Benefits of ESOPs in structured buyouts
October 2010 | TALKINGPOINT | PRIVATE EQUITY
J. Michael Keeling of The ESOP Association moderates a discussion between Janet Singletary Thomas at Hirschler Fleischer, Regina Carls at JP Morgan Chase and John Vitucci at Pension Equity Advisors, LLC, on the benefits of using ESOPs in private equity buyouts.
Keeling: In your opinion, what are the benefits of ESOPs in private equity buyouts?
Thomas: First, an ESOP can be a vehicle to plug a hole in the capital structure. For example, the potential for deferral of gain for sellers selling to an ESOP (owning C corporation stock) may make such a sale attractive relative to other opportunities. That, in turn, may pave the way for a seller-financing component. An ESOP can also provide important tax benefits to the company by making both principal and interest on debt used by the ESOP to acquire stock deductible. This can be helpful both in the initial acquisition as well as for future add-ons. For example, the ESOP could buy the target’s stock using pre-tax dollars, since both principal and interest on acquisition loan could be deducted. Finally, an ESOP can provide a tax shield to the extent the stock in the ESOP is S corporation stock. Since an ESOP is not a taxable entity, the S Corporation income attributable to it is shielded from US federal income taxation.
Carls: There are three benefits to private equity firms in combining their investment with an ESOP. The first benefit is the tax savings that can be realised by ESOP companies in the United States. In most private equity ESOPs, 100 percent of the common ownership of the company is held by the ESOP. The form of entity is an S corporation, in which the federal income tax is paid by the shareholders. The ESOP is a tax exempt trust for federal income tax purposes. Thus, the entity does not currently pay a federal income tax. The federal income tax is paid by the participants of the ESOP when they receive a distribution. The private equity firm’s investment is in the form of subordinated debt with PIK interest or a warrant. The increased cash flow drives the second benefit of private equity ESOPs. The capital structure typically allows for increased senior leverage and a lower required equity investment. The third benefit is that the interests of the employees and the management team are closely aligned with the interests of the private equity firm. Thus, tough operational decisions are easier to implement.
Vitucci: The greatest benefit in structuring a PE deal with an ESOP is to lower labour cost (possibly swapping some compensation for equity and higher pension benefits) and to integrate the ESOP as part of a strategy to offset the target’s defined benefit pension cost. PE that utilises this ‘hybrid’ ESOP floor-offset approach that combines the best attributes of an ESOP and a defined benefit pension will be able to have an additional capital source to help execute a transaction, improve the portfolio company’s cash flow, align with labour, and reduce pension risk and related cost. It can also provide a vehicle for distressed portfolio companies to self finance versus outsource or reorganise via bankruptcy while drawing PE, management and labour closer together because of a shared vested interest in the success of the business.
Keeling: Studies have shown the ESOPs help to increase productivity and motivation in employees. An important aspect of this is education of employees on what an ESOP is and isn’t and understanding the expectations and concerns of employees and the company. What advice would you offer in this regard?
Carls: The operational aspects of most businesses are complex. The type of business that empowers every employee to think like an owner is better positioned to perform better than its peers. In fact, there are recent studies that indicate that ESOPs have survived the recent economic recession better than non-ESOP companies, including a recent ESCA study of S Corporation Resilience. If every employee understands that shareholder value is created through increased cash flow then daily decisions that are made by front line employees may impact the business positively. Our experience indicates that ESOP companies that communicate these concepts to the employees create winning employee cultures that are stronger in withstanding business risks, and result in an ESOP that is embraced by all shareholders and claimants.
Vitucci: Besides a number of tax benefits, an ESOP can link rewards to the business strategy and the talent strategy. An ownership culture can generate significant value, if embraced. It is extremely important that all parts of the organisation be aligned with the merits of employee ownership for true value to be realised. The process needs to be continuous, not intermittent. If an ESOP structure is adopted then PE needs to align with the worker stakeholders for true value to be generated. This alignment could substantially improve the return on investment and put in place an exit mechanism for PE.
Thomas: Most successful ESOP companies are those that develop a true culture of employee ownership. This can be fostered by establishing and supporting an active ESOP communication committee whose mission is to raise the profile and educate employees about the ESOP. Sending employees to high quality ESOP conferences such as those sponsored by The ESOP Association is also an excellent idea. One large ESOP client of mine has a full-time employee devoted solely to ESOP communication and administration – and it has produced results.
