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“You Get Out When We Get Out”How to Make Private Equity Pay Work in Publicly Held Companies
If Tony Soprano was the CEO of your company, what would happen if you didn’t get the job done? In this article, we intend to compare and contrast these neighborhoods, investigate the pros and cons of pay-for-performance and traditional compensation, and offer up a newer, hybrid model that may even bring a little peace to the community. Why are CEOs paid? To lead the company. To motivate staff. To produce return on equity. Why are CEOs paid when they don’t meet these goals? One of the great corporate conundrums. In the public sector, executives strive to win over shareholders and Boards of Directors with steady increases in stock price and shareholder value, however that value is defined. Not surprisingly, they often fail. In Booz Allen’s extensive 2007 study, “CEO Succession 2006: The Era of the Inclusive Leader,” it was found that from 1995 to 2006, annual CEO turnover had grown 59 percent. In the same period, performance-related turnover increased by 318 percent. In 1995, one in eight departing CEOs was forced from office. Astoundingly, in 2006, nearly one in three left involuntarily. One revelatory finding in the report: “Performance-related turnover fell slightly in 2006, but remained high with 32 percent of departing CEOs were forced to resign because of either poor performance or disagreements with the board.” Reasons abound, but analysis is out of the scope of this brief paper.
Conflicting Agendas Pressure for public companies to follow SEC regulations, disclosure policies, and to meet quarterly Wall Street expectations is burdensome, at best. Ironically, CEOs and executives in public companies enjoy relative job security with severance and retirement packages. This type of compensation security combined with historically relaxed performance targets, at least on the surface, seems at cross-purposes. Add to this, the reality that a larger portion of CEO pay is guaranteed in public companies, and base salary and incentive compensation are typically adjusted on an annual basis. Where’s the risk? What drives executive compensation in the private equity owned companies is in stark contrast to the public sector. Typically, executives:
What’s more, private equity companies give scant focus to SEC regulations or disclosures. Their executives and sponsors are significantly committed to the deal until there is a lucrative IPO, some form of liquidity event, or the restructuring fails. High stakes.
Allure of Private Pay An increasing number of private equity companies have either taken over, or are in the process of taking over, undervalued or poor-performing public companies. With surgeon-like precision, they revamp these companies and retake them public through IPOs. Investors and executives are drawn to the upside potential like paparazzi to the latest Hollywood starlet. Private equity deals in 2006 alone totaled $737.4 billion worldwide, cites Business Week. Players include the Carlyle Group with $75 billion in assets; Kohlberg Kravis Roberts (soon to go public) with $53 billion in assets; and The Blackstone Group, now public, with $98 billion in assets. Some of the household brands under transformation by private equity companies include Dunkin Donuts, Toys ‘R’ Us and J. Crew. Little wonder that former headliner CEOs have been inspired to join the business. Here’s a quick line-up:
Such moves are made because the reward can be so great: 1) significant capital accumulation opportunities; and, 2) freedom from disclosure and unwelcomed public scrutiny. But it’s a leap of faith, not unlike an unexpected switch from mat wrestling to pole vaulting.
Worth the Risk Executives in the private equity world tolerate high levels of risk. They believe in possibility, the possibility of huge upside financial reward. And, for the most part, they are right. So their public sector brethren peeked under the tent and liked what they saw. Among private compensatory advantages: Long-term incentives are paid out in “real participation equity stakes” in the company; Executives have a significant and direct impact on their variable incentives; and Any gains in private equity investments are taxed as capital gains (15%) at a liquidity event. Given the accelerated timeframes and performance demanded in private equity deals, there is a free-thinking (not free-wheeling) pro-risk culture. Call it a culture of candor. Flexibility and efficiency. Traditional public companies can also exhibit these attributes, but it may be challenging to convince a Board of Directors or stockholder group to accept them. There are so many conflicting agendas. In their defense, they live in a post-Sarbanes-Oxley world unfriendly to free-thinkers. Strategic alignment seems to happen quite naturally in private equity companies: Since all parties take on substantial risk, there is a strong sense of pay-for-performance. These executives will usually earn smaller base salaries, even below the competitive market rates of public companies. What’s more, they are not granted perquisites or executive benefits. In all likelihood, they are operating in a turnaround or distressed situation. Makes no sense. The bulk of private equity style compensation is paid in company equity or some other form of equity simulation, usually in the form of stock options or performance shares. Moreover, there is limited termination protection and far less generous severance arrangements than in public companies.
