Large institutional investors are pushing public companiesto take a page from the private-equity playbook.
Several union funds, mutual funds, and others haverecently urged that, since the management compensationstructures in private-equity deals ensure thatprivate-equity portfolio companies pay their CEOsbased only on results, they constitute the ultimate payfor-performance model for the public sector.
Yet the models can’t be easily cut and pasted intopublic company environments. Whatever theveracity of investors’ criticisms, more than a simplerevision of typical executive-pay practices would beneeded to achieve private-equity-like results at theaverage public company. For a variety of reasons,most public companies are more likely to attract,motivate, and retain critical executive talent with awell-designed but more traditional pay package thanwith private-equity-like incentives.
That doesn’t mean they don’t stand to learn athing or two from private-equity pay schemes.Understanding what executive pay looks like in theprivate-equity sector and responding to the dilemmaposed for public-sector boards by the availability ofthese pay packages—amidst relentless hindsight criticismof typical public-sector pay practices—is key.Possible responses to this dilemma include changesto typical public company long-term incentive-compensationportfolios. While there are certain types ofpublic companies most likely to benefit by adoptingsome private-equity pay practices, not all publiccompanies will be able to consider these changes,partly because several aspects of private-equity dealsare hard to emulate in the public sector.
The argument that management compensationstructures in private-equity deals constitute the ultimatepay-for-results model has been well articulatedin the business media. Last May, University ofChicago Graduate School of Business ProfessorSteven N. Kaplan told The Wall Street Journal: “Private-equity owners really pay for performance…andthe CEOs won’t be criticized for making a lot ofmoney…because private-equity investors are clearlyat arm’s length.” It is certainly true that a few privateequityportfolio companies try to limit investmentdilution by relying more on cash performancerewards than equity-based compensation. However,by far the more common practice—and the “buzz”in the marketplace—concerns managements’ significantequity stakes in private-equity deals.
“Management Promote”
When recruiting CEOs for their portfolio companies,private-equity funds, by some estimates, oftenoffer as much as 5 to 10 percent of a company’s totalequity. And managers often invest their own capitalequal to as much as two years’ worth of salary in thecompany, according to one study conducted by theBoston Consulting Group (BCG). While publiccompanies recently have been contracting stockoptiongrants to reduce the burden of FAS 123Rmandatory expensing, private-equity portfolio companiestypically extend ownership and profit-sharingopportunities to a relatively wide group of keyemployees, the BCG study found.
The foundation of the typical private-equity portfoliocompany’s executive compensation program isthe so-called “management promote.” This is thename commonly applied to equity plans designed to“promote” the best interests of private-equity sponsorsby motivating managers to take actions to createincremental shareholder value.
In order to prevent too much dilution of theprivate-equity sponsors’ investment, managementpromoteequity pools are typically capped at a specifiedpercentage of the portfolio company’s totalequity. Allotments from this pool are made availableas specified individual equity stakes, called “carriedinterests,” to key executives by grade level. Forexample, at the senior vice president level and above,managers may receive carried interests of up to 3 percentof the portfolio company’s total equity.
Under a management-promote model, carriedinterests take the form of front-loaded, or one-time,grants of stock options. Vesting of some or all of theseshares may be based on continued employment, butmore often a portion will vest, based on the company’sperformance.
To make sure incumbent executives who areretained after the public-to-private transaction willhave some “skin in the game” along with privateequitysponsors, there is typically a mandatory “buyin”as a condition of the incumbents receiving theircarried interests. In order to participate in the management-promote pool allocations, incumbent executivesare required to roll over a percentage–typically50 percent–of their equity holdings in the formerpublic company into a purchase of shares of restrictedstock of the private company. The remainder of theirequity holdings in the public company is usuallycashed out when the company is taken private. Whilevesting of the restricted shares is usually based on continuedemployment, additional “kicker” shares mayvest, based on the company’s results.
Most boards at public companies are no more willing to “bet the ranch” by adopting a private-equity-like pay structure than their management is likely to do so by jumping to the private-equity sector.
Together, “carried interests” (stock options) andmandatory “buy-ins” (restricted stock) provide a cruciallinking of managers’ incentive compensation tothe creation of shareholder value for private-equitysponsors. Neither compensation vehicle has a guaranteedreturn, and managers can, in fact, lose money ontheir buy-in if the private-equity deal results in a lossfor other investors. Managers are not permitted tocash out either compensation vehicle until a liquidityevent, such as an IPO, sale, or divestiture occurs.Thus, the typical private-equity executive-pay structurecreates a real parallel between the interests of thesponsors and those of the managers.
Public Dilemma
Critical executive talent, particularly potentialCEOs and other top talent that can drive outstandingcorporate performance, is not a fungible commodity.Rather, it is a finite resource in an expandingmarketplace for that resource. Quite naturally, competitionfor this finite resource has grown intense asthe global economy has expanded. As competitionhas intensified, the laws of supply and demand havedriven performance rewards for top executives tounprecedented heights.