Keeling: In terms of corporate governance, what do you think needs to be defined by companies considering an ESOP?
Vitucci: Proper corporate governance can also have a significant impact on deal value. The proper relationship between management, the ESOP trustee and the board of directors can be the difference between a successful and unsuccessful transaction. Roles need to be clearly defined. It is also important to understand any potential conflicts of interest and bring in independent advisers and fiduciaries in certain instances, such as a purchase or sale transaction. Conflicts between trustee and officer roles are most likely to arise in connection with unsolicited offers to purchase its stock from the ESOP. The US courts have established the principle that the trustees of an ERISA-covered plan must give offers impartial consideration and may be obligated to delegate decisions to an independent fiduciary if their personal interests are strongly involved.
Thomas: This is one of the most important and complex areas of ESOPs. First, it is important to note that the trustee’s role is that of shareholder – not board of directors or board member. The trustee does not oversee and govern the business operations of the company. That function is maintained by the board according to the local governing law. The relationship between the ESOP trustee and the company’s board of directors can be sent up in two fundamentally different ways, however, and should be clearly delineated in the plan documents. An ‘independent’ trustee makes decisions independently of the board on those things for which the trustee is required to vote. A ‘directed’ trustee on the other hand is directed by the board in how to vote and must follow such direction unless doing so would be contrary to the trustee’s fiduciary duty. Finally, certain fundamental matters – such as merger or sale of substantially all assets – must by law be submitted to the participants in the plan for vote. Although broader ‘pass-through’ voting rights can be built into the plan, in my experience that is rarely done in the PE context. A final point here – the PE firm should analyse and fully understand the extent to which a board seat in an ESOP company may expose the firm to ERISA fiduciary liability. Rarely would the PE firm want a representative to serve as a trustee for this reason.
Carls: The ESOP is a qualified plan that is designed to invest primarily in the stock of the sponsoring company. The corpus of the ESOP trust is maintained to provide for the retirement benefits of the employee participants in the plan. Thus, as a shareholder the ESOP is a long term passive investor. From a corporate governance perspective the ESOP should be able to participate in decisions that affect their shareholder rights or dilute their interest. In our experience it is not best practice to involve the ESOP in day to day operational decisions that are best left to a qualified management team that understands the industry, the competition, the customers, etc.
Keeling: Repurchase obligation is something every ESOP will have to deal with in time. Do you think financial modelling should be a factor in determining whether or not a company should consider an ESOP? If an ESOP is already in place, would you suggest modelling as a way to deal with repurchase obligation and why? What benefits do you see for the company? Are there any new repurchase liability strategies being employed in the market?
Thomas: Financial modelling is essential. Many things should factor into the modelling, including amount and terms of acquisition debt, vesting schedule, predicted employee turnover, actuarial assumptions concerning employee population, and potential tax savings. The importance of this work cannot be underestimated and should be done in the very early stages of due diligence. It should also be updated at least annually.
Vitucci: In private ESOP companies, employees receiving a distribution from an ESOP retain a put option granting them the right to sell employer securities to the employer at fair value. This is commonly referred to as a ‘repurchase liability’ which can become an overwhelming challenge for mature ESOP companies. Planning for the repurchase liability is extremely important in managing cash flow. Without proper planning, the claims of retiring workers can be a drain to the business and possibly limit future acquisitions or capital expansion that can ultimately reduce value. Where the repurchase liability becomes such a challenge, it may be necessary to sell the company or go public.
Carls: The private company ESOP transaction solves an ownership transition objective and, with that, creates the next ownership transition need with the shares now in the ESOP trust. The repurchase liability is the ownership transition that occurs when the employee participants receive a distribution of their ESOP shares. It is an obligation of the company that should be managed. Modelling in the initial design stages is essential to making sure the ESOP structure satisfies the company’s and the shareholder’s long term objectives. An important concept in the ESOP design is to be sure that the employee benefit delivered to participants in the plan is commensurate with the market. The most sophisticated strategy today is for the company to redeem shares from departing participants and recontribute treasury shares to the ESOP each year. The recontribution amount is a compensatory decision made by the company’s board of directors or a compensation committee. Thus, compensation can be managed so that repurchases are not dilutive to other non-ESOP shareholders. The benefits to the company are a sustainable ESOP structure and an efficient capital structure.
