CEO Supply Crunch Pushes Executive Pay Higher

Wanted: Skilled CEO with entrepreneurial flare and successful track record to take promising company to next level. Knowledge of LBO ownership model a must. Management talent is a hot commodity in today’s buyout arena, and general partners are willing to pay the price for it. “CEO compensation is definitely on the rise because you’ve got a shortage of talent,” says Joe Griesedieck, vice chairman and head of the CEO practice of Korn/Ferry International, a Los Angeles-headquartered executive search firm. “Fifty million to 60 million baby-boomers are getting ready to retire and only 30 million to 40 million are stepping up to take their places.” General partners often replace the incumbent CEOs of their acquisition targets with one they’ve already hand-pick for the occasion. And amidst the fevered pace at which LBOs are being consummated today, and the high multiples that accompany them, it’s no surprise that top-tier CEOs—or “human capital” as some pointedly term them—are in high demand.

Even as a number of public-company CEOs are jumping over to the private side, primarily to escape from regulatory requirements and to take part in the exit-time cash-outs, the competition remains fierce to get a hold of savvy CEOs. Moreover, demographic trends are having an evaporating affect on the number of executives there are up for grabs. That’s leaving some firms wading through a talent pool that’s more shallow than its been in a long time.

Indeed, with equity management equity pools reaching up to 20%, buyout pros at times are put in a position where they have to concede some of their returns to attract the right CEO. “Investors value equity more than cash, so it’s sort of a tug of war,” says Todd McCarthy III, a managing partner at Matlin Partners LLC, a Newton Mass.-based executive search firm that recruits management for buyout-backed portfolio companies. “To get the right guy you have to offer the right amount, but they want to be conservative on how much they offer.”Equity Trumps CashChief executives are being lured into the LBO world with three-prong compensation packages that—regardless of deal size—include base salaries to rival what some buyout pros themselves are making; performance-based cash bonuses for meeting or exceeding revenue or EBITDA hurdles; and most notably, equity incentives in the form of either restricted stock or stock options that can be worth millions to hundreds of millions of dollars after a typical five-year holding period.Most often, the equity component takes the form of stock options, where management is given the opportunity to purchase a certain percentage of their company’s shares at a pre-determined strike price, with the CEO taking the largest chunk, says Mark Foster, a partner at law firm Nixon Peabody LLP.

Oftentimes the management team is free to exercise their options at any time throughout the GP’s holding period, and managers are often given discounts and tax breaks to incentivize them to have some skin in the game.Restricted stock, on the other hand is often given, not sold, to the management team. In such cases, the GPs set aside for the CEO and other managers a percentage of the company’s stock and dole it out to them on an annual basis for a period of four to five years. The incentive is designed to keep the management tied to the company, Foster says.And money isn’t the only resource that firms are spending to find their next chief executive. “I’d say that we dedicate about 25% of the firm’s time to prospecting and evaluating CEOs,” says Rich Kracum, a managing director at Chicago-based Wind Point Partners. The model at Wind Point for the past 10 years has been to recruit CEOs on the front end, assign a partner or principal to work with them on a weekly basis, and identify investment opportunities that are tailor-fit to the executive’s managerial background. Wind Point requires its CEOs to invest a minimum of 25% of their liquid net worth into the company they’re running; it offers them an incentive equity program that allows them to buy up to 10% of their company’s common stock at a discount. That gives the chief executive a chance to make between $20 million and $30 million in a four- to five-year period, Kracum says.

“We want them to view it as the best personal investment that they’ve ever seen. So in a sense, they’re betting on themselves and the [value enhancement] plan that they create,” Kracum says.New York-based Charterhouse Group is another firm that keeps a stable of on-hand management talent that it matches up to each investment it makes. “We look for the jockey first, and then we try to go out and find the horse together. It’s not just a matter of looking at auctions,” says David Hoffman, a partner at the firm. “You end up kissing a lot of frogs,” Hoffman adds. “It’s easy to find talent in managers, but tough to find those with an entrepreneurial spirit and an understanding of what private equity is.” GPs were reluctant to give out numbers related to their CEO base salaries, but some did agree to give them on background. One buyout pro that operates in the small and lower-middle markets (which for these purposes includes companies earning between $2 million and $10 million in EBITDA at the time of acquisition) says his firm’s CEOs typically get paid annual salaries between $200,000 and $300,000. That amount, according to the 2006 “Private Equity Compensation Report,” published by Glocap Search LLC and Thomson Financial, publisher of Buyouts, is generally consistent with the average salary earned by mid-market buyout shop principals.

