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The Executive Edition

June 2015

The Executive Edition 2015 No. 2

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in the news

June 2015

in the news

Shareholders score again as financial results climb

1 Cooking up a better pay mix: active shareholders emerge as a new ingredient

After a record year in 2013, when shareholders earned a total shareholder return (TSR) of 34.6 percent, it was difficult for companies to have a comparable banner year. But performance in 2014, while not as spectacular as in 2013, was still a very solid TSR of 16.6 percent. Shareholders had consistent growth over the past two years and CEO pay followed suit.

design

5 Performance share awards: design considerations 8 Private equity firms: compensating the executives of portfolio companies

data

10 Employment contracts, severance and change-incontrol provisions

Cooking up a better pay mix: active shareholders emerge as a new ingredient Findings from The Wall Street Journal/Hay Group 2014 CEO compensation study By Steve Sabow

Copyright © 2015, Hay Group. All rights reserved in all formats. This publication is designed to provide accurate and authoritative information with regard to the subject matter covered. If legal, tax, or accounting advice is required, the services of a person in such area of expertise should be sought.

In particular, firms made pay mix adjustments. Overall, 2014 turned out to be a good year for a majority of the 300 CEOs looked at in the study.

For the second year in a row, in 2014 companies achieved solid gains in performance as chief executive officers (CEOs) watched their pay rise. In the say-on-pay era, shareholders’ views are being heard throughout the year as companies reach out to engage with them. After listening to the expressed concerns and recommendations, many firms implemented various changes to their executive compensation programs.

Overall, companies were profitable in 2014, with a 6.6 percent jump in net income. In this age of “pay-forperformance,” it is likely that when a company is profitable, its CEO’s annual pay will rise. As a result of this performance, CEOs saw their salaries grow 2.0 percent to $1.2 million while annual incentives rose 4.3 percent to $2.5 million, yielding a 4.1 percent increase in median annual compensation (salary + annual incentives) to $3.7 million. Given the high TSR figures, companies overall could have justified much larger long-term incentive (LTI) awards. However, they generally exercised restraint, as CEO LTI grants in our study were up a median of 5.6 percent in 2014 to $8.1 million, and total direct compensation (TDC, composed of salary + annual incentives + LTI) also increased a respectable 4.6 percent to $11.8 million.

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2014 CEO compensation changes and values 15.0%

13.5%

12.0% 9.0% 5.6%

6.0% 3.0%

4.3%

4.1%

4.6%

2.0%

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in c $8 en ,1 tiv 03 es ,7 58

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2

Individual values are medians that should not be added

In a methodology change this year, Hay Group and The Wall Street Journal are reporting pay figures as they are disclosed in the Summary Compensation Table of the annual proxy statement. After adding in the change in nonqualified deferred compensation earnings plus the change in pension value, as well as all other compensation, total CEO compensation was up 13.5 percent to $13,563,355.

Consumer service and health care companies pay more in 2014

The evolving pay mix: shareholders added into the formula In 2014, shareholder outreach intensified as companies engaged investors throughout the year to identify and discuss pay issues that mattered most to them. As a result of hearing views of key shareholders, some companies revised their compensation programs. One noteworthy response involved LTI pay mix changes that were adopted either immediately or for future years.

The largest pay increases were seen in the consumer service industry, where TDC increased 10.1 percent with only a 3.8 percent change in net income but a substantial one-year TSR of 22.6 percent. Health care companies saw TDC rise 8.4 percent with only a 2.4 percent improvement in net income but with a 23 percent one-year TSR.

For example, a company that granted an equal amount of restricted stock, stock options and performance equity likely heard that its pay mix should be modified so that more compensation would be tied to performance. Changes to the LTI pay mix often resulted in one of the following allocations:

At the other end of the spectrum, TDC for technology companies remained flat at 0.0 percent, along with a net income increase of 3.8 percent and the second highest (24.3 percent) sector in one-year TSR. For a straight second year, the pay increase at oil and gas companies was almost flat (0.6 percent), along with a decline in net income of 0.2 percent and the lowest one-year TSR (-6.1 percent).

and 50 percent performance equity; 50 percent restricted stock and 50 percent performance equity; 50 percent stock options and 50 percent performance equity; or 100 percent performance equity. Although we have observed such pay mix changes over the past five-plus years, they were more common in 2014 as shareholders stepped up their involvement in the compensation process. Steady and gradual evolving modifications of the LTI pay mix likely will continue into 2015 and beyond; many of the changes we saw in the 2015 proxy statements were only to take effect in the next fiscal year.