Keeling: There are many questions surrounding the trustee issue, including whether they should be internal or external, whether they should include board members or company executives? What are your thoughts on the role of trustees in employee owned companies?
Carls: The ESOP trustee has a fiduciary obligation to the participants in the ESOP. There are some fiduciary obligations that may conflict with other duties of insiders. Thus, employees/participants may view an outsider, acting as trustee, more capable of looking out for their interests when these conflicts arise. There is an added cost for an independent trustee which is another consideration. However, an insider should also be protected with fiduciary insurance. As many E&O insurance policies exclude ERISA acts, there may be an additional charge for this type of coverage. For purposes of the initial purchase by the ESOP, or other significant transactions involving the ESOP, an independent trustee is recommended by experts. The major role of the ESOP trustee is to determine the value of the stock annually. It is important that the valuation process be monitored independently.
Thomas: I think the answer to this requires a balance of the practicalities of a specific situation with the risks of different approaches. From a liability perspective, an external, independent trustee without a seat on the board offers the best protection. Depending upon the size of the company, however, this may not be practical. With proper counsel and understanding of fiduciary obligations, I believe that internal trustees who also serve as company executives or board members can operate effectively. If there is an internal trustee, however, I almost always recommend bringing in a ‘transactional trustee’ to negotiate the deal and have the internal trustee step aside for those decisions.
Vitucci: An ESOP’s trustees typically are officers of the employer. There may also be an institutional trustee, but it generally takes a passive role and acts only in accordance with instructions from the individual trustees. In his or her role as a trustee under ERISA, a corporate officer must ‘discharge his or her duties solely in the interest of the participants and beneficiaries’. Officers who do not serve as trustees are not ERISA fiduciaries, because the essence of fiduciary status is discretionary management or control of plan assets, and the assets of an operating company are not plan assets. If directors mismanage an ESOP-owned corporation, it may be the duty of the ESOP trustees to remove them from office, but the non-trustee directors themselves should not face liability under ERISA.
Keeling: In the United States, ESOPs and 401(k) plans are not always part of the same deal. However, studies have shown that ESOP companies do offer additional retirement benefits in addition to the ESOP. What are your thoughts on incorporating ESOPs and 401(k) plans in private equity deals?
Vitucci: Utilising 401(k) money as part of a transaction can create diversification risk for workers unless limits are put in place. Also, in the 401(k) scenario incremental SEC reporting and disclosure requirements can increase cost and the timeframe to execute and exit a transaction. For these reasons, PE may wish to avoid the utilisation of 401(k) assets in a transaction but consider the utilisation of defined benefit pension assets as part of a transaction since such reporting and disclosure rules do not apply. Also, using pension assets to invest in company stock in conjunction with an ESOP instead of 401(k) assets in conjunction with an ESOP is less likely to interfere in the corporate governance issues that are so important to PE. It is extremely important for ESOP companies to offer alternative retirement benefits through a 401(k), profit sharing or a defined benefit pension. This provides diversification in case the company enters bankruptcy.
Carls: Many ESOP companies that bank with JPM also have 401(k) plans. Based on what happened to employee retirement savings in Enron it makes sense for the employees to have additional investments besides employer stock. Although uncommon, some ESOPs allow employees invest their 401(k) salary deferrals in employer stock. Due to the daily valuation requirements, offering this option is quite challenging. It is more common for the employer to redirect the 401(k) match or other discretionary retirement plan contributions to the ESOP. In fact, the substitution of the cash benefit for the employer stock benefit can provide additional cash flow to aid in financing the ESOP’s purchase of employer stock. Another source of capital in ESOP transactions is a rollover of investments from other qualified plans. Taping into this source of capital is costly and requires significant disclosure. Traditional private equity investments are not able to access qualified plan balances to finance transactions. Thus, most ESOPs provide incremental benefits to the employees beyond other qualified plans which can lead to enhanced performance, as proven by research by The Employee Ownership Foundation.
Thomas: Many employees have come to expect the availability of a 401(k), and it can be an important complement to an ESOP, providing diversification that the ESOP does not offer. In the early years of paying down an ESOP acquisition loan, a company may be limited in how much it could contribute to a 401(k) but that frequently changes over time.
