This article is reprinted with permission from the
May 30, 2008
edition of
New York Law Journal.
2008 NLP IP Company.


Public Versus Private-Equity-Controlled Companies

How do executive pay programs in publicly traded companies compare with those in private-equity-controlled companies?[1] Can valid comparisons be made or do differences between the two environments prevent meaningful comparisons of pay packages? To the extent comparisons can be made, do they support, or not support, suggestions in the media that private-equity-controlled companies are attracting key executives away from public companies by offering them larger pay packages?

Current Compensation

Salaries. Salaries in public companies tend to be higher than salaries in private-equity-controlled companies of comparable size and type. This reflects, in part, the emphasis in private-equity-controlled companies on preserving cash. It also reflects the primary "lure" of private-equity-controlled companies in offering (or being perceived as offering) greater long-term equity opportunities than are offered by comparable public companies (See further discussion on this point under heading of Long-Term Incentives below).

Annual Bonuses. Annual bonus opportunities in public companies tend to be as large as, if not larger than, those in comparable private-equity-controlled companies (that is, comparable in size and in comparable industries). A significant proportion of the bonus in a typical public company situation is based upon achievement of predetermined performance targets (reflecting, in many cases, the Internal Revenue Code §162(m) requirement for performance-based compensation to qualify for the exception from the $1 million cap on deductibility of pay of certain senior executives; §162(m) does not apply to private companies). If "target" is achieved, a stipulated percentage of salary ("target bonus") is paid, with adjustments up or down from the "target" bonus amount based on actual performance. Private-equity-controlled company bonuses tend to be left more to the discretion of the board of directors than to prefixed formulas. Both public and private-equity-controlled companies often provide guaranteed bonus amounts in the first year of an executive's employment (and, occasionally, for the second year).

Thus, currently paid compensation of top executives in publicly traded companies tends to be greater for comparable positions than in private-equity-controlled companies.[2]

Long-Term Incentives

The largest portion of long-term incentives in public companies is in the form of equity awards (stock options, restricted stock and other forms of equity). Public companies also award long-term incentives in the form of nonequity awards (such as "intermediate term" - typically three years - awards). In most private-equity-controlled companies, by far the predominant form of long-term awards is equity, with stock options being the principal form of award. In private-equity-controlled companies, in addition to such awards, it is not uncommon for stock also to be purchased at the outset of employment by a senior-level executive (often at a favorable price). This stock generally is subject to buy-back rights in the company if the executive leaves within a specified period of time after purchase.

In addition, it is not uncommon for very senior level executives in a private-equity-controlled company to be awarded a participation in the carried interest held by the private equity firm that oversees the portfolio company in question. (There is a practical limit on what a private equity firm is willing to do in this respect since a carve-out of a share of the carried interest dilutes directly the compensation that the private equity firm principals are expecting to receive from overseeing the investment in the portfolio company.)

The Differences

The following is a discussion of other differences between equity awards customary to public companies and those customary to private-equity-controlled companies:

1. Comparing sizes of awards: Some of the difficulties in making accurate comparisons

Different terminologies used in expressing sizes of awards. Grants of equity to executives in public companies tend to be made in terms of dollar values (generally determined, as discussed in paragraph 2 below, by Black-Scholes or comparable models). Private-equity-controlled companies tend to award equity to the CEO and other top executives in terms of a percentage of the outstanding equity, rather than based on a dollar value. (In both public and private companies, the awards will be expressed in shares but it is the underlying basis for determining the number of shares that is the point.)

For example, it is not uncommon for a chief executive officer in a private equity situation to receive three to five percent of the outstanding equity, and to have it expressed among the interested parties in that way. (Contrast a grant of equity to a CEO of a public company, reported in the proxy statement in terms of dollars and derived, at least in part, from compensation committee comparisons to equity awards to other CEOs at comparable companies, likewise expressed in dollars.)