How has CEO pay been in the heavily-watched financial services sector? Salary plus bonus saw no (0.0 percent) change, whereas net income rose 7.4 percent. Further, TDC was only up 4.3 percent with a 10.8 percent one-year TSR.

25 percent restricted stock, 25 percent stock options


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The evolving TDC pay mix, 2010 to 2014 2010

18%

2011

17%

2012

16%

2013

15%

2014

14%

0%

29% 27%

14%

19%

23%

16%

22%

13%

60% Stock options

For the fifth consecutive year, long-term performance equity plans (e.g., performance shares or performance restricted stock units) were the largest component of the LTI pay mix. Considered by many as the most important piece of CEO compensation, shareholders’ support of such programs provides evidence that companies are trying to make the pay-for-performance connection. The typical performance-based equity grant is a contingent award that only vests upon meeting certain performance goals over a defined performance cycle, often three to four years. The usual time-vested restricted stock or restricted stock unit grant has no such performance targets and is earned simply by the passage of time. It was no surprise that performance-based equity awards continued to be the most popular and favored award approach of shareholders and their advisors. In this year’s sample, performance awards (performance equity + performance cash) constituted more than half of a CEO’s LTI at 50.8 percent, up from 48.9 percent in 2013. More companies made performance-based awards in 2014 as well: a record 85 percent of companies, up from 72 percent the previous

30% 31%

16%

40%

Long-term performance equity plans: largest piece of the pay mix

24%

15%

16%

Bonus/ annual incentives

21%

15%

17%

22% 20%

Salary

18%

32% 80% Restricted stock

100% Performance awards

year. Companies granting performance equity totaled 79.3 percent of the sample in 2014 and 66.3 percent in 2013, while those awarding performance cash were only 12.7 percent in 2014 and 13.3 percent in 2013. Stock options continue to be the second-most prevalent vehicle, with 60.3 percent of the survey group awarding them to their CEOs (up from 55.3 percent of companies in 2013). Further, options composed 25.5 percent of the LTI award value. Timevested restricted stock was used in 58.3 percent of companies (up from 50 percent in 2013), comprising 23.7 percent of the LTI award value. Once again, the use of all three vehicles increased, as companies continued to make annual grants that included more than one type; 79.7 percent of the companies reported such grants. While the most widely-used combination included all three award types (i.e., stock options, restricted stock and performance awards), it dropped in prevalence to 29.1 percent from 32.2 percent the preceding year. However, the next two most popular combinations both increased in prevalence: stock options and restricted stock jumped to 26.3 percent from 23.7 percent, while restricted stock and performance awards rose to 23.2 percent from 19.5 percent. Since 2013, the prevalence of granting only one such vehicle (such as stock options only) dropped across all vehicles.

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Change in CEO long-term incentive prevalence – All incumbents, 2013 to 2014 216 Performance awards

255 2013

150 Restricted stock

175

2014

166 Stock options

181 0

50

100 150 200 Number of companies

250

300

Includes only constant incumbents

After five years of say-on-pay votes, how have companies evolved? With say-on-pay in its fifth season, most companies have been obtaining high levels of shareholder support. But three or four years of votes in excess of 90 percent do not guarantee a similar result going forward. Companies understand that and many adopted outreach programs to communicate with their shareholders throughout the year. Building a close relationship between a company and its largest shareholders can often help address the issues before they cause problems.

adopted claw-back policies for their annual and

long-term incentive grants. Over the past five years, low levels of favorable sayon-pay votes (typically between 40 percent and 70 percent) at some large companies lead to revisions in executive pay programs. Common changes included: adding performance share units (PSUs) revising the LTI pay mix adopting claw-back policies changing to “double triggers” for equity vesting modifying performance metrics