But public-sector CEOs are accountable topublic-sector boards rather than private-equity sponsors.Over the last 20 years or so, a risk-averse andshort-term culture has emerged in some public-sectorboardrooms.
From a strategic and operational standpoint, thisrisk aversion and short-term orientation can result inan unwillingness to place big bets (certainly not if thatinvolves taking on big debts) or to make bold, rapidchanges like those that many private-equity companiesmake. This can make it hard for CEOs to streamlineand improve operations substantially or to adopta dramatically different strategic focus. Accordingly,in order to deliver the steady shareholder returns thattheir boards favor, many public sector CEOs resort tothings like share repurchases and divestitures.
From a compensation standpoint, this risk-averseand short-term culture helps explain one of thebiggest differences between executive pay in theprivate-equity sector and the public sector. It alsocreates one of the biggest barriers for public-sectorcompanies to adopt private-equity-style pay plans.Rather than make front-loaded or one-time equitypayarrangements, as private-equity companies typicallydo, public companies typically make annuallong-term incentive grants. Moreover, unlike private-equity companies, which denominate theirequity-pay arrangements in terms of specified individualpercentage equity stakes, most public companiesuse Black-Scholes or some other, similar valuationmethod to make equity-pay arrangements thathave estimated dollar compensation values.(Recently, some companies such as Google, Cisco,and Zions Bancorp have been experimenting withmarket-based valuation methods.) In thatway, public companies can plug in equitypay that has the estimated value necessaryto give an executive’s overall compensationpackage the size and pay mix deemednecessary to make the company competitivein the battle for critical executives insimilar positions and with similar scopes ofresponsibility.
Together, “carried interests” (stock options) and mandatory “buy-ins” (restricted stock) provide a crucial linking of managers’ incentive compensation to the creation of shareholder value for private-equity sponsors.
Making annual long-term incentivegrants pegged to estimated dollar values,instead of granting individual equity stakesup front that can increase or decrease in valuealong with stock performance, has theanomalous—some would say diabolical—effect of a “dollar averaging” exercise orgrant prices. In other words, more shareswill be granted when the share price dropsand fewer shares will be granted when theshare price rises. In an era when all equitygrants will, through disclosure, be transparent,shareholders understandably haveproblems making sense of this practice. Thiskind of compensation clumsiness really setsoff union funds, mutual funds, and institutionalinvestors. It is easy to understand,however, why public-company boardswould want to ensure that their CEOsreceive competitive pay packages. After all,the demand for their services is increasingin an expanding global economy.
In the post-Sarbanes-Oxley era, thecomplexity and vulnerability involved inrunning a public company have greatlyincreased and, it is safe to say, the fun inbeing the CEO has greatly diminished.The spotlight from newly expanded publicdisclosures and relentless, secondguessingmedia coverage places increasedpressure on public company boards.
Traditional institutional investors andtheir advisory services urge boards to eliminatecompensation programs that allowmediocre CEOs—even outright failures—to become fabulously wealthy. Hedgefunds, which have been playing an increasingrole as a source of capital in recentyears, urge their portfolio-company boardsto drive short-term shareholder value.
Copy That!
In fact, it has become fashionable forinvestors to observe that private-equity firmsare much better stewards of the public companiesthey acquire than the boards of directorsthey replace and, therefore, to demandthat public companies emulate privateequity-like pay-for-results programs. But,this demand ignores a grim reality.
Some aspects of private-equity situationsare harder to emulate in the public sector.Private-equity sponsors have their ownmoney at stake. They typically have hugedebt to repay, which makes it imperativethat the companies they acquire generatethe necessary cash flow. So, they focusquite single-mindedly on cash, rather thanGAAP net income, and on being able toliquidate their investment by IPO, sale, ordivestiture as quickly as possible. No onewould ever call them risk averse. In orderto stay in business, private-equity sponsorsneed to have a record of earning more thanthe cost of capital—the return that, onaverage, investors would earn fromsimilarly risky investments. Accordingly,private-equity sponsors have a greaterincentive than public-sector boards to bevery demanding of the CEOs they appoint,even in an era of heightened sensitivity inpublic-company boardrooms to the importanceof sound corporate governance.
Managers who succeed in generatingthe necessary cash flow to retire debt andotherwise get their company ready to besold in a sufficiently short period of timeand at a sufficiently high price to earn thesponsors more than their cost of capitalwill accumulate major personal wealthover that same relatively short time frame.
The private-equity sector, acting like avacuum cleaner for top executive talent,has had a major impact on CEO turnoverat public companies. The success rate fornew CEOs of public companies hadalready become a coin flip over recentyears as boards, faced with various crises,either made internal promotions of executiveswho might not have been ready ortook their chances in recruiting from theoutside—always a risky venture. (See “TheLeader Within,” page 52.) As the allure ofprivate-equity deals increased, the publiccompany CEO turnover rate soared andaverage CEO tenure shrunk. (Although asthe sector deals with the credit crunch, thiscould be subsiding.)
