John V. Jazylo • MAY 2017
As the war for executive talent continues, private company CEOs are confronted with making some difficult decisions relative to executive compensation. A review of compensation policy surveys completed by several consulting firms over the last two years indicate that approximately 60% of private firms polled compete against public companies for executive talent.
Moreover, over 50% rank the current market for executive talent as competitive, and one-third rank it as highly competitive. Despite this landscape, the majority of private companies do not feel disadvantaged when competing against public companies, perhaps due to the erratic performance of the stock market, since public companies rely heavily on equity programs for executives.
Private companies CEOs (60%) who do not believe they are at a competitive disadvantage see a whole range of reasons they can compete for the best talent, beginning with company culture and work/life balance. They also cite:
Those CEOs (35%) who feel they do not compete well against public companies for talent cite the following:
Of the private companies that provide more cash, or cash only pay plans, there is a disproportionate level of cash compensation when compared to public companies, with base salaries exceeding 70% of the executives’ compensation, and only 6% based on some form of non-cash long-term incentive.
As this dilemma causes even further consternation for private companies, there is a concerted effort to evolve more towards a public company like pay program and there is an increasing trend towards basing more pay on performance and over a long-term.
When private companies benchmark their pay programs, half of the firms surveyed believe they are providing similar levels of cash-based incentives as the public firms, but only about one-quarter believe they are providing competitive equity-based incentives.
While a preponderance of private firms offer an annual incentive of some kind, only about one-half offer long-term incentive-based compensations to their employees.
Of the private firms who offer long-term equity-based incentives, similar to public companies, these companies offer a mix of stock options, restricted stock, phantom stock and other equity vehicles, with stock options the most popular incentive. The big difference between public and private companies is the heavy use of cash-based long-term incentive plans. More than half of the companies that offer long-term incentive plans offer these cash-based plans, with the large majority of those being operational or milestone based.
Relative to governance, strategy and performance in private equity companies, the compensation model is evolving.
In terms of governance, the boards of directors of private equity firms are heavily influenced by the principal investors. Outside directors may not occur until the transaction event (IPO); consequently, these firms often face no requirements for public disclosure until they take the business back to the public markets. This tends to result in simpler processes for obtaining investor approval of management contracts, equity grants and incentive plans, with processes driven by the principal investors as opposed to a board reacting to management proposals.
The business strategy is marked by an added emphasis on free cash flow/debt service – and far less of a fixation on accounting-based earnings, EPS and similar measures. Private equity firms tend to have a good track record of maintaining important investments, including R&D spending and strategic capital improvements. They frequently target acquisitions aimed at consolidation in fragmented industries to gain economies of scale, along with divestment of non-core assets to focus squarely on operational improvements in the core business.
This translates into management performance objectives that typically emphasize value creation through accountability for capital spending, control of discretionary costs and growth that exceeds the rate of return assumed by the principal investors. There’s usually little or no emphasis on performance relative to industry peers.
Private equity companies insist upon a high-risk/high-reward profile in their compensation arrangements for senior managers they hire to lead their acquired businesses, with the overwhelming design emphasis pegged to the investment horizon of the investors and relatively little concern for what happens after the liquidity event.
They also favor an above average risk/reward profile for those below the senior executive ranks, although they tend to take a hands-off approach to management levels below the top tier – leaving top management responsible and accountable for the pay and compensation costs of other employees. The compensation strategy is closely tied to the investors’ strategy and evolves as the company approaches the exit event.
Because of the private ownership structure, investor relations tend to be more transparent and “arm’s length” than in public companies, and there’s far less disclosure of management compensation to the rest of the organization. There’s also less concern about benchmarking pay practices to the norms of public company peers, such as overhang, burn rates and market positioning.
Executive pay programs act as a signal to management about what investors think is important. Since base pay in private equity companies tends to be conservative, the emphasis in the executive compensation package is squarely on the incentive components.
Typically, the annual cash incentive plans in these organizations tend to be more performance sensitive than in public companies, providing more upside opportunity for exceeding goals and a meaningful risk of zero bonus payouts if the performance requirements are not achieved. Minimum performance requirements also tend to be more challenging than in many public companies.
Annual performance measures for senior executives often have the following characteristics:
Investment groups usually give senior management in these private companies almost total discretion to determine the incentive formulas for the rest of the organization; they also bear full accountability for the cost impact of their decisions.
Long-term equity-based incentives are clearly the sweet spot in the compensation package, often representing 65-70% of the total compensation opportunity. In most public companies, the percentage is closer to 50-55%. The way these incentives are structured, delivered and valued is markedly different from typical long-term incentive practices in public companies.
Here are some of the characteristics of how private equity firms manage these incentives:
It’s clear that the opportunities for wealth creation that private equity firms offer are very significant – and often very attractive to talented people. In an increasingly competitive market for talent, this has important implications for the challenges public companies will face in attracting and retaining experienced leaders.
The private equity model can teach about focus and performance and how rigorous goal setting around sharply focused objectives can help drive a management team to success. The private equity model also serves as a reminder that participation in equity-based incentives is an important company by company decision that should align with the specific goals and time horizon of the investors.
John V. Jazylo is an equity Partner in the Information Technology, Financial Services and Board/CEO practices of Leadership Capital Group. John has recruited CEOs, CIOs and other functional leaders for some of the most recognizable global industry brands. He is the author of several treatises in the delivery of financial services to consumers and corporations.