The importance of business cycles.

• Author: Lupo, Peter
• Position: PICKING A PEER GROUP

Peer group selection traditionally was a relatively simple process, in which companies focused on finding 10-20 firms of similar size and industry. There wasn't much need for a more in-depth search since peer companies were used primarily to benchmark pay and pay-design practices.

With investors and the media keenly focused on measuring the link between pay and performance, the use of poorly chosen peer groups is increasingly viewed as a factor in inflated executive pay packages. Aside from unwanted attention to the board and the company, the consequences of basing pay decisions on a peer group that is perceived as inappropriate include potential "say on pay" failures and voting campaigns against board members.

There is often a key--but frequently overlooked--factor in determining whether a potential peer company is really an apt point of reference: its alignment with the subject company's business cycle.

Evolving Approaches to Peer Group Development

In constructing a peer group, compensation committees juggle a host of new considerations. Where once a second peer group might have been created if a comparison with corporate performance was needed, governance advocates today maintain that both pay and performance should be measured against the same group of companies.

Among other analytics, companies are paying much more attention to ensuring that each peer company is sized appropriately by either revenue or market cap and assets for financial firms.

Another difference is that it's not enough for peer companies to be in the same industry classification: they also should have similar business model characteristics. Committees are digging deeper into whether a potential peer is primarily in the same business, related businesses or different business, and how their business model contrasts to the subject company's.

These decisions became paramount since peers, even if in the same industry classification, may either under- or over-perform the company under study solely based on how well the business model matches the company under study.

For example, assume a company is in the property and casualty insurance (P&C) industry and 80 percent of the subject company's business falls under P&C insurance while 20 percent is reinsurance. Contrast this to another P&C company that has 20 percent in insurance and 80 percent in reinsurance. These companies are both in the P&C industry but have different business models.

The evolving approach to peer group construction must take into...