Executive Compensation in Restructuring: Recommended Approach and Pitfalls to Avoid

Editor’s Note: Below is the latest in Reorg’s Expert Views series, an article written by Jon F. Weber. Weber helps creditors manage operationally intensive investments. He has led operating partner groups at Elliott Investment Management, Goldman Sachs Special Situations Group and Icahn Enterprises, where he worked closely with dozens of pre- and post-restructured companies. Earlier in his career, he was an investment banker at Morgan Stanley and JPMorgan and a corporate lawyer at Weil Gotshal.

When former creditors become controlling shareholders, poor compensation decisions often plague future performance. Creditors can make matters worse with haste, indecision or by designing or perpetuating plans with perverse incentives. Instead, creditors should thoughtfully design compensation to build trust, conserve cash and drive value creation. This article highlights common pitfalls and proposes a pathway to better align rewards with creditor recoveries.

Case Study: Risks of Creditor Misalignment on Pay

NEW YORK--(BUSINESS WIRE) - DebtorCo today announced that it has commenced a comprehensive reorganization to strengthen its capital structure and financial performance and best position the Company for future success. Upon restructuring, DebtorCo will reduce its debt by half and have access to new capital to better serve customers. According to DebtorCo’s CEO, “the transaction greatly enhances our company’s financial position so we can continue to invest and pursue meaningful growth opportunities. We look forward to beginning this new chapter for DebtorCo. Our lenders will become our new owners and strategic partners and are aligned with our long-term strategy.”

Absent from the press release is a brewing controversy between creditors and management about compensation. Through its lawyers, DebtorCo management has demanded cash retention payments equal to several years of salary to be paid out over six months upon completion of the restructuring. One executive confided, “Our salaries have been frozen as we took out costs. We missed our targets for the past two years, so no one has gotten a bonus. Our last equity plan is now worthless, so without these cash payments, our pay is way below market. We need these cash payments now, or we will continue to lose key people. Though there has been talk of a new management incentive plan (MIP), we don’t know the details. For all we know, the lenders may flip the company and the MIP will be worthless.”

Creditors face a dilemma: Reject management’s request and risk that key members of management will quit or check out. Or accept the request understanding that retention payments provide no incentive to improve the business and, when disbursed, may encourage executives to go elsewhere or will require additional payments to get them to stay.

As future owners, DebtorCo’s creditors should have proactively seized the opportunity to reset compensation. Creditors could have offered a realistically achievable wealth creation opportunity upon exit, reduced cash outlays and maintained flexibility to bolster the management team with future grants. Instead, to avert imminent resignations, creditors signed off on a sub-optimal stopgap pay-to-stay arrangement requiring cash payments with no extra reward for creating value for new owners. Fearing that creditors will fire-sale the company, key members of management are updating their resumes and have lost focus on turning around the business. This could have been avoided.

Traditional private equity and public company approaches to management do not work well in a change of control restructuring often characterized by low trust and high stress.

Creditors

• Are unfamiliar with operational issues and unsure how and when they will exit.


• Question management’s motivations and abilities to turn around the business.


• Want to avoid making commitments that drain cash and depress EBITDA.

... and Management

• Is skeptical about equity incentives having been burned by a prior plan.


• May not understand or agree with creditors’ investment objectives.


• Sees creditors as adversaries or, at best, not supportive PE investors.

To make matters worse, management may cherry-pick “market data” on compensation provided by advisors to the company beholden to management, potentially undermining the interests of creditors.

The resulting cash grab and misaligned incentives can lead to confrontation between creditors and management and imperil prospects for the restructured company. If instead creditors dedicate time upfront to take concrete actions to adopt market-competitive incentives aligned with investment outcomes, they could allay management’s concerns and begin to reframe the relationship with management as a partnership, setting the groundwork for a better outcome.

Recommended Approach

Take the initiative. Do not wait for management to present demands or engage outside advisors to address perceived grievances. Take the lead to reach out early to learn management’s concerns and constraints. Show a genuine commitment and dedicate resources to create fair and aligned incentives to reward management for value creation.

