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Why Not Pay Executives Like Private Equity Does?

Long-term executive incentives could better align the financial interests of executives with those of shareholders.

With their proliferation of plan-design alternatives and features, long-term executive compensation practices have become more and more complex over the years.  Where once there was restricted stock and stock options we now have performance shares, stock-appreciation rights, performance cash, deferred stock units, performance units and countless other faintly dissimilar alternatives.

Gregory V. Milano_box

Gregory V. Milano

What’s more, the quest for better and better mousetraps has led to incentive methods that often do a worse job of actually motivating management to think and act like committed long-term owners.

For example, consider that many long-term incentives now have some sort of “performance test” that determines the degree to which the award vests.  One common type of performance test measures total shareholder return (TSR) in the form of dividends and share price appreciation against a list of peer companies.  Typically, if TSR ranks atop the peers, 200 percent of the award vests with less vesting at lower TSR ranks.  Bottom quartile performers often get no award.

That seems logical.  The better the share price performs against peers the more shares management gets.  If the only reason the share price increased is the industry did well and the company is bottom quartile against peers, then the award is forfeited.  This is designed so awards are not excessive for just being lucky.

As good as that sounds, there are numerous problems with TSR performance tests.  Executives can earn a lot more or less based on different starting and ending points, making performance tests a bit of a lottery.

Opinion_Bug7Consider United Continental Holdings, Inc. (UAL) and Delta Air Lines Inc. (DAL).  A comparison of TSR over the three years ending January 10, 2013 shows United ahead by 94 percent.  Comparing the very same two direct competitors nine months later shows Delta ahead by 103 percent.  That’s quite a swing, demonstrating just what a game of chance TSR performance tests can be.  Executives just do the right things and hope the compensation works out.  It’s unlikely that that motivates any desired behavior.

Perhaps more importantly, TSR performance tests do not motivate smart business-unit portfolio management and capital-allocation choices.  Although a management team can move its company into areas with better growth and return on capital opportunities, if it does so, it will be compared to new peers with potentially better TSR.  This may diminish the financial benefit to management and can stand in the way of motivating the right portfolio-management decisions.

Perhaps compensation committees should look to how private-equity motivates executives.  Management wins if private-equity investors win and vice versa.  Managements typically earn a “promote,” which is an equity participation that increases depending on how high the IRR is for the investors.  They don’t tend to worry as much about whether the success was skill or luck; they simply reward success.  And perhaps that helps them achieve more success.

One thought on “Why Not Pay Executives Like Private Equity Does?

  1. Mr Milano makes excellent points. Fundamentals, however, require us to consider if share price increases over any particular fiscal term are truly reflective of long-term company value or if management decisions to drive share price are truly in the best interests of the company.

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