helps us get access to important information.

Not arm's length

In a quick analysis, it would be pretty easy to miss this. The company references transactions that were completed at arm's length basis, and certainly some of the transactions were. However, the compensation committee has fallen short of the goals shareholders should have for them. The committee has hired an independent compensation consultant group to advise them on compensation. I'm okay with that. It's expensive, but it sure beats throwing away far more money on excess compensation.

The problem is the way goals are set and measured. Here is the portion that caught my attention:

" Our compensation committee seeks the views of our chief executive officer in setting and administering our executive compensation programs. In particular, at the beginning of each year, Mr. Casale oversees the development of corporate and individual goals for purposes of annual and long-term compensation. These goals are derived from our corporate business plan and include both quantitative measurements and qualitative considerations selected to reinforce and enhance achievement of our operating and growth objectives. The compensation committee reviews these goals with Mr. Casale, adopts revisions it deems appropriate and determines the final goals for compensation.

Following the end of each year, Mr. Casale reviews with the compensation committee, at several meetings, the achievement of corporate, business unit/regional and individual goals and the performance of each other named executive officer and presents his evaluation of such executive officer's performance to the committee. Decisions about individual compensation elements and total compensation are made by the committee, using its judgment, focusing primarily on each named executive officer's performance against the officer's performance goals as well as our overall performance. With respect to the non-quantitative performance measures applicable to our executives, the compensation committee relies heavily on the views of Mr. Casale (other than as to himself). As chief executive officer, Mr. Casale oversees the day to day performance of the other named executive officers. As such, our compensation committee believes that he is well positioned to evaluate their performance and make recommendations as to their overall compensation."

I'm going to break that down so it makes sense. Mr. Casale is the Chairman, CEO, and President. He is in charge of the development of goals for the company and for individuals. Those goals are used to determine how much each person is paid. The compensation committee reviews the goals and has the authority to change them. When it is time to determine how much to pay the other executives, Mr. Casale is considered the best resource.

Who would stand up to him? If a member of the compensation committee determines that his goals are too simple and will result in ensuring he reaches the target, what will they do? Will they convince the committee to change the goal? Will that member of the compensation committee think they will be serving in the same position after the next election? Institutional firms vote in favor of management, they rarely do adequate proxy research. If the chairman recommends a group that doesn't contain that member, effectively, they're out. The chairman can, for all intents and purposes, fire them for trying to set new goals for him. That is not even remotely independent.

Will any other executive stand up to him? Standing up to him could mean that they are likely to miss their qualitative goals. It was the Chairman that designed the goals and evaluates them. I am not impressed.

I get that some people that are long on the stock may be upset that I just keep hammering on this point. Effective communication in our culture isn't subtle. Winston Churchill said, "If you have an important point to make, don't try to be subtle or clever. Use a pile driver. Hit the point once. Then come back and hit again. Then hit a third time - a tremendous whack." Here's the whack:

Click to enlarge

In 2012 the CEO was paid about 1 million dollars. In 2013, he made nearly 20 million. Who feels good about that raise? Who feels the compensation committee unilaterally served the interest of the stockholder? They were paid to represent the shareholders. In my opinion, the compensation committee doesn't deserve to be paid. They failed the stockholders. Anyone wonder if the chairman will nominate them to continue in their role?

Golden parachutes

The parachutes range from 1.5 to 2 times the annual compensation. Lower than the industry average, but higher than companies that are intentionally restricting parachutes.

Equity based compensation

It does not appear that this is going on. I would not consider it a significant risk at this point.

Adjusted "Equity" definition

This doesn't appear to be happening, but for the sake of clarity I will explain it. If you're only concerned with the conflicts that are happening, you can skip to the next section.

The explanation is a few paragraphs, so I'm reproducing it from another article I wrote:

"Many REITs that create external manager structures provide themselves a payment based on the book value of the equity. At first, that might seem okay. The executives would have an incentive to grow the equity so they could be paid more in later years, and they wouldn't get paid for taking on excessive leverage. Sounds good, right? Most REITs redefine the term 'Equity'. They don't all use the exact same definition, but most definitions include that Equity will not include adjustments for changes in AOCI (Accumulated Other Comprehensive Income) or Retained Earnings or Loss.

In practice, that means the best way to increase their compensation is to continue issuing shares. To give an extreme example:

Company Imagination earns 0 dollars in net income. They pay out 1 million dollars in dividends. They issue stock for 1 million dollars. Under the 'Adjusted Equity' definition, their value of equity has increased by 1 million dollars and they will proceed to pay themselves a percentage of those one million dollars every year."

That is an example of how it is done in the most simplistic form. Normally management will try to disguise it.

Indemnification

The executives have been indemnified. It's the industry norm, but it doesn't encourage ethical behavior. Indemnification isn't worth much unless you're planning to do something wrong, but it is very common. When executives are not indemnified, then I'm surprised.

Other employment / No meaningful restrictions / Competing employment

Non-compete clauses are effective during the time the executive is employed and for 18 months afterwards. For Mr. Casale, it is extended to 24 months. That matches the pay period for the parachutes. It seems wiser to have the non-compensation clauses only be effective during their employment and for a week afterwards, then apply a non-solicitation agreement that lasts for two years. That removes part of the argument executives have for absurd parachute payments.

The wording used in the proxy isn't very strong for a non-compete clause, but it may just be the person preparing the financial statements figures no one is actually going to read the thing. Given that the non-compete clearly applies to the industry segments that the executives have experience in, I'm not too concerned about them taking a job delivering pizza and having it cut into their schedule. The important parts of the non-compete appear to be there.

Conclusion
ESNT has some significant conflicts of interest. Nearly all of the problems stem from a poorly designed plan for the compensation committee. They do try hard to come up with ways to make the compensation committee sound good, but it is a tall task. When the CEO and Chairman are the same, it takes significant measures to keep the compensation committee beyond the reach of the chairman. It is not impossible, but it requires a very direct approach to tackling the problem. The approach used by ESNT was more akin to dancing around the problem and hoping it would go away. That weakness undermines what is otherwise an appealing company.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from either Yahoo Finance or the SEC database. If either of these sources contained faulty information, it could be incorporated in our analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.