Besides meeting with their shareholders, companies worked at enhancing the text in the Compensation Discussion and Analysis (CD&A) section of their annual proxy statements to provide more explanation and rationale on pay decisions, such as pay-forperformance and pay metrics. During the current proxy season, we saw some companies do one or more of the following in response to shareholder interactions and feedback:

including absolute governors on relative TSR PSU

agreed with shareholders and recommended that

Meeting with large shareholder groups throughout the year and reporting on those meetings in the annual proxy statement has quickly become the norm in large companies. We are following how companies react to expanded shareholder outreach in 2015, and whether that interaction continues to cook up a new and better pay mix that is currently dominated by performance equity grants.

a majority shareholder vote can approve a “proxy access” proposal changed their performance metrics in their annual and long-term performance programs so that they employ different performance metrics and do not pay twice for the same metric added a TSR metric to a long-term performance equity program changed from three one-year performance periods to one three-year performance period for a performance-based equity program, and/or

plans eliminating tax gross-ups, and/or limiting perquisites. Companies overall gained from the experiences of others and concluded that they must become more proactive where say-on-pay voting yielded disappointing levels of support.

Steve Sabow is a consultant in Hay Group’s US board solutions group. You can reach Steve at (201) 557-8409 or [email protected]. n


design

Performance share awards: design considerations By: Matthew Kleger With the focus on “pay-for-performance” and shareholder alignment in today’s executive pay environment, performance share awards (PSAs) have taken center stage. At many of the largest US companies, chief executive officers (CEOs) and other C-suite executives now often receive at least 50 percent of their total direct compensation in the form of long-term incentives (LTI). In this pay mix, PSAs increasingly comprise at least 50 percent of the overall LTI value. While other types of LTI awards may include performance components (including stock options and awards payable in cash), our discussion focuses on PSAs – namely, awards in the form of equity that provide the opportunity to earn shares or units payable in shares upon achieving certain performance goals/targets over a pre-determined performance period. Given the significant organizational, employee and shareholder implications associated with PSAs, companies need to get it “right” when designing, implementing and communicating these programs. There is no “one size fits all” approach to PSA design; rather it should support and promote each organization’s unique business strategy and compensation philosophy while aligning with the interests of key stakeholders. Although many of the concepts also apply to privatelyheld entities, the focus here is on design considerations at publicly-traded companies. While tax, accounting and legal issues, as well as administration and communication matters, are also important, those topics are in large part driven by the specific set of facts and circumstances relevant to a particular PSA design and are not addressed here.

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Eligibility PSAs are typically utilized for senior executives and may cascade one to three levels down depending upon various factors such as the organization’s size, structure, business/compensation strategy and compensation philosophy. For example, a company with $500 million in revenues and a flat organizational structure may limit PSA eligibility to C-suite executives only while a company with $20 billion in revenues and a multi-layer structure may provide PSAs to all employees at the vice president level and above. A key consideration in determining PSA eligibility is the ability of each participant to influence critical business objectives and outcomes. If a participant doesn’t understand the design of the PSA program or his/her ability to impact measured results, the likelihood of driving the desired behaviors is reduced.

Performance measures and measurement Two of the most important decisions in the design of PSAs are the selection of performance measures (i.e., what is being measured) and performance measurement (i.e., how to measure). Unlike annual incentive plans which often include strategic, operational and/or individual performance measures, PSAs tend to focus on objective financial performance measures. While the choice of performance measures in part may be driven by tax deductibility considerations, it is also heavily influenced by the manner in which institutional shareholders and the proxy advisory firms view “performance.” Performance measures Considering that the largest proxy advisory firm, Institutional Shareholders Services (ISS), utilizes total shareholder return (TSR) as its only measure of performance, it is not surprising that TSR has become the most prevalent performance measure in PSA plans. While debate rages on around the use of TSR as an indicator of senior management performance, some take comfort in aligning with ISS’ approach to determining performance – regardless of whether or not it is the most appropriate measure for the particular organization’s business. In addition to TSR, some of the more prominent financial performance measures relate to profitability (e.g., operating income, earnings per share [EPS], net income, EBITDA), capitalefficiency/returns (e.g., ROE, ROA, ROIC), revenue/ sales and cash flow (e.g., free, modified, operating). We have found that most companies use one or two performance measures. Measurement of performance PSAs are measured on either an absolute (versus internal plan/budget/goals) or relative (versus some type of comparator group) basis. Absolute goals are typically financial in nature while relative goals