2. Different methodologies in valuing awards.

Another difficulty in comparing the size of equity awards in public versus private-equity-controlled companies is the difference in valuation methodologies. In public companies, stock awards are valued based on the public market price and stock options are generally valued, as noted above, based on Black-Scholes or similar methodology. When equity awards are granted in private-equity-controlled companies the tendency, when value is discussed, is to base the value on the investment made by the private equity fund. This value does not take into account a "premium" such as the premium associated with publicly traded stock (reflecting its liquidity and the dynamics of a public market) or the "enterprise value" associated with a private sale of the portfolio company to a third party.[3]

3. Other difficulties in making comparisons

(a) As noted above, in many private-equity-controlled companies, in addition to receiving equity awards, the CEO, and frequently other senior executives, purchase stock at the start of employment. The "discount" or "bargain purchase" element, if any, varies. The proportion of equity, if any, purchased by CEOs and other senior executives at the outset of their employment with public companies is very small.

(b) In some cases, as also noted above, private equity firms give the top executives of a portfolio company a share of the private equity firm's carried interest in that portfolio company. This, too, should be included in the equity ownership of a senior manager of a private-equity controlled company even though it is derived from the private equity firm's own carried interest in the portfolio company.

4. Proportion of total compensation package represented by an executive's equity.

In public companies, the long-term/equity portion of the package, valued at time of award (not at payout), has tended to be in the range of 50 percent of the total package (that is, the package of salary, annual bonus and long-term incentives (valued at time of award)). The range varies considerably between the percentage for the larger U.S. public corporations, for example, those over $10 billion in market capitalization (with the equity portion of the package being in the range of two-thirds of the package) and smaller U.S. public corporations, for example, those below $1 billion in market capitalization (the corresponding equity package being in the range of 45 percent).

In private-equity-controlled companies, equity tends to be a greater portion of the "target" opportunity. Measured as an "opportunity" at date of grant ("hopeful expectations" might be an appropriate description in some private equity situations), the equity portion often is in the range of 65 to 70 percent of what the executive expects to earn over a period of time (three to five years).

The circumstances noted in Section 3 above make it more difficult in many cases to identity accurately the portion of the equity of a portfolio company that represents equity that should be included as part of the executive's overall package.

• First, did he purchase stock as part of the deal when he joined the portfolio company and, if so, did he make a real investment, or was it a bargain purchase with a substantial discount? A purchase with a deep discount makes it look more like pay than a purchase.

• Second, has the private equity firm awarded the executive a share of its carried interest in the portfolio company and thus, in fact, added to the equity paid to him to join that company?

5. Form of awards.

In recent years, publicly traded corporations have tended to increase the use of restricted stock as an alternative to stock options as a form of equity award. (This reflects changes in accounting rules resulting in options becoming a charge against earnings. It also reflects a "taint" attributable to large grants of options made in the 1990s, with special notoriety attributable to large option grants at companies entangled in corporate scandals, including backdating of options.)

Stock options continue to be a dominant form of public company equity award but their dominance has been diminished. In private-equity-controlled companies, the predominant form of equity award by a significant margin continues to be stock options. With options, the executive's stake is entirely dependent on the growth in the value of the enterprise and this has a marked appeal to private equity investors (and, in logic, it should appeal to shareholders of public companies as well; however, as noted, grants of restricted and performance stock have replaced a substantial portion of the stock options being awarded in many public companies).

6. Vesting.

In publicly traded companies, vesting periods tend to range over two, three or four years, with three years probably the most typical. (In a few cases there is cliff vesting but that is not typical.) Once equity is vested in a public company, it generally is relatively easy for the executive to liquidate, subject to blackout rules (and, of course, its being registered for sale under the Securities Act of 1933, which generally it is).

In private-equity-controlled companies, equity awards, while frequently vesting on schedules similar to those of public companies, cannot be liquidated until the "liquidity event" occurs (i.e., a sale or an initial public offering). Even then, there may be a "waiting in line" before the awards can be liquidated (e.g., after the IPO of the company's stock, a further delay may be required before the management stock is registered for sale). If the private-equity-controlled company is not sold or IPO'd it may be a long time before the executive's stock can be liquidated.[4]

7. "Dollar averaging."

The pattern of equity awards in public companies, occurring over a period of years at regularly scheduled intervals (annual being quite customary), tends to produce a form of "dollar averaging" in the equity awards.