Keeling: How can ESOP companies incorporate defined benefit plans with their ESOP and satisfy pension funding obligations?
Carls: A defined benefit plan is limited to holding only 10 percent of employer securities. An ESOP component can be designed to hold up to the 10 percent limit and provide the same tax benefits to the company sponsor as traditional ESOPs. When publicly traded company stock is contributed to the defined benefit plan the company is able to satisfy the defined benefit cash obligation with the publicly traded security, thus reducing the current cash obligation.
Vitucci: Companies can use a floor-offset design which is a ‘hybrid’ design that combines the best attributes of an ESOP and a defined benefit pension. The floor offset plan promises to pay the amount calculated by the pension formula offset by the balance in the (newly created) ESOP. If the ESOP balance is greater than the amount promised by the defined benefit formula, the ESOP balance is paid and no further benefits are due. If the ESOP balance is not greater, then the residual amount is paid by the defined benefit plan. Employee participants in floor-offset designs can obtain the benefits of employee ownership including both financial upside and technology advances with downside protection through a guaranteed pension. The floor offset design maintains an overall pension foundation while allowing a maximum of 10 percent investment of pension funds in employer securities.
Keeling: While research has shown numerous benefits to employee ownership, ownership is still a risk and is not always the best option for a company. What do you tell clients that are interested in using an ESOP in private equity deals to make sure they understand all aspects of the ESOP?
Thomas: I do not typically try to ‘sell’ a team on an ESOP but rather attempt to help them identify whether it is the best solution for their specific circumstances. Too often I believe ESOPS are ‘sold’ as a ‘product’. They are too fundamental to the operations of a company and the welfare of the employees to implement without a thorough understanding and determination that it is the best course.
Carls: An ESOP does not add incremental business risk to an equity investment. In fact, most advisers see the employee empowerment and tax benefits as a reduction in business risk. Businesses fail. If a business fails and it happens to be owned by an ESOP then did the business fail or the ESOP? If an industry is declining the ESOP cannot infuse capital. However, in most ESOP designs, the tax benefits give the company more time to survive a threat to its operations if the company is profitable. The added risks in ESOPs are the financial risk associated with the repurchase obligation, increased leverage, and increased regulatory scrutiny. The repurchase obligation can be modelled and managed. The ESOP tax benefits aid in reducing the financial risk as ESOP companies tend to de-lever more rapidly. As it relates to regulatory risk, the private equity investor needs to work closely with qualified ESOP/ERISA lawyers to understand the regulatory requirements of the DOL and IRS and maintain compliance. It is important to assess the ESOP tax benefits, analyse the economics of the transaction, and review other non-financial shareholder objectives before proceeding with an ESOP.
Vitucci: Cost, cash flow, corporate governance and speed of transaction are important factors in designing the right ESOP for PE. If a PE firm is interested in creating long term value and interested in aligning the needs of workers, the business and society, incorporating an ESOP is an excellent tool to create such an alignment and long term value for all stakeholders. If the goal is a very short term investment with a quick exit strategy, then an ESOP may not be the right tool. Understanding the ESOP risks and benefits, properly utilising existing benefit assets in executing a transaction and appreciating and utilising the value of an ownership culture are the most important factors. Tax benefits should be viewed as a secondary benefit since the economics of a business should drive any transaction.
Keeling: Could you outline how private equity firms can utilise ESOPs to dispose of portfolio companies?
Vitucci: An ESOP provides a superb divestiture alternative for PE as a ‘sell strategy’ for disposing of portfolio companies or a division and/or subsidiaries of portfolio companies that may not align with the PE’s business strategy. Defined benefit assets can be utilised in conjunction with third party debt and equity to execute a transaction. Such an approach can unlock unrealised value to PE while providing management and workers an opportunity to realise future value utilising an ESOP while providing workers the downside protection of a defined benefit plan. It provides an incentive for a significant culture transformation and alignment. The successful execution of this strategy could allow maximum enterprise value to be realised while providing retirement security and diversification to workers. This can allow for the reinvigoration of business and a smooth business transfer from PE.
Thomas: If the PE firm identifies a buyer interested in taking advantage of the benefits that the ESOP structure can offer, a more favourable sale can at times be negotiated. Also, the potential for rapid growth fuelled by increase in cash flow can drive up value.