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are predominately TSR-based. Relative TSR is fairly common in the market and it aligns with the only performance measure within ISS’ quantitative payfor-performance assessment. In addition, recently proposed rules regarding pay-versus-performance released by the Securities and Exchange Commission would require the use of relative TSR in mandated disclosures under section 953(a) of the Dodd-Frank Act. When utilizing relative performance measurement, companies should carefully consider the composition of the peer group due to its implications in a payversus-performance analysis. Comparator groups typically consist of one of the following, each of which comes with its own advantages and disadvantages: Compensation peer group utilized for executive pay

benchmarking Financial performance peer group utilized for financial performance benchmarking Custom peer group which may be comprised of companies that share similar business characteristics, but not necessarily size An industry index such as the S&P 1500 Healthcare or NASDAQ Telecommunications A broader index such as the Fortune 100, S&P 500 or Russell 3000 In balancing the benefits and drawbacks of each approach, many companies use both types of measures in their PSA design, allowing them to balance absolute performance with relative out-performance.

Performance period The most common performance period for PSAs is three years; this generally is the longest period of time over which companies are comfortable with forecasting business performance and is considered “standard” by many institutional shareholders and the proxy advisory firms. However, three years may not work well for some companies. If the current state of an organization’s business does not allow the board and senior management to set meaningful, realistic and measurable goals over a three-year period, plan participants may discount, or even worse, ignore, the intent of the PSA program. To address this concern, some companies use a one- or two-year performance period with additional vesting on the “back-end.” For example, if a company has poor visibility regarding forward-looking performance (especially when non-TSR financial measures are used), it may adopt a one-year performance period with two additional years of vesting after the completion of the performance period. While this type of PSA design provides a longer-term focus than annual awards

and can encourage retention, it is not the preferred approach of many institutional shareholders and the proxy advisory firms.

Vesting period Three years is by far the most common vesting period for PSAs; it also is the preferred (but not prescribed) approach of many institutional shareholders and proxy advisory firms. While a total vesting period of three years is quite common, the vesting structure varies by company and typically takes one of the following forms: Cliff: 100 percent at the end of the performance/

vesting period (most common PSA approach) Pro-rata: equal installments over the vesting period (i.e., 33.3 percent per year over three years) Other: any structure not considered cliff or pro-rata

(i.e., 25 percent after year 1, 25 percent after year 2 and 50 percent after year 3)

Goal-setting and leverage Many PSA programs contain the following three levels of performance and corresponding common payout levels (i.e., the performance/payout calibration): Threshold. A “floor” that represents the minimum

level of performance that must be achieved before PSAs can be earned. For non-TSR absolute financial performance measures, threshold performance is generally in the range of 80-90 percent of target. For a relative TSR performance measure, threshold performance is generally set around the 25th-35th percentile versus the applicable comparator group. In each of these cases, the threshold payout level is generally 25-50 percent of target. Target. The expected and/or planned (budgeted) level of PSA performance achievement and payout. For non-TSR absolute financial performance measures, 100 percent of plan/budget typically equals a 100 percent payout. For a relative TSR performance measure, target is often set at the 50th percentile (median) versus the applicable comparator group, equating to a 100 percent payout. Maximum. The total PSA opportunity that may be earned for superior performance, sometimes referred to as a “cap.” For non-TSR absolute financial performance measures, maximum performance is generally in the range of 110-120 percent of target. For a relative TSR performance measure, maximum performance is generally set around the 75th percentile versus the applicable comparator group. In each of these cases, the maximum payout level is often 150-200 percent of target. In an

The Executive Edition effort to provide “fairness” and better align with shareholders, an emerging trend for PSAs using relative TSR includes a limit on payout at target levels when an organization’s TSR is negative over the performance period but relative performance would have resulted in above-target/maximum payouts. Outcomes for performance/payouts are often interpolated between threshold/target and target/ maximum levels. The calibration of threshold and maximum performance goals depends on various factors, including the performance measure, the performance period, the organization’s size, the ability to forecast future performance, the “message” being signaled to plan participants and the probability of expected outcomes (discussed below). In designing the performance/payout calibration, organizations also should consider certain ancillary issues such as share pool availability and reserve, full-value award limits and fungible ratios within the equity plan, burn rate and dilution, sensitivity around accounting expense and institutional shareholder/proxy advisory firm policies/preferences. Probability of achievement From a goal-setting perspective, companies should consider internal and external performance expectations as well as any shareholder feedback. The probability of achieving different performance outcomes is another relevant consideration, with awards often structured based on the following likelihoods: Threshold is achieved 8–9 times out of 10 Target is achieved 5 times out of 10 Maximum is achieved 1–2 time(s) out of 10

If goals are too stringent, plan participants may discount (or even ignore) this pay component (so that the company incurs a cost without concomitant benefits). If goals are too flexible, the PSA design may not drive “stretch” performance.

