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:

• Organizational structure
• Geographic location
• Corporate responsibility
• Type of business
• Benefit programs

Those CEOs (35%) who feel they do not compete well against public companies for talent cite the following:

• Approximately 75% are disadvantaged due to compensation level and mix.
• Almost 60% state that they do not provide both cash and equity compensation.
• And, if no equity, approximately 60% say that they must offer more cash.

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.

Private Equity Companies… Redrawing the Traditional Rules

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.

Implications for Compensation Strategy in Private Equity Firms

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.

Annual incentives help focus performance

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:

1. They focus on EBITDA and cash flow.
2. They recognize the opportunity cost of the capital investment.
3. They’re funded from operating income, with both plan funding and payout levels contingent on the available cash flow.
4. Performance goals are usually based on the investor return-on-enterprise value.

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.

Key Characteristics of Long-Term Incentives in Private Companies

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:

• Typically, the management incentive program is structured to deliver a percentage of the total appreciation in the value of the company (usually 8-12%) to the executive team, rather than a targeted dollar amount. Providing a “piece of the total gain” is the driving factor in developing the program, while concepts like overhang, run rates and competitive grants are subordinate.
• The executive team realizes this value only if the deal is successful, which is usually defined as 2.5 to 3 times growth in the equity value of the investment over a three to five-year time horizon. If the value of the company increases from $1 billion to $ 2.5 billion, the management team’s share would be $120 to 180 million.
• The vehicle for delivering this value is typically a large, up front grant of stock options, creating more leverage in the program than annual grants. Generally, about half of the options will be time vested and the other half will vest based on performance, based on measures like EBITDA or an internal rate of return.
• These equity grants are usually reserved for the company’s senior management (no more than 30 to 40 people) and investors tend to hold the line on the total equity offered, rarely making additional authorizations.
• The fact that so few executives receive significant equity stakes (one recent study found that 80% of the equity granted pre-IPO went to five people, on average) can create significant retention issues regarding managers below the top tier, who would normally receive stock-based incentives in public companies. To address these issues, some private equity companies have introduced cash based long-term incentive programs – such as deferred or matched bonuses, multiyear plans pegged to operating objectives or formula value plans – to make up for the lack of equity-based awards.
• Private equity firms usually expect the top leadership of the companies they own to roll over the gains and/or invest in the new company following the liquidity event. Most look for their executives to invest 50-75% of their after-tax equity gains by writing a check, waiving change-in-control payments at the IPO or taking their annual bonuses in stock. In some cases, private equity firms entice these reinvestments by providing matching stock option grants ($1 investment in stock is matched by $1 face value in options).
• Finally, private equity firms usually provide little or no opportunity for executives to liquidate their equity holding prior to the IPO or other transaction event.

Key Lessons for Public Companies

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.