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Fears that the lure of private equity pay opportunities will tempt top talent away from the listed sector, leaving a ‘reserve team’ of leaders for everybody else, are unfounded, says PricewaterhouseCoopers LLP (PwC) in its annual review of UK pay trends. The reason, PwC believes, is that private equity is genuinely a much riskier place to be.

Executive Compensation: Review of the Year 2007 shows how a typical private equity deal will be funded by much higher levels of debt and a further proportion by preference shares. This compares with the much less leveraged shares in which an executive in a public company would invest. The result is a very different risk profile.

The report shows the distribution of returns through long term incentives (LTIs). There is a 20 per cent chance of a tenfold return on a private equity investment over five years. These are the ‘jackpots’ that hit the headlines and there is negligible chance of such a return in the listed environment.

Working with no return 

The extra return, however, comes at a price. There is more than a 40 per cent chance of executives making a loss on their investment, as compared with only 10 per cent over five years in a listed company reward structure. Many executives baulk at the prospect of working five prime years with no return.

Recent research has shown how around half private equity funds fail to achieve the minimum hurdle rate of return (around 8 per cent pa) needed to trigger a carried interest payment, a quarter of funds lose around 25 per cent of their value and 10 per cent of funds lose over half their value.

Tom Gosling, partner, PricewaterhouseCoopers LLP, said that experienced talent is generally less interested in the private equity risk profile. He believes that it is for the ranks of the up and coming talent that the huge returns of a successful private equity deal will be most attractive.

“There are also non-financial benefits in the listed sector that keep many there. Handling external shareholders and quarterly reporting are often cited as disadvantages of the listed sector but experience in these areas carry kudos and are an important aspect of CV building for an ambitious CEO,” Gosling added.

Private equity style pay models 

The success of using private equity style pay models to achieve corporate goals in the listed sector is also examined in the report. It finds that private equity style arrangements can be helpful where urgent turnaround is needed or a company is in a ‘change or die’ situation.

Where such an imperative does not exist, focusing a large quantum of reward on a single set of objectives can lead to distorted or even dysfunctional decision making.

Salary increases for FTSE 100 board members appear to have settled around the 6 per cent – 7 per cent mark, although PwC’s survey returns for 2007 suggest that CEO increases are closer to 8 per cent.

For senior executives, the figure is closer to 5 per cent, although certain functions (such as finance and legal) have seen greater increases.

Executive salary increases are still well above pay settlements and pay increases for the average employee. Remuneration committees remain influenced by market benchmarks, despite the Association of British Insurers’ request for companies to justify positioning of salaries ‘at or above’ median.

Non-financial measures 

There has been a sharp increase in the use of non-financial measures such as customer satisfaction, levels of health and safety and employee engagement, market share, environmental measures and corporate and social responsibility (CSR).

Executive Compensation: Review of the Year 2007 shows how, even at board level, fewer than 20 per cent of companies now rely solely on measures of financial performance in their annual bonus schemes.

The use of non-financial measures has risen from 35 per cent of bonus schemes last year, to 57 per cent this year.

There is no doubt that incorporating non-financial targets into bonus plans can deliver benefits including a focus on the long term, increased relevance to individuals’ actions and better communication of the business strategy.

As Goodhart’s law in the British Private Equity Venture Capital Association’s pre-budget report submission 2007 stated, the very act of using a metric reduces its effectiveness as a measure.

Put simply: if a target is set, managers will often find a way of meeting it by the intended means or otherwise. As the NHS has discovered with waiting lists, it is possible to achieve a specific numerical target in a way that was not envisaged.

When using such measures, however, companies have to be careful of unintended consequences.

PwC partner Matthew Thorogood warned companies to be careful to choose metrics which are genuinely used in the management of the business. He said that there is now a great opportunity for companies to consider how such metrics support the long-term sustainability of the business in the broadest sense, both in terms of relevant operating measures and corporate and social responsibility goals.

“If they get it right, incorporating such non-financial measures into reward schemes is a powerful way of directing strategy and bringing about change,” Thorogood concluded.

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Related links

• PricewaterhouseCoopers
• Executive Compensation: Review of the Year 2007
• Non-financial performance measures in FTSE 100