In private equity long-term incentive (LTI) plans, pools of equity are set at predetermined levels of company total equity. Allotments from the pool, which can reach 10 percent of the company’s total equity, are made to key executives in the form of individual equity stakes, also called carried interests. Carried interests are front-loaded grants of stock options that normally vest based on a combination of continued employment and performance results. It is important to point out that on average private equity turnaround deal will occur over five years. That’s why these LTI pools of equity, referred to as management promote plans, do not allow executives to leave prior to liquidity events. A real Soprano moment: “You get out when we get out.” And the plot thickens. In addition to the rules restricting turnover, executives are often required to ‘buy-in’ to receive carried interests; that is, incumbents are mandated to roll over a large portion—usually 50 percent—of their equity holdings from former public companies to participate in equity allocations. These buy-ins are based on restricted stock, which vests for continued employment. Top officers may also be required to invest up to two years worth of salary into the company.
Performance Metrics Cash flow return on investment (CFROI) is the most commonly used metric for management to promote equity plans. This metric directly reflects sponsor needs to retire debt and prepare the company for resale, whereas in a public company, the metric is share price improvement. Understandably, when an executive leads a distressed company through a successful turnaround, he or she is well rewarded. Consider these examples:
Drexler invested $10 million with TPG. Successful IPO in June 2006.
Frissora led a six-month turnaround and successful IPO, While these examples could be the cause célèbre for public companies to adopt private equity style pay, it is often quite difficult, if not impossible, to implement in a public company culture. Keep in mind, most private equity style plans are designed with double-digit internal rates of return. When those are not met, principals do not hesitate to snuff out compensation and terminate the executive. There are other mitigating factors why what works in private won’t in public.
Public Pay Unplugged In the presence of the short-term stock price environment, senior executives in the public sector often have to make unpopular tactical moves to improve share price. They may be forced into share repurchase, recapitalization, even reorganization to improve share price. If unsuccessful with these tactics, they may be forced into divestitures, layoffs or outsourcing. Examples are well documented in the daily business pages and news programs. Further, front-loaded equity grants made in stock options are less prevalent today. The onerous expense of such grants on the company balance sheet is prohibitive. And, a large number of options offered at one time would more than likely dilute shareholder value and push grant limits, or both. In our experience, it is far more difficult for public companies to select and agree on an appropriate set of performance metrics. Perhaps, the role of the Board of Directors adds to this complexity, as does the rise in more aggressively vocal shareholders with differing opinions and interests. Besides, private equity pay arrangements go beyond what most institutional shareholders would support. Shareholders also would not take comfort in large, front-loaded equity payments that could dilute value. Even worse, performance metrics like CFROI could trigger vesting at the very time when shareholders themselves are not reaping benefit from a simultaneous increase in share value. In a recent PricewaterhouseCoopers study of private equity companies, it was found that executives faced a 40 percent risk of losing their investment in five years. One could make the argument that public companies are more likely to attract, motivate and retain executives with traditional pay packages. However, don’t give up. We still believe, under the right conditions, that it is possible for public companies to design, implement and benefit from private equity style plans.
Cultural Shift Required This transition, in our opinion, calls for public companies to undergo a slight shift in attitude. And that shift requires certain must-haves:
New Emulation Model We want to help public companies explore a new space in executive compensation, a new model, a workable hybrid. To emulate private equity pay, compensation committees at public companies can link the majority of executive pay to long-term performance and goals. Here are some general guidelines: Place base salaries and annual bonuses at or below the market standard for public companies.
LTI awards function best as performance-based stock options or formulaic performance shares that are granted in a one-time front-loaded grant. The magnitude of the grant will represent a considerably lower stake in the company than in private equity grants. To justify ambitious “stretch” goals, it is appropriate to set the maximum payout above the maximum possible payout in a traditional, lower risk long-term incentive plan. Because it is so important to treat vesting as a reward for both exemplary performance and executive retention, we envision that half of the options vest based on continued employment. The remainder should vest when well-defined performance targets are achieved. In our narrative, thus far, we have investigated the pros and cons of pay-for-performance as compared to traditional compensation, and offered up a fresh approach to help public companies achieve their strategic business objectives with our emulation model for LTI performance.
In Public Practice Before we conclude, we want to provide a solid example of where the emulation model is in play.
Better still, the market cap-based LTI program has been scaled down and extended to other executives, helping to shift the company to a pro-risk culture. Think he’ll hit the goals? We do. Stay tuned.
At a Minimum Now, we have a better sports analogy. While your company may not be ready to pole vault, it can leave the floor mat and move to the balance beam, with strength, stability and agility. We encourage you to step outside the comfort zone and raise the bar on performance with the right compensation strategy. And, at a minimum, apply some of the underlying principles of the private equity pay model to build lasting linkage between pay and performance. If all else fails, ask yourself: What would Tony Soprano do? Have a laugh and do another draft of the plan. An 83-year old executive once said: “You are only as big as the problems that worry you.”
For a prompt and thoughtful response to your questions, please contact: Frank Glassner - fill out the web form or call 415-618-6060 David Stecher - fill out the web form or call 858.964.3412
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When it comes to executive pay and results, private equity ownership lives in a tough, high-stakes neighborhood compared to the trimmed-lawn bungalows of the public sector. One may not be better than the other. They just hang out on different street corners. 
