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.
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
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
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