Private Equity Pay Deals
6 March 2007 Marcus Peaker
Explaining a private equity pay deal in the listed environment is a lot like trying to describe the proverbial elephant. Marcus Peaker of Halliwell Consulting sheds some light on the subject.
Private equity pay deals seem to share common main features. There is usually a very high level of potential reward to the senior executives of the company implementing the arrangement and a bonus or share plan structure which in one or more significant aspects (normally quantum of reward) is outside the parameters of normal arrangements supported by institutional shareholders and their representative bodies such as the ABI, NAPF (RREV) and PIRC.
The company proposing the arrangement is often in a turnaround situation or has an aspect of its business which lends itself to generating the required levels of return to shareholders. The level of return to shareholders should be commensurate with the rewards provided to the senior executives of the company. This is generally one of the most contentious areas between the company and its shareholders.
ARE PRIVATE EQUITY DEALS NECESSARY?
In a nutshell the argument used is that, with the rise of private equity and the potential rewards that senior management can receive, certain listed companies need these types of deals to be competitive when trying to retain their senior management. Any sector where private equity has been active gives rise to some listed companies looking at a private equity type of pay deal.
An alternative, perhaps cynical view, would say that this whole area is a red herring designed solely to provide another justification to ever rising levels of executive pay. But what is the reality of the situation?
It is very difficult to implement a private equity-style pay deal in a listed company. Furthermore, for the majority of executives in listed companies, taking all factors into account, they may have a higher probability of receiving a greater benefit using traditional listed company remuneration packages.
PAY DEAL CONCERNS
There are a number of issues facing a company wishing to implement a private equity-type of pay deal in a listed environment.
The company will need to consider how it is going to deliver the level of returns required to ensure shareholder support for the package. One of the bones of contention with some shareholders and Cable & Wireless was whether the potential bonuses to executives were commensurate with the value delivered to shareholders.
This is one of the areas where there is a significant difference between actual private equity deals and this type of private equity pay deal in a listed environment. True, private equity deals generally require high double-digit internal rates of return. This is extremely challenging in a listed company unless the company has some fairly unique features.
The potential quantum is another potential issue worth considering. The press and a number of institutional shareholders can become very concerned about the actual amount of money that might be received by executives under these proposals. In my experience these concerns tend to focus on a mixture of the following:
- The level of proposed payout is not commensurate with the levels of return – too high a payout for too little additional shareholder value
- The concern of shareholders of criticism in the press for supporting pay to 'fat cats'
- The 'English disease' – the idea that there is too much money that can be paid to any one individual
One of the issues raised during the introduction of the Berkeley Group Holdings plc long-term incentive plan by some shareholders was a desire to see the potential amount received by the executives capped. There was a feeling that there was too much money that could be earned by executives irrespective of the value delivered to shareholders.
Some shareholders and their representative bodies are concerned about setting a precedent. If they support one company this may be used against them by other companies who are less deserving.
Whilst this is a legitimate concern, a 'real' private equity pay deal in the listed environment should be unique to the specific company and should therefore be very difficult to implement by another company.
The number of interested parties will also need to be considered. In private equity, the pay deal is agreed between a small number of firms buying the company and its management. However, in the listed company the number of interested parties is huge, all with different views. Just to get the majority of shareholders to agree to this type of arrangement in a listed company is a challenge that should not be underestimated.
The P&L cost to the company and dilutive cost to shareholders (if a share arrangement is being used) can be very substantial. This is something that can be more easily dealt with in a private equity environment where all these costs can be passed through prior to an exit. In a listed company these costs could have a material impact on the results of the company, again increasing the pressure on the acceptability of the proposed pay deal.
HOW TO MAKE IT WORK
So what do you require to make a private equity pay deal work in a listed company? There are a number of factors to take into account, some more important than others. Without doubt, one or more of the following is required as a starting point. A highly respected and experienced management team is important. Shareholders will invest money in a management team who have historically delivered value and who they believe can do so again, a good track record is important.
Shareholder support is obviously a key factor. The pay deal has to directly link to a business strategy which will deliver shareholder value. Further, shareholders must buy into the strategy to have any chance of the pay deal being accepted. The management will here have to persuade shareholders why they need this level of reward to unlock this additional shareholder value.
One of the questions management will face from investors is whether or not it is their job to makes these changes without expecting large payments for doing so. It is important that management believe that shareholders do support them, they can deliver the strategy and the levels of return to shareholders will materialise. It's a two-way process.
The business itself has to be able to deliver the returns required to justify the level of reward provided to its executives. This is why a turn-around business or business which has unlocked value is the best bet for these types of deal. This trend will continue in the future.
Unless management is confident that the above factors can be satisfied they would be better off receiving a more standard executive compensation package for a listed company. Private equity deals in a listed environment can and do work – but the mix needs to be right for all parties.