Buying and selling ESOP corporations

August 2012 | 10QUESTIONS | PRIVATE EQUITY

financierworldwide.com

J. Michael Keeling, President and Chief Staff Officer of The ESOP Association, speaks with Gregory K. Brown, a partner at Katten Muchin Rosenman LLP, about buying and selling ESOP corporations.

Keeling: What is motivating ESOP-owned companies to purchase other companies? Where is the money to make these purchases coming from?

Brown: The motivation for ESOP-owned companies to purchase other companies reflects usual corporate motives for making acquisitions, that is, to reach additional markets, add product lines, improve distribution, and so on. In some cases, the ESOP-owned companies are acquiring other ESOP-owned companies, which is an interesting corporate culture match-up. The money for these acquisitions is coming from multiple sources. For ESOP-owned companies that have elected S Corporation status, substantial cash has been accumulated from their federal income tax shield, and that is the primary source. In addition, most acquirers have used senior financing and some have used mezzanine financing. In a few cases, private equity financing has also been used.

Keeling: Are you seeing foreign buyers for ESOP-owned companies? Is there a trend of buyers coming from particular industries?

Brown: We have seen foreign buyers purchasing ESOP-owned companies in the last two years, taking advantage of favourable exchange rates and low interest rates. This has occurred in electrical distribution and technology and technology infrastructure industries.

Keeling: To what extent are private equity funds acquiring ESOP-owned companies?

Brown: We have seen some limited activity here with private equity funds focusing on strong management groups in growth fields.

Keeling: Has there been an increase in private equity funds selling portfolio companies to ESOPs?

Brown: While we have only seen a slight increase in private equity funds selling portfolio companies to ESOPs, the tax motivation for both sides remains intact. For private equity funds with taxable investors, the tax deferred provisions for sales to ESOPs are quite attractive, and for the ESOP company, the tax deduction of principal payments for C corporations and S corporation tax shield are significant deal enhancements.

Keeling: Have you seen special purpose acquisition companies purchasing ESOP-owned companies?

Brown: We have seen two instances of SPACs purchasing ESOP-owned companies thus far in 2012. I am not sure that this represents a trend, but does indicate that SPACs have ESOP-owned companies on their radar screens.

Keeling: Going forward, do you expect to see ESOP-owned companies divest subsidiaries and/or divisions?

Brown: Yes, ESOP-owned companies are just like other companies in this respect. In one case where an ESOP-owned company divested a subsidiary, the buyers were management and an ESOP sponsored by the divested subsidiary.

Keeling: How would you describe valuations of ESOP-owned companies in the current market? Are you seeing a continued disparity between buyer and seller expectations over price?

Brown: While valuations in many industries have substantially recovered from the financial crisis, the recovery has been moderate and appears to be sustainable. That said, we see less disparity between buyer and seller over price expectations and more negotiation over other terms such as escrows.

Keeling: What specific considerations need to be made when structuring transactions that involve an ESOP-owned company as either buyer or seller?

Brown: The number one consideration is that, where the ESOP is the buyer or seller, the ESOP trustee has fiduciary considerations under ERISA to deal with. While the ESOP may borrow money to acquire company stock, it cannot accept a debt instrument from a buyer of the ESOP’s stock. In addition, an ESOP seller of stock is less willing to accept escrows than a non-ESOP seller because of fiduciary concerns.

Keeling: Could you provide an insight into the complications that may arise when addressing issues of control in the deal structure?

Brown: It is permissible for an ESOP to pay a control premium for company stock if, as a result of the transaction, the ESOP owns a majority of the outstanding stock – if it has control – these premiums are normally in the 10-20 percent range. Where the seller is the trustee after the transaction and controls the voting of the ESOP stock, it is difficult to justify a control premium because the same person maintains voting control. On the sale side, a majority ESOP will seek a control premium from the buyer in the 10-20 percent range.

Keeling: Could you explain repurchase obligations and what impact this may have on the deal process?

Brown: Repurchase obligations arise in private ESOP-owned companies because the company is required to purchase stock that is distributed to retirees or vested terminees by the ESOP. This purchase must be at current appraisal fair market value and be for all cash or a combination of cash and secured promissory notes from the company. Most ESOP lenders and trustees will insist that a repurchase liability forecast be done before a leveraged ESOP purchase is closed. On a going forward basis, the annual appraisal updates will reflect a small discount for lack of marketability if the appraiser has confidence that the company will be able to satisfy its repurchase obligation. A larger discount will be applied if there is less confidence. In some cases where a company experiences large growth but has a block of expected retirements of employees with large balances, this may place the company in a cash crunch. We have seen large repurchase liabilities motivate an ESOP company to sell to a third party or even to do an IPO.

J. Michael Keeling, CAE, is 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. He can be contacted on +1 (202) 293 2971 or by email: michael@esopassociation.org.

Gregory K. Brown is a partner at Katten Muchin Rosenman LLP. His practice emphasises Employee Stock Ownership Plans (ESOPs), ERISA fiduciary matters, tax-qualified retirement plans, executive compensation and ERISA litigation. Mr Brown has written extensively and given many speeches and presentations on employee benefits law topics across the country. He is a leading authority on ESOPs and other forms of employee ownership for both domestic and international employers. He is a past member of the Board of Directors of The ESOP Association and is a past chair of its Legislative and Regulatory Advisory Committee. Mr Brown is currently the chair emeritus of the ESOP subcommittee of the American Bar Association’s Section of Taxation Employee Benefits Committee. He can be contacted on +1 (312) 902 5404 or by email: gregory.brown@kattenlaw.com.

THE RESPONDENT

Gregory K. Brown

Katten Muchin Rosenman LLP