Multi-year performance periods For PSA programs that utilize a multi-year performance period, the two most common approaches to goalsetting are cumulative and “build-as-you-go.” A cumulative approach means that an organization sets the entire multi-year goal “up-front” while a “buildas-you-go” approach means that the multi-year goal is built one year at a time. The cumulative approach is the most prevalent in the market; it is the “purest” form of a long-term plan, the most advantageous from an accounting perspective, and is preferred by institutional shareholders and proxy advisory firms.

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However, goal-setting can be especially difficult under a cumulative approach and, if not developed appropriately, can render the entire multi-year goal meaningless early on in the performance period (e.g., a bad start that would be extremely difficult to overcome). The build-as-you-go approach is desirable for companies that have difficulty with multi-year goal-setting as it allows goals to be determined based on the financial outlook at the time of each goal-setting event. While less of a true long-term plan and potentially disadvantageous from an accounting perspective, some companies prefer the flexibility in navigating their limitations on setting multi-year goals.

Termination provisions Prior to grant, companies should determine the treatment of PSAs in the event of a participant’s termination prior to the expiration of the respective performance period – i.e., what happens to all unvested PSAs at time of termination? The termination provisions will typically be memorialized in the plan document, individual award agreement and/or other types of agreements (e.g., employment, severance, change in control [CIC]), commonly providing for various termination scenarios (e.g., by employer for “cause,” resignation without “good reason,” death, disability, retirement, by the employer without cause, by the employee with good reason and in connection with a CIC). With respect to each termination event, the relevant materials should address: How is vesting determined – e.g., forfeited, partial, full, continued? When is performance measured and payout made

– at the time of termination or at the end of the performance period? How is performance measured – based on actual or target performance? What happens in the event of a CIC? The treatment of PSAs in each termination scenario should balance organizational and shareholder considerations, prevailing market practices, institutional and proxy advisory firm policies/ preferences and any optical considerations associated with publicly-available disclosures. The potential application of various tax provisions (e.g., Internal Revenue Code sections 162(m) and 409A) and accounting treatment also must be considered.

In closing While design trends and considerations will change over time as programs evolve, PSAs should remain prevalent for the foreseeable future. Prior to the adoption and implementation of any PSA program, input advice should be obtained from interested

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internal and external parties; these generally include senior management, finance, human resources, legal, compensation consultants, outside legal counsel and outside accountants. A successful design can be achieved by starting with the business strategy, identifying the internal and external design team, and working through each of the issues in context of an organization’s culture, talent and pay philosophy.

overarching philosophies and structures, each company has unique characteristics and opportunities that should be aligned and reinforced with focused pay programs. The make-up and quality of compensation designs can vary by deal, at times resulting in situations where management and investors are not fully aligned. This can create a need to formulate or leverage the PE firm’s best practices to improve the effectiveness of the compensation arrangements.

Matthew Kleger is a consultant in Hay Group’s US board solutions group. You can reach Matthew at ( 215) 861-2341 or [email protected]. n

Overarching pay structure Private equity-backed buyout deals are wealth creation opportunities where the combination of variable compensation and ownership creates a powerful compensation model that drives management team behaviors and reinforces the alignment of interests among the team, the business and the investors. The pay design typically includes three elements: base salary, an annual incentive opportunity and a longterm incentive (LTI) program. This compensation structure is widely supported by the marketplace and institutional shareholders.

