The verdict: Many PE-backed companies embrace the same bad practices and unenlightened governance structures that are pervasive at public companies, including poison pills and other anti-takeover defenses. By some measures, sponsor-backed businesses were the worse offenders, notably weak at using performance-tied pay incentives to keep CEOs' feet to the fire and on average paying them more. What's more, CEOs of private equity-backed companies had less skin in the game, typically owning far less equity than CEOs of companies with no PE ownership.
In other words, PE firms often coddle and protect the CEOs of companies they control in ways that undercut their own investment returns. And why? The report speculates that sponsors may do so to foster cordial relations with the executive set to win more deals.
Unfortunately, such speculation, like the report itself, rests on very thin evidence and specious arguments. Upon scrutiny, in its particulars and overall thrust, the study fails to make its case.
Consider, for instance, its finding that "CEOs of [the] non-PE-backed companies had much more significant shareholdings in their firms than the CEOs of companies backed by buyout firms." The statement is attention-grabbing, all right, because PE firms trumpet the fact that the CEOs they work with, in contrast to many public-company CEOs, risk major money of their own on the companies they run.
Well, several pages later, the report supplies the explanation for the earlier finding: Before they sold a stake in themselves to the public, 43% of the non-PE-backed companies the study examined were "founder firms" whose CEO-founders had owned much of their companies' stock and who kept large stakes after the IPOs.
The lopsidedness of the sample renders the comparison meaningless.
Elsewhere, the report says that before going public, many of the PE-backed companies paid their CEOs no stock options or other long-term incentive compensation at all. This, the report says, refutes the widely accepted idea that "buyout-firm-backed companies have a very highly incentivized executive group."
But the report tellingly ignores why the CEOs weren't given incentive pay. The reason is that executives of buyout-firm-owned businesses generally have a much more powerful prod to perform well than incentive pay provides: namely, the personal wealth they've staked in the deal.
Compensation experts and private equity lawyers explain that when a buyout firm takes a company private, the main weight of incentives shifts radically away from stock awards to money the executives risk in the take-private. That, in the minds of many buyout sponsors, is incentive enough. "We want the CEO to focus like a laser on enhancing the value of his and our investment," says one. "That's all the incentive he or she needs."
Carl Reisner, a private equity lawyer at Paul, Weiss, Rifkind, Wharton & Garrison LLP, says most CEOs of private equity-owned companies have significant "skin in the game."
Reisner says: "I can't speak for every PE firm, but most of the ones I deal with require some level of personal investment by the key executives. Many require [CEOs] to buy their own stock," which typically ranges from 1% to 5% of a company. Senior management collectively may own 10% to 15%.
"They don't get options and they don't get grants. [CEOs] have to pay for their equity," he says.
Once PE-backed companies go public, their CEOs generally start to receive incentive pay. The report found that most get a hefty pay hike -- as did executives of non-buyout-firm-backed companies in the wake of an initial public offering. Interestingly, the report found that CEOs working for PE owners "have higher proportions of incentive," or performance-tied "pay as a whole," than the non-PE group. Still, the report pans the composition of the incentive pay: too much cash bonus and restricted stock and too few options.
Reisner has a ready explanation for the tilt toward cash. He observes that pre-IPO cash compensation for CEOs of PE-backed companies "often is on the low side because they're supposed to be compensated mainly through the equity arrangement." When a PE-backed company does manage to go public, senior managers, he adds, usually sell little if any of their stock because it could depress the stock price. "To make up for that," he says, "management may get additional cash compensation after the company emerges" from an IPO.
One glaring omission in the report concerns the severance packages. As The Deal has reported ("Deliver and you get paid," June 4-10, 2007), when buyout firms take companies private, they often expunge lavish golden parachute severance arrangements that reward failed, cashiered executives. In the buyout domain, CEOs tend to have very modest safety nets, which the report doesn't mention.
Paul Hodgson, who authored sections of the report dealing with compensation, was unavailable for comment.
The notion that PE sponsors make ample use of poison pills and shark repellants doesn't hold water, either. According to the report itself, just 10.9% of the PE-backed companies installed poison pills. While that was higher than the 2.4% of non-PE-backed companies that did so, it was well below the 29% of U.S. public companies that had poison-pill provisions in place as of 2008.
The report does score some points, mostly anecdotal, singling out instances of inflated pay and perks. It contends that PE firms sometimes wield disproportionate clout at companies they have taken public and only partially exited.
Not that institutional investors are complaining. One remarks: "Who would you rather have monitoring the company and the CEO? A board of nominally independent directors made up friends of the CEO, or a PE firm that owns 30% or 40% and whose overriding aim is to maximize its return on investment? I go with the PE firm."
Even fierce critics generally concede that in one area, private equity is on the side of the angels. In contrast to publicly owned companies, whose CEOs often get lavishly rewarded for mediocrity and failure, pay-for-performance is the inviolable rule in the world of leveraged buyouts, and the interests of portfolio-company CEOs and portfolio-company owners -- the buyout firms -- are perfectly and eternally aligned. So goes the PE industry's spiel, which academic studies have tended to support. Indeed, how could things be otherwise?