Meanwhile, a GP in the mid-market (companies with EBITDA between $25 million and $50 million at the time of acquisition) says his CEOs earn an average of $600,000 per year in base salary, which puts them in the same realm as some of the better-paid buyout shop partners. Partners, according to the compensation report, bring home average salaries in the $400,000 to $600,000 range. But salary, GPs and recruiters say, is often the least enticing component of the executive package next to things like management equity pools and “on-target,” or performance-based, cash bonuses. River Associates LLC, a Chattanooga, Tenn.-based buyout shop typically sets up an incentive pool for its management teams that could total anywhere from 10% to 20% of the company’s equity, with a “disproportionate amount” set aside for the CEO, says Mark Jones, a partner at the firm. Equity pool pay-off for River Associates CEOs typically comes at the time of exit. “It reinforces the concept of driving the value of the company and puts the management on same page as the sponsor,” Jones says.

The cash bonuses, meanwhile, are normally tied to annual revenue or EBITDA hurdles that are set by the company’s board of directors the prior year. “If [management] hits the budget set out by the board, they get a meaningful cash bonus based on their performance, and if they hit a home run, they can make up to a 100% of there salary,” says Jones.As for the fabled perks of high-powered senior execs (think hidden wet bars behind the revolving bookshelf wall or hot tubs under the sliding trap door behind the CEO’s desk)—those days are no more. “Any negotiation [with a CEO candidate], whether you’re trying to come to an agreement over perks or anything else, is like a microcosm of your relationship going forward,” Charterhouse’s Hoffman says. “When we get requests we consider inappropriate, we look at it as a sign that maybe we should not work with this person going forward.” Kracum agrees. “In a private company it is bare bones in terms of perks,” he says. “Everybody understands [that compensation] should be completely focused on the value of the stock. In fact, executives that express a lot of interest in perks are usually not of interest to us because it’s a sign that they have a ‘big company’ mentality.”

Taking It Private

It’s challenging to place top talent at the head of a company, but there is one trend putting some wind at private equity’s back (at least in the large market) when it comes to recruiting. Particularly over the past two years, a number of public CEOs have become willing to either take their businesses private or get placed at the helm of one that already is. The impetus for these candidates is that they would be free of Sarbanes Oxley and the scrutiny that comes with public filings, not to mention skittish or hostile shareholders. Notable movers and shakers that recently made the move to the private side of the tracks include Mark Frissora, who, earlier this year, opted to leave his position as CEO of Tenneco Inc., a publicly-traded supplier of automotive emission control products, to become CEO of car rental company Hertz Corp. Hertz was acquired last December for $15 billion by Clayton, Dubilier & Rice, The Carlyle Group and Merrill Lynch Global Private Equity.

“We’re seeing a lot of interest from public CEOs coming to us saying, ‘I don’t want to be under that microscope anymore. Give me a nice private deal,’” says Matlin Partners’s’ McCarthy. But if CEOs think they’re catching a ride on the gravy train they’re mistaken. “One thing a lot of these [CEO candidates] don’t think about is that there is regular scrutiny from [the general partners] on performance issues,” Griesedieck says. “Running a private company might be less of a hassle in some ways, but it’s no cakewalk.” “The thing that a lot of [CEO candidates] overlook,” Griesedieck adds, “is that when you run a private equity-backed company, you have to create enough value, in a fixed amount of time, for the next buyer—whether they’re strategics or financial—to find it attractive. A lot of people think that under a private equity firm they will just be able to run a company for five years and then just cash out. The reality is that investment horizons and exit strategies can be very tough to work with.” Indeed, Charterhouse’s Hoffman notes that one of the most frequent challenges when negotiating terms with a prospective chief executive is setting the hurdles for financial earnings growth and other initiatives, such as subsequent acquisitions to build national distribution, national coverage or a national brand. “Management will often try to set the bar a little lower than we’d like,” Hoffman says.

Sidebar: Mid-Market Buyout Pros Get A Raise

Competition for top-tier management is not only fierce on the portfolio company side of the equation. Qualified fund managers in the middle market, too, are in high demand. And, as such, they’ve seen a substantial increase in compensation for their services, according to the preliminary findings of the 2007 Private Equity Compensation Report compiled by Glocap Search LLC and Thomson Financial (publisher of Buyouts).

“The middle-market guys are acting defensively to keep their professionals from being poached upstream,” says Brian Korb, a senior partner at Glocap. “The mega-funds have been doing a lot of recruiting from the lower markets to help them manage all the new capital that they’ve been raising.”

The high demand for top talent led to a rather substantial increase in compensation in 2006. CFOs working for firms whose latest fund is $750 million or less are commanding an average salary and bonus of $476,000 this year, versus the $370,000 they made last year, an increase of 22% (or $106,000). Meanwhile, senior associates working for firms whose latest funds are between $750 million and $1.5 billion in size are taking home an average salary and bonus of $296,000 his year versus last year’s $244,000, an increase of 18 percent.

Glocap and Thomson Financial are expected to come out with their complete 2007 Private Equity Compensation Report later this month. —A.N.