In contrast, private-equity-controlled companies tend to grant a larger portion of the equity in the first year or two of employment. This is especially true in start-up companies but it is also true for many private equity companies that are trying to attract outstanding executives.

The result is that the private-equity-controlled company executive receives more of the benefit from the rise in the value of the company from the beginning of his or her employment than does his or her counterpart in a public company. On the other hand, if the value of the business declines the private equity executive is not likely to receive future stock option grants at the future lower price (if he or she is still around) that accompany the "dollar averaging" over a period of years for the executive in a public company.

8. Number of participants.

In publicly traded companies, stock options (less so, restricted stock) frequently are spread over a large number of executives, not just the handful that may be the key decision-makers running the company. In private-equity-controlled companies, all or substantially all, of the equity awarded "management" is generally limited to a relatively few senior executives who share in the key decision making responsibilities in operating the company.

9. Loans to executives to acquire equity.

In publicly traded companies, the practice of making loans to executives to purchase stock in the employer has been virtually eliminated because of the Sarbanes-Oxley law.[5]

In private-equity-controlled companies, loans continue to be made in connection with the acquisition of equity by executives who are joining the private-equity-controlled company.

Based on the author's experience (but not on published surveys), the use in private equity situations of significant-size loans to purchase stock is somewhat less frequent than it was in the 1990s (perhaps because of the bubble bursting in the private equity situations at the end of the 1990s with resulting financial hardship to many private equity managers).

Conclusion

As noted at the outset, there have been reports in the media suggesting that many executives are leaving public companies to join private-equity-controlled companies to "make more money."

Based on the author's experience, it is doubtful that most such moves are motivated by realistic expectations of "more money." Instead, many of those who join the portfolio companies are doing so because of failure of their current situation to provide the career opportunity they seek (or, in some cases, because they actually are out of a job). It may be that some junior executives find the lure of potential equity gains, together with expanded job responsibilities, attracts them from the public to the private sector.

But for most public company executives it appears unlikely that a move to a portfolio company will result in an increase in the overall pay package from that available to them in the public company sector.


FOOTNOTES:

1. In its references to "private-equity-controlled companies," the column is referring to those companies owned by private equity funds (such as those described in this column, NYLJ, Aug. 29, 2007, at p. 3). Sometimes the private-equity-controlled companies are called "portfolio" companies because they are part of the private equity fund's portfolio of investments. A private-equity-controlled company in this sense does not include a "family owned" or "closely held" company (meaning for this purpose controlled by a family or a group of founders or other individuals without major investment by an outside private equity fund).

2. An example of the data "out there" comparing executive pay in private-equity-controlled companies with pay in public companies is the following statement by Walter Williams, a partner at the executive search firm Battalia Winston International:

. . . a CFO at a portfolio company might earn 20 percent to 40 percent less in total annual cash compensation than a CFO at a similar public company . . .

as quoted in Marshall Krantz, "Private Equity Paints 'Help Wanted' Sign" at http://www.cfo.com/article.cfm/11360846/?f=CFO_Careers_topstories (May 13, 2008). CFO.com is a Web site of the Economist Group.

In the author's experience, like that noted in respect of CFOs, the annual cash compensation of CEOs as well as other top management in the private sector tends to be less than that of their counterparts in public companies.

3. Also contributing to a lower expressed value in a private-equity-controlled company is the motivation on the part of the portfolio company executives, as well as private equity fund principals, to minimize date-of-grant value of such a company for tax purposes. For example, a grant of stock may be taken into income as of the date of grant notwithstanding its being subject to a substantial risk of forfeiture by making a Code §83(b) election. The objective of those making such an election is to maximize later long-term capital gains treatment for gains from the sale of the stock.

4. This does not take into account that, in many cases, holders of stock in private-equity-controlled companies have rights, under certain circumstances, to put the stock to the company. However, generally speaking, there are conditions including time delays associated with these put rights. Therefore, even where such put rights exist, a significant discount in value applies to a private equity situation due to its having less liquidity than a publicly traded stock.

5. Sarbanes-Oxley Act of 2002, PL 107-204, 116 Stat. 745, §402 (codified as §13(k) of the Securities Exchange Act of 1934).