Private equity firms: compensating the executives of portfolio companies By Greg Kopp Industry investment teams at private equity (PE) firms operate in an environment of high valuations, with constant and intense competition for deals. As these teams may have hundreds of billions of dollars to put to use on behalf of their investors, they continuously search for opportunities to evaluate potential transactions and to operate their portfolio companies more efficiently and effectively. Increased emphasis is being placed on the human capital side of deals to address a key question: how can we align the interests of management and investors more quickly so that the process of value creation can begin sooner and enable us to hit our investors’ performance expectations? In the last several years, we have seen a greater appreciation of the talent side of the business in driving investor returns: namely, having the right talent that can execute the strategy, supported by a compelling compensation program, to expedite the process of creating value and delivering returns to fund investors. The compensation program is a critical management tool to help shape and motivate executive behaviors. Although executive compensation arrangements at investment (or portfolio) companies have similar

A fourth (and critical) element of compensation programs is an expectation that management coinvests in the portfolio company along with investors. Such use of personal funds creates real “skin in the game,” reinforcing management’s commitment to the success of the business and strengthening its alignment with investors. Investment team professionals also are expected to invest in their deals to reinforce their alignment. The commitment of personal proceeds unifies the interests of the fund investor, the deal team and the portfolio company executive team.

Compensation elements Annual cash compensation (base salary and annual incentives) Base salary is deemphasized in the overall pay program and tends not to fluctuate when a company is acquired unless there is something unique about the existing pay structure. The goal is to provide a competitive salary within a pay framework that emphasizes variable, performance-based compensation. While many portfolio company annual incentive programs are discretionary (which is also common in the financial services model), we observe (and favor) the more structured annual incentive programs utilized by public companies: predetermined performance goals that align with a leveraged incentive opportunity. These arrangements typically consist of a target bonus (expressed as a percentage of salary), combined with a threshold payout for near achievement of goals and an upside (or maximum) opportunity which aligns with superior levels of performance. This common model

The Executive Edition helps limit short-term decision-making and reinforces the long-term upside of the LTI and ownership elements of the pay model. The level of performance needed to achieve threshold bonus payments at portfolio companies is often more rigorous than at public companies. While public companies often start to pay out at 80 percent of performance, the PE firms overseeing a portfolio company may not be willing to pay out until performance reaches the range of 90-95 percent of goal (often EBITDA). Although private equity firms dislike paying incentives for below target performance, they do understand the importance of executive retention and often consider the circumstances surrounding a missed performance objective. Accordingly, at times PE firms may allow a modest “special funding” to support the short-term cash compensation program; this can be attributed to PE firms having a small and focused shareholder population that is invested and intimately involved with the operations of their portfolio companies. Long-term incentives The LTI program, along with the co-investment, are the primary drivers of shareholder alignment and the wealth creation opportunity.

Types of LTI awards Historically, the long-term incentives were in the form of appreciation only awards (e.g., stock options) that were consistent with a growth strategy and with the PE carried interest model which, broadly stated, is equal to 20 percent of the appreciation over a performance hurdle. More recently we have seen full-value shares (e.g., restricted stock) being implemented in the LTI program for the same reasons observed in public companies: retention-focused, more akin to ownership and with fewer shares/less dilution required. There are also LTI vehicles used in PE-backed deals that mirror the economics of stock options or restricted stock (e.g., profits interests) but with the potential for preferential tax treatment. Operationally, these awards are similar to stock options or restricted stock, but require very specific structuring and coordination with legal counsel.

Equity allocations Similar to public companies, portfolio companies reserve a portion of the equity to be allocated to the LTI plan. While a wide range of equity reserve models may be used, as a starting point, 8 to 12 percent is common. However, we have worked with companies that had as little as 3 percent and as much as 20 percent. The amount of the reserve is a function of various factors, including the deal size and potential value creation, the number of executives that will participate in the plan,

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and in some cases, the amount of co-investment that the management team makes available.

Grant frequency A significant difference in the grant strategies between a portfolio company and a publicly-traded company is the frequency of the LTI grant. Given the expected short-term ownership of the portfolio company (i.e., 4-6 years), the LTI is usually granted at one time at the close of the transaction. This approach provides the executives with an opportunity to maximize their returns by receiving their entire grants upfront, allowing for the full awards to participate in the value created. A challenge to this strategy, which many PE companies are currently experiencing, is when a company may be in the portfolio for a longer term than originally anticipated. As the value creation and exit time frames take longer, they begin to impact the perceived value of the LTI award (e.g., with an assumed five-year horizon). In such cases, management teams may seek “refresh grants” and/or opportunities to monetize portions of their investment prior to an exit event; these variations run counter to the PE model. The trend of expanding exit timeframes has led to discussions on how best to maintain the alignment of interests, while also keeping management motivated and incentivized over the longer-term.

