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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.

Often there is a minimum return for investors before management participates.  That can be anywhere from 5 percent to 10 percent and is often described as an internal rate of return, or IRR.  Any value created above that is shared between management and investors according to a formula.  For example management might get 15 percent, 20 percent or 25 percent of any value created above the minimum IRR.

Often there is another, higher threshold of IRR, above which management will share in an even higher percentage of the value created.  Though the specifics vary, it is usually the case that the more money investors make, the more management earns, which forges a very strong alignment of their interests.

Public company compensation committees could reach outside their normal comfort zone and implement long-term compensation structures that work more like those in private equity.  They could directly copy the private-equity arrangements or use a simplified stock-option structure designed to accomplish similar objectives.

To emulate the typical private-equity deal, a company could establish a subsidiary for the purpose of holding treasury stock that management might earn going forward.  The subsidiary could be financed with, say, 10 percent in equity from management, either via paid-in capital or a time-vested grant.  The remainder could be financed with debt or preferred stock with a pay-in-kind feature so the amount of financing builds every month to set a minimum threshold before management participates.

The value of management’s stake would increase if the value of the company grew faster than the pay-in-kind financing.  That would replace the typical annual equity grants over, say, five years, with a single front-loaded opportunity. Thus, the size of the equity pool would need to be calibrated to deliver an appropriate high, medium and low payoff under different share-price performance scenarios.

Admittedly, implementing such a structure is fraught with all sorts of legal, accounting and tax complications, and may prove confusing for investors and proxy advisory firms.

A simplified stock-option structure can be used to mimic the private-equity approach in a way that is more consistent with normal public company practices. In place of the next five years of equity grants, management could be granted one front-loaded package of stock options that might come in five tranches, each with different vesting dates and exercise prices.

The first tranche might vest in one year and have an exercise price 8 percent above a benchmark share price, say the three-month-trailing average price.  The second tranche might vest in two years and have an exercise price 16 percent above the benchmark share price. And so on.  Each tranche might be exercisable over one to three years after they vest.

That package would provide a huge potential payoff if management was very successful and very little payoff if they failed to create value.  Though this sort of plan carries a greater potential for retention risk if the share price declines, that must be weighed against the potential for a much stronger motivation to succeed.  Many companies will find that weaving some elements of this into their normal compensation approach can be beneficial even if they choose to not embrace it completely.

Gregory V. Milano, a regular CFO columnist, is the co-founder and chief executive officer of Fortuna Advisors LLC, a value-based strategic advisory firm.  Copyright © 2014 Fortuna Advisors LLC.  All rights reserved.

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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