Do the homework. Understand the company’s compensation practices, history of payouts, executive employment agreements and incentive plans. Even if these arrangements do not survive restructuring, they will inevitably anchor management’s expectations and frame negotiations. Also compare data on comparable companies’ pay mix and total direct compensation. Hiring and actively managing a compensation consultant can help gather data and manage the process.

Solve for dollars, not percentages. Executives may seek rewards based on percentage ownership without acknowledging the benefit of a delevered post-reorganization capital structure. Accordingly, it is best to negotiate awards as potential dollars earned under a realistic base case. The table below illustrates how a smaller management pool struck at a lower enterprise value with less debt can deliver more value to management than a larger nominal award in a more highly levered company.

In this example, a 4% grant in a post-reorg company can be more attractive than a 10% pre-reorg grant, because the equity will be in-the-money at a much lower EV.

Align rewards with creditors’ objectives. To avoid making management indifferent to an exit below an aspirational exit value, structure a plan that allows for management participation in all desirable creditor recoveries. By way of example, depending on the circumstances, instead of options, consider restricted stock units or other instruments that mirror returns to creditors. Set thresholds appropriately so that management will be well rewarded for a quick exit that creditors find attractive. In the example below, creditors share with management their entire recovery compared with a traditional equity plan where value is shared only when equity valuation exceeds the strike price of options.

Save cash. Pay mix is the share of total direct compensation comprising salary, bonus and long-term incentives. Creditors should focus on pay mix to minimize cash outlays and maximize long-term incentives. To the extent practicable, ask management to co-invest in long-term incentive awards by forgoing salary increases or even decreasing annual bonuses. Pay mix heavily weighted towards long-term incentives may also deter management from setting low annual targets to achieve annual bonuses. If appropriate, explore structures that provide management with capital gains treatment to enhance the attractiveness of packages without impacting creditor returns.

Be clear on process and timing. Engage with management on a creditor-directed compensation planning process including key milestones such as fulfilling information requests, agreement on benchmarking, designing annual incentive and long-term plans, reaching agreement on compensation term sheet, drafting definitive docs and board approval. Rather than rush towards an outcome, set realistic expectations for design and implementation of awards.

Over-communicate. Even the best designed plan will not work unless communicated clearly and repeatedly to plan participants. Ensure that the CEO and CFO understand and effectively evangelize the plan to participants through periodic updates explaining how performance drives rewards. Guide management to sell the plan with easy-to-understand collateral along with FAQs to be shared in one-on-one meetings with plan participants.

Common Pitfalls to Avoid

Kicking the can. Delaying compensation planning until the new board is seated may exacerbate management’s fears, add months before implementation and create distraction post-restructuring when management should focus on execution.

Ad hoc decision-making. Do not succumb to pressure to make piecemeal decisions on salary, bonus schemes or long-term awards without a thoughtful, holistic solution. Hasty decisions may have a domino effect on compensation costs for other team members and future hires. Solve for total direct compensation rather than its components. Every discrete commitment made will constrain flexibility and may lead to claims of re-trading.

Complexification. Avoid complex incentives arrangements with waterfalls, multiple triggers and vesting parameters understood by CFAs but not management. Clear, easy-to-explain plans, even if imprecise, will better drive desired behavior than more sophisticated plans.

Glossing over details. Focus on forfeiture events, vesting and acceleration, treatment of unallocated grants and key definitions such as “cause” and “change of control,” as widely different practices prevail. Unless told otherwise, management may expect details of arrangements to mirror past practice, even when inconsistent with market.

Using long-term financial metrics. Long-term incentives (as distinct from bonuses paid on annual performance) should be set based on exit value, not financial metrics such as revenue or EBITDA. The latter are inherently unpredictable if set at the time of a reorganization, may drive perverse outcomes such as tacitly encouraging low margin revenue or capital-intensive EBITDA, and can result in equity earned that is not tied to shareholder outcomes.

Conclusion

Getting compensation right can alleviate headaches and controversies that can jeopardize creditors’ chances for recovery. Management may understandably insist on early cash payouts without a clear and convincing plan that they will share in substantial long-term value creation. Designing effective compensation to drive performance requires considerable time and effort, but if managed effectively, it can build trust, save cash and align management to achieve an exit consistent with creditors’ objectives.