Eisner PEQ: Private Equity Pay Plans

Large institutional investors are pushing public companies to take a page from the private-equity playbook.

Several union funds, mutual funds, and others have recently urged that, since the management compensation structures in private-equity deals ensure that private-equity portfolio companies pay their CEOs based only on results, they constitute the ultimate payfor- performance model for the public sector.

Yet the models can’t be easily cut and pasted into public company environments. Whatever the veracity of investors’ criticisms, more than a simple revision of typical executive-pay practices would be needed to achieve private-equity-like results at the average public company. For a variety of reasons, most public companies are more likely to attract, motivate, and retain critical executive talent with a well-designed but more traditional pay package than with private-equity-like incentives.

That doesn’t mean they don’t stand to learn a thing or two from private-equity pay schemes. Understanding what executive pay looks like in the private-equity sector and responding to the dilemma posed for public-sector boards by the availability of these pay packages—amidst relentless hindsight criticism of typical public-sector pay practices—is key. Possible responses to this dilemma include changes to typical public company long-term incentive-compensation portfolios. While there are certain types of public companies most likely to benefit by adopting some private-equity pay practices, not all public companies will be able to consider these changes, partly because several aspects of private-equity deals are hard to emulate in the public sector.

The argument that management compensation structures in private-equity deals constitute the ultimate pay-for-results model has been well articulated in the business media. Last May, University of Chicago Graduate School of Business Professor Steven N. Kaplan told The Wall Street Journal: “Private- equity owners really pay for performance…and the CEOs won’t be criticized for making a lot of money…because private-equity investors are clearly at arm’s length.” It is certainly true that a few privateequity portfolio companies try to limit investment dilution by relying more on cash performance rewards than equity-based compensation. However, by far the more common practice—and the “buzz” in the marketplace—concerns managements’ significant equity stakes in private-equity deals.

"Management Promote"

When recruiting CEOs for their portfolio companies, private-equity funds, by some estimates, often offer as much as 5 to 10 percent of a company’s total equity. And managers often invest their own capital equal to as much as two years’ worth of salary in the company, according to one study conducted by the Boston Consulting Group (BCG). While public companies recently have been contracting stockoption grants to reduce the burden of FAS 123R mandatory expensing, private-equity portfolio companies typically extend ownership and profit-sharing opportunities to a relatively wide group of key employees, the BCG study found.

The foundation of the typical private-equity portfolio company’s executive compensation program is the so-called “management promote.” This is the name commonly applied to equity plans designed to “promote” the best interests of private-equity sponsors by motivating managers to take actions to create incremental shareholder value.

In order to prevent too much dilution of the private-equity sponsors’ investment, managementpromote equity pools are typically capped at a specified percentage of the portfolio company’s total equity. Allotments from this pool are made available as specified individual equity stakes, called “carried interests,” to key executives by grade level. For example, at the senior vice president level and above, managers may receive carried interests of up to 3 percent of the portfolio company’s total equity.

Under a management-promote model, carried interests take the form of front-loaded, or one-time, grants of stock options. Vesting of some or all of these shares may be based on continued employment, but more often a portion will vest, based on the company’s performance.

To make sure incumbent executives who are retained after the public-to-private transaction will have some “skin in the game” along with privateequity sponsors, there is typically a mandatory “buyin” as a condition of the incumbents receiving their carried interests. In order to participate in the management- promote pool allocations, incumbent executives are required to roll over a percentage–typically 50 percent–of their equity holdings in the former public company into a purchase of shares of restricted stock of the private company. The remainder of their equity holdings in the public company is usually cashed out when the company is taken private. While vesting of the restricted shares is usually based on continued employment, additional “kicker” shares may vest, based on the company’s results.