Participation Portfolio company LTI plans typically are limited to the senior executives who are most directly aligned with value creation. While programs at public companies commonly go much deeper into the organization, the structure at PE firms reflects their limited share reserves, complexity of arrangements and a philosophy that stresses putting ownership into the hands of the executives who are most directly accountable for delivering returns. Organizations that need to provide LTI to a broader set of employees may use multi-year cash plans, but the emphasis of the wealth creation opportunities still is focused on the senior management team.

Vesting The LTI program typically follows public company practice: a combination of time and performancevested awards. Practices vary, but a common approach is 25 – 50 percent of the award being time-vested, with vesting on the balance (50 – 75 percent) of the award contingent on satisfying performance criteria. The performance standards generally consist of one or two return-based criteria: return on capital invested (usually 2X and higher) and an internal rate of return requirement (typically 20 percent and higher) which

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considers the amount of time required to generate the return on capital invested. The performance-vested awards typically have multiple tranches with increasing performance requirements (e.g., 25 percent vests at 2X return, 25 percent vests at a 2.5X return).

data

Monetization The ability to monetize, or convert the awards to cash, is aligned with the investors, and occurs when the portfolio company investment is sold (i.e., the exit event) and the investors receive their return. Co-investment opportunities The alignment of interests is further strengthened when management co-invests in the portfolio company along-side the PE investors. This is a powerful element of PE strategy as it creates a unified ownership model among the fund investors, investment team and management team that ultimately aligns all stakeholders toward a successful exit event (and subsequent monetization) in the future. The management team’s proceeds are often funded by transaction-related payments triggered by the sale to the PE firm: payouts from LTI programs, retention awards, or severance or CIC payments are all potential sources of funds for investment in the portfolio company.

Summary The PE pay model aligns the interests of the investors with those of the management team and creates a wealth accumulation opportunity that is a powerful motivator and influencer. Companies outside of the PE industry have taken notice and are looking for opportunities to incorporate elements of the program into their strategies. Inside the industry, the significant “dry powder” and continued deal activity, along with the range of practices by company and the changing exit strategy time frames, are beginning to impact the thinking underlying these program designs. A refresh on pay philosophy can help leverage the best practices to help construct an aligned and motivated management team. Gregory Kopp is a consultant in Hay Group’s US board solutions group. You can reach him at (703) 841-3118 or [email protected]. n

Employment contracts, severance and change-incontrol provisions Findings from The Wall Street Journal /Hay Group 2014 CEO Compensation Survey By Sydney Hilzenrath In The Wall Street Journal /Hay Group 2014 CEO Compensation Survey, Hay Group examined the compensation levels of chief executive officers (CEOs) of the top 300 reporting companies (by revenue). Summarized below are our findings on various aspects of CEO agreements as disclosed by the studied companies, including the prevalence of employment contracts, restrictive covenants, and certain severance/ change-in-control (CIC) arrangements. Note: Our analysis is based on the details disclosed in a company’s latest proxy statement without reviewing plans that may be disclosed in the attachments to the company’s Form 10-K.

Prevalence of employment agreements and restrictive covenants Employment agreements are often used to specify the terms of employment arrangements between top executives (typically the CEO and often other named executive officers, especially new hires) and the employing organization. Practices can vary substantially, with some companies not using employment contracts at all, while others extend them two or three levels down from the CEO. These agreements may address topics such as the term of agreement, whether the agreement has an evergreen (automatic) renewal, the employee’s


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duties and responsibilities, the compensation and benefits provided, termination provisions, and various restrictive covenants that protect the company during and after an individual’s employment.

multiples that included the CEO’s annual bonus were disclosed by 123 companies; two times bonus (55.3 percent) was the most common (and also the median) for this group.