Carls: A profitable portfolio company that can withstand leverage might make a perfect ESOP. Some private equity firms seek out qualified management teams that may also see the benefits of an ESOP. One hundred percent ESOP structures typically require the private equity firm to take back some seller paper as the transaction funding is likely to not be fully supported with senior financing. Thus, the private equity firm may need to be willing to participate on a minority basis alongside the ESOP. The ESOP does not exert operational control so the private equity firm does have control for all practical purposes. The 100 percent S Corporation ESOP structure can be designed to be anti-dilutive if the private equity firm continues to participate. Management is likely to prefer this strategy to being sold to another private equity firm as they will have a stake in the business, in the future.
Keeling: How can private equity improve its hurdle rate utilising an ESOP?
Thomas: The significant tax advantages of ESOPs typically have a large positive effect on cash flow. This ‘found’ money can be used to generate higher returns for the shareholders, including the ESOP participants. In addition, the potential for an ESOP-owned company to finance acquisitions on a pre-tax basis provides a competitive advantage versus non-ESOP companies.
Carls: The most common private equity ESOP structure involves the ESOP holding 100 percent of the common equity and the private equity investor holding a debt like security. One hundred percent S Corporation ESOPs de-lever more rapidly, motivate employees, provide continuing equity incentives for deeply subordinated holds of seller paper, and allow the company to take advantage of the ESOP tax benefits.
Vitucci: The potential sunset in the US of the Bush tax cuts at the end of 2010 and the potential of the favourable capital gain tax arbitrage associated with the ‘carried interest’ paid to PE going away may trigger more creative structuring utilising ESOPs of PE and their portfolio companies. Given these changing dynamics, we could see more of a shift to the PE model similar to that of a ‘Berkshire Hathaway approach’ but utilising an ESOP coupled with defined benefit pension plans to attain desired investment returns. For example, a restructuring from a partnership model of a PE firm to a model with an ‘umbrella ESOP structure’ in the US utilising an S corporation ESOP holding company that buys and sells multiple ESOP companies in conjunction with a floor-offset pension design could potentially provide a higher ‘hurdle’ rate. This higher ‘hurdle’ rate may even be attained without a change in tax rates
J. Michael Keeling, CAE, is the President and Chief Staff Officer of The ESOP Association, a national trade association promoting the growth of employee ownership in America through Employee Stock Ownership Plans, or ESOPs. He is also President of the Association’s affiliated 501(c)(3) educational and research foundation, the Employee Ownership Foundation. He is a graduate of Yale University and the University of Texas Law School. For more information on The ESOP Association, please visit www.esopassociation.org.
Janet Singletary Thomas is a member of the Hirschler Fleischer’s Business Section. She regularly counsels clients in mergers and acquisitions, contract drafting and review, capital structures and financing arrangements. Ms Thomas has particular expertise in transactions involving Employee Stock Ownership Plans (ESOPs) and has advised many different parties to ESOP transactions, including sponsoring companies, lenders, selling shareholders, and trustees. Jan also has significant experience representing both lenders and borrowers in a wide range of credit facilities. She can be contacted on +1 (804) 771 9532 or by email: firstname.lastname@example.org.
An 18 year veteran and former Division Manager in middle market banking with JPMorgan Chase, Regina Carls is director of the ESOP Advisory Group (EAG). She provides strategic direction, assists in setting policy for EAG’s involvement, is liaison with other areas of the bank and is intimately involved in all deals that pass through EAG. Regina is dedicated to helping bankers and their privately held clients evaluate the benefits of selling stock to an ESOP and provide liquidity in the transition. She can be contacted on +1 (630) 221 2116 or by email: email@example.com.
John N. Vitucci is president of Pension Equity Advisors, LLC. He has 27 years of experience working with corporations and investment banks in all areas of employee benefits. Mr Vitucci was a senior partner at Deloitte Tax LLP where he worked for 24 years. He was the ESOP leader and helped establish ESOPs at over 50 Fortune 500 companies. His primary focus was in serving clients, developing new employee benefit products and leading Deloitte’s New York client innovation committee. He was a qualified plan specialist with the Employee Plans Division of the IRS. He can be contacted on +1 732 542 1849 or by email: firstname.lastname@example.org.
© Financier Worldwide
J. Michael Keeling
The ESOP Association
Janet Singletary Thomas
JP Morgan Chase
Pension Equity Advisors, LLC