Recently, I was asked a naughty question by a student of my online executive course in PE: 'Ludo, I think it is quite clear to all of us the one thing that annoys you most in the PE industry, but what is the one thing you like most?'
I kinda wrote it in the past but not that clearly. So, here is my redemption; but am afraid it will be controversial nonetheless.
Recently there was a debate in France about whether CEO salaries should be capped. Teh amount mentioned was 30k per month. All the CEOs were outraged at that thought.
I am actually in favour of this cap. I think that any salary above 30k is most probably the result of a market friction rather than that of a well functioning market.
When you want to see what a well functioning market for management is, PE is certainly the place to look at. And what you will see is that CEOs of PE-held companies are usually paid about 30k a month. steve schwarzman, the richest of all, is famously paid 30k a month.
The main argument againt the cap is that CEOs who can add a lot of value would not take the deal, go abroad etc. Well, they do accept the deal in PE, so, that argument does not fly. Another argument is that they need an incentive to work hard. This one is as hard to stomach for 99% of the people as it feels totally natural for 1% of the people. Why would someone need millions to work hard? How about being fired or jailed for doing a bad job? But, again, turn to PE for a solution. PE certainly knows a thing or two about CEO incentives. It is actually fair to say that PE is a masterclass in CEO incentives.
In PE, management is asked to put their money into the company at fair price. The rule of thumb is half of their wealth but we see some deviations of course. The equity is split so that the common equity, which is the most junior tranche, is 5x what management has put in. This way, management has 20% of the most junior claim in the capital structure. This is steep: if the company is sold for just $5mn more (remember that mid-size companies in the PE space would be worth circa 1bn), the management pocket an extra $1mn. That's a lot! But if company goes down, the first people to lose money is the management.
Management sometimes pocket $100mn over 4 years, but frankly, I do not mind. They put their own money where they mouth was. If they are as good as they claim to be, they should put their money where their mouth is. If they deliver they get rich, fine, if they fail they lose their wealth. That's fair enough.
And THERE IS NO GOLDEN PARACHUTES IN PE. I REPEAT NO GOLDEN PARACHUTES IN SIGHT. SO, IN A MARKET WHERE THERE ARE NO AGENCY FRICTIONS BETWEEN MANAGEMENT AND THE SHAREHOLDERS, WE NEVER EVER OBSERVED GOLDEN PARACHUTES.
The equivalent in publicly traded companies, where we see these very high pay for management, the equivalent would be for management to buy their stock option at market prices and not to receive them for free. Or buy stocks in their own company at market prices and not get them for a discount (and if they do receive any of this at below market price, pay income taxes on these).
When you hear management saying: yes, I earn $10mn but it is because I am so good at this. Fine. Then buy your own stock and stock options, and if you are so good at this you will earn a return on your investment.
If you bring this proposition to management of publicly traded companies the typical reaction will be: oh, no, but stock price can go down even if I am good, so, this is not fair. But that means it can go up for reasons that are not connected to your talent, and therefore that should not be ok either!
To get back to the original question. The one thing I like in PE, is the deal for management. I like the idea of having this for all employees actually. But, again, everyone should buy a piece at fair price. No free stock options or discounted stocks (unless this is declared as income, in which case it is equivalent to have used your salary to buy at fair price). Voila! I do like a thing or two in PE 🙂
For more: chapter 5 of the book, and, this paper:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3333053