Details on employment agreements were provided by 40% of the top 300 companies in the proxy statements examined. This does not mean that the other 180 companies do not have employment contracts, but rather that the proxy statements of those organizations did not disclose information regarding such agreements. Of the 120 companies that provided details regarding employment contracts, 35 reported the term of the CEO’s agreement. In this modest sample, we found that the median term was three years (17 companies), with 10 companies disclosing 5-year terms. Surprisingly, among the 35 companies, well over half of the agreements have an evergreen renewal clause.

CIC severance pay multiples With respect to a CIC, companies tend to use pay multiples that are larger than for general severance events. For example, CIC arrangements were disclosed by 227 companies (75.7 percent), and 195 companies reported the CEO’s median CIC payment multiple as it relates to the CEO’s base salary. Three times base salary (49.2 percent of companies) was the most common. Further, CIC severance multiples including the CEO’s bonus were disclosed by 186 companies; three times bonus was the most common (49.7 percent of companies).

Companies frequently incorporate restrictive covenants into employment contracts or have other agreements with executives simply to impose restrictions, including: to ensure that the executive does not compete with

the company (i.e., a non-compete) to provide that the executive cannot solicit employees or customers/clients away from the company (i.e., a non-solicit); and to protect the company’s trade secrets and promise not to share any details about the employer’s business (i.e., a confidentiality provision). Many companies used more than one type of restrictive covenant. Looking at the main types of restrictions, 52.7 percent of the 300 organizations mentioned noncompetes, 46.7 percent reported non-solicit covenants and confidentiality agreements/clauses were disclosed by 32.7 percent of the companies.

Severance and change-in-control arrangements Severance and CIC arrangements provide for payments to executives in situations involving the termination of their employment and/or a CIC. The two basic categories involve either: (i) a termination by the employer “without cause” or by the employee “for good reason” (as such terms may be defined), and (ii) in connection with a CIC. General severance provisions were disclosed by 228 (76 percent) of the companies in the study, 175 of which reported the CEO’s median general severance payment multiple (in relation to the CEO’s base salary). Two times base salary was by far the most common multiple (and the median as well), followed by one- and three-year salary multiples (which were significantly less common). General severance

While our research did not specifically focus on CIC pay multiples for executives other than CEOs, we observed that multiples for non-CEO executives typically were lower than for the CEO. These other executives often received one to two times salary plus bonus, in some cases depending on whether an individual is a named executive officer. Equity termination provisions The shift away from single trigger vesting of equity awards (i.e., all equity awards vest upon a CIC, without the requirement of a severance event) has been growing annually. In 2014, with say-on-pay and shareholder outreach programs favoring double triggers (i.e., CIC accompanied by an involuntary termination), there was significantly more pressure to amend agreements containing single triggers and board discretionary triggers. Only five companies in our sample did not disclose any equity termination provision, possibly because they do not have any LTI programs. Of the 295 companies that provided information on equity termination, we found: 72.9 percent of companies with long-term incentive

plans have stock options that accelerate upon a CIC 81 percent have restricted stock or restricted stock units (RSUs) accelerating upon a CIC; and 79.3 percent have performance equity accelerating upon a CIC. Of those companies, equity is triggered as shown in the following table: Double trigger

Options RS/RSUs Perf. equity

86.5% 86.2% 87.6%

Single trigger

12.1% 12.1% 10.7%

Board discretion

6.5% 3.3% 3.8%

11

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Finally, we note that the use of one trigger does not preclude the use of another. For example, a company that has a double trigger on RSUs may also allow board discretion to determine the amount of equity paid out if a CIC occurs. There are also situations where a company has a double trigger for stock options awarded to executive officers, while still maintaining a single trigger for certain other stock option grants. Sydney Hilzenrath is a consultant in Hay Group’s US board solutions group. You can reach Sydney at (201) 557-8407 or [email protected]. n

Hay Group is a global management consulting firm that works with leaders to transform strategy into reality. We develop talent, organize people to be more effective and motivate them to perform at their best. Our focus is on making change happen and helping people and organizations realize their potential. Irv Becker US leader, board solutions 215.861.2495 [email protected] Bill Gerek Regulatory expertise leader Board solutions – US 312.228.1814 [email protected] Steve Sabow Director of research Board solutions – US 201.557.8409 [email protected] Jim Otto Southeast regional leader Board solutions – Atlanta 404.575.8740 [email protected] Brian Tobin Midwest regional leader Board solutions – Chicago 312.228.1847 [email protected]

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