Private Equity Pay For Public Companies
02/07/2007
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This opinion piece by Michael Robinson of Guerdon Associates, was published on 16 May 2007 in the Australian Financial Review.

One of the absurdities of current governance guidelines is that private equity executive pay would never pass muster for public companies because it is outside the parameters supported by institutional shareholders, proxy firm advisers and governance groups. It is absurd because private equity, when it is done well, is a governance business. It is all about creating a new and better model of management than exists in a typical public corporation.

Integral to this is an incentive-alignment transformation that private equity performs on a company-by-company basis, out of public view. This differs fundamentally from the highly public push for all companies to implement one-size-fits-all pay governance practices.

Cynics will say that this is a red herring designed solely to justify ever rising levels of executive pay. This attitude displays a complete misunderstanding of private equity’s higher risk and reward trade-offs.

But the reality is that it is very difficult to implement a private equity style pay deal in a listed company. To implement such an approach requires management and the board to agree to undertake considerably more risk than most public companies would countenance.

To replicate the private equity approach, public company directors and top management need to have substantial “skin in the game”. CEOs may need to be willing to take on full recourse debt to acquire company shares many times his/her annual pay.

While bonus and option opportunities would be far larger than for comparable peers, annual compound double digit returns that results in plaudits for others will be the absolute performance minimum expected for such high reward. Further, both the board and the CEO have to be reconciled to much tougher standards for the CEO’s continued tenure.

Directors would need to be actively engaged in looking over the CEO’s shoulder, requiring direct and relevant experience in the change being sought. The additional workload (on top of public company duties) would necessarily require a revamp of board pay and equity holdings requirements to share the risk and return.

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.

So, while there can be scope for incorporating reward to replicate private equity governance models in a public company setting, is it any surprise that there may not be too many takers?

There are a number of factors to take into account to make a private equity pay deal work in a listed company, some more important than others.

A highly respected and experienced management team is important. Shareholders will invest money in a management team that has historically delivered value and whom 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 that will deliver shareholder value. Further, shareholders must buy into the strategy to have any chance of the pay deal being accepted. 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 unrealised value is the best bet for these types of deal.

The difficulty of implementing private equity style pay in a public company explains why there are few examples where this has been applied anywhere in the world, and none yet in Australia.

But we may see the wheel beginning to turn. In the UK, governance groups that once opposed the potential largesse of private equity style pay arrangements are changing their tune as they begin to see the benefits to shareholders. In Australia the federal government’s review of the business judgement rule may result in directors more inclined to take on more business risk in the interests of better shareholder returns.

On a subtler note, we are discerning incremental progress in public companies to increase equity ownership by management and pay responsiveness to performance, and a more sensitive relationship between CEO tenure and performance. And rather than an all or nothing approach, degrees of the risk and reward private equity model that suits the circumstances of each company are now being actively considered.

Public companies can replicate the governance and operational wonders of private equity. Being the right sort of company in the right sort of situation is only part of the requirement. Another is a courageous and talented board and management team willing to buck a public company governance system that puts a brake on risk taking, entrepreneurialism and shareholder returns.

© Guerdon Associates 2021
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