Selective Changes
Demands that public-company boardsrevise their executive-compensation programsto emulate private-equity pay programsare somewhat simplistic. Revisingexecutive pay is not enough to achieveprivate-equity results.
It is one thing to commit to paying forresults, but quite another to be bold inensuring that the critical top talent necessaryto achieve the desired results is onhand and locked up for the long term.This is not limited to having the rightCEO for the right situation. It includes allkey positions. The glue for keeping themanagement team working hard togetherat any public company has to be found intheir belief in each other, their businessstrategy, their excitement over progress,and the prospects for continued success.
Public-sector boards must attach heightenedimportance to talent managementand succession planning. While theseitems are on most boards’ agendas, inmany cases they are not given the prioritythat other items receive.
Nevertheless, the key question remains:How can a public company keep its criticalexecutive talent in place and motivated,rather than watching them jump toprivate equity?
A large part of the answer must lie inmaking changes to the company’s longtermincentive-compensation portfolio,because this typically is the most significantpart of the overall rewards package for seniorexecutives. Logically, the possiblechanges follow from a simple side-by-sidecomparison between long-term incentivesin the private-equity sector and long-termincentives at public companies.
In making their annual long-term incentiveawards, public companies typicallygrant more shares when the share pricedrops and fewer shares when it rises. Butsome public companies might actually beable to deliver larger traunches of equity totheir key executives by granting equitystakes up front that can increase or decreasein value with subsequent stock performance,particularly in situations where management’spast performance has alreadyresulted in stock-price appreciation.Denominating equity-pay arrangements interms of individual percentage equitystakes, rather than estimated dollar compensationvalues, passes the risk of subsequentshare-price performance on to executives.Deferred vesting of up-front equityawards can also protect against resignations.
Another difference in pay models is thatprivate-equity firms typically use restrictedshares only for incumbents’ “buy-ins.”Whether a public company should emulateprivate equity in relying mostly on optionswould depend upon its board resolvingissues relating to its belief in the prospectsfor stock-price appreciation and shareholderdilution concerns that might affect theirauthorization of additional shares.
In order to truly emulate private-equitylikepay-for-results programs, public companylong-term incentive awards shouldlogically use cash flow return on investment(CFROI) as the key performancemetric. As economists will tell you, at anygiven time, CFROI reflects the market’sestimate of the present value of currentand expected future cash flows plus thevalue that the market places on the company’sassets. Therefore, the measure correlateswell with shareholder value. Inaddition, CFROI corresponds nicely withprivate-equity firms’ need to generate cashto retire debt and earn more than their costof capital for their investors.
A public company that wants to makechanges to its long-term incentive compensationportfolio to emulate privateequity should consider:
- Making one-time equity awards, ratherthan annual grants
- Taking an “equity-stake” approach indenominating these awards
- Switching back to stock options insteadof full-value share awards
- Using CFROI as the performancemetric for leveraging equity-based compensationawards
Any public company that is willing tomake these changes would have to have anexperienced and respected managementteam motivated to make substantial betson itself and supportive, sophisticatedshareholders willing to authorize the necessarydilution levels resulting fromupfront equity awards. The problem is,both of these commodities are dwindlingin the public sector. Companies in turnaroundsituations and those whose businesseshave locked up value are the mostlikely public companies to be willing tomake these kinds of changes. They are thevery companies that are ripe targets forprivate-equity firms and hedge funds,provided their business strategies lendthemselves to generating management,board, and shareholder confidence that asatisfactory level of returns can beachieved within a satisfactory time frame.
All of this brings us to the true publicsectordilemma that results from leveragedbuyout activity, whether led by management,hedge funds, or private-equity funds.Most boards and management teams atpublic companies are no more willing to“bet the ranch” by adopting a privateequity-like management pay structure thantheir management is likely to do so byjumping to the private-equity sector. Norcan most public companies be assured ofthe requisite shareholder support for animmediate increase in dilution levels. Thisis not entirely due to risk aversion and shorttermism.Most public companies are notfailing to unlock value or, if they fail tounlock value, they have not yet discoveredthe key (business strategy) to doing so.
Taking all these factors into account, ata majority of public companies, executivesmay have a higher probability of receivinggreater rewards using traditional pay packages,rather than trying to emulate privateequity-like pay-for-results programs. Thus,in order to attract, motivate, and retaincritical executive talent, most public companieswould be best off with a welldesignedbut more traditional pay package.In that case, the trick would be to communicatethat fact to large institutionalshareholders.
Yale D. Tauber is principal of IndependentCompensation Committee Adviser, LLC.This article is based on a presentation deliveredat The Conference Board GovernanceCenter’s Corporate Investor Summit inOctober 2007.