Private equity – using ESOPs as an exit strategy

August 2013 | TALKINGPOINT | PRIVATE EQUITY

financierworldwide.com

FW moderates a discussion on the use of ESOPs as a private equity exit strategy between Regina Carls at JPMorgan Chase & Co and Gregory K. Brown at Katten Muchin Rosenman LLP.

FW: Could you provide a brief overview of private equity exit activity in the past 12-18 months? What notable trends have you seen?

Carls: We have seen several deals in the past 12-18 months involving private equity both as a co-investment in an ESOP transaction and as an exit vehicle. While the number of transactions is relatively low, we are beginning to have more conversations with private equity firms about the use of ESOPs in their structures. As a result, we fully expect to see an increase in ESOP structures used by private equity in the future.

Brown: In the last 12 to 18 months we have seen two deals in which private equity used an ESOP as an exit vehicle. We have however, seen more awareness in the private equity world that ESOPs can be used for this purpose and have had more feasibility counselling assignments from private equity firms concerning the use of an ESOP as an exit strategy.

FW: How can ESOPs be used to realise higher returns on portfolio companies? Do you see this strategy being used regularly by PE firms?

Carls: The tax advantages of leveraged ESOP transactions provide significant benefits to PE firms investing in deals to finance ESOP buyouts. The largest benefit accrues to 100 percent ESOP owned companies that elect to be taxed as an S corporation, which essentially pay little or no income taxes. The tax savings enhance the company’s cash flow, resulting in more rapid de-levering, faster return of the PE firm’s invested capital and lower risk on the PE firm’s investment. In addition, the tax savings may provide the company with greater senior debt capacity, reducing the PE firm’s required investment. Overall, a PE investment in an ESOP deal can provide the PE firm with a better risk-adjusted return than a comparable direct equity investment. For this reason, nearly all ESOP buyout transactions involving PE investment represent 100 percent ESOP deals.

Brown: We have seen some instances where ESOPs are used as co-investors with private equity portfolio companies. Here the ESOP may hold a convertible preferred stock or super-common stock with preferred dividend or liquidation rights and the private equity investor holds regular common with higher potential overall returns. Here, the use of ESOP tax benefits are used to improve the rate of return for the private equity investor. We have also seen several private equity investors invest in subordinated debt of ESOP companies and enhance their returns from those debt instruments, sometimes with warrants or equity conversion rights.

FW: For what reasons, and in what circumstances, should PE firms consider ESOPs as an exit strategy for portfolio companies? When might this method not be appropriate?

Brown: The single best reason for a private equity investor to consider an ESOP as an exit vehicle is the ability to defer the capital gains tax on the sale. This is available for equity holders in a C corporation who have held the stock for at least three years and sell at least 30 percent of the outstanding shares to the ESOP. That will allow the private equity investor to reinvest the sale proceeds in a new portfolio company and defer the capital gain until the sale of the new company. Of course, this works best for a private equity fund with substantial taxable investors and where feasibility analysis demonstrates that an ESOP is appropriate for the company.

Carls: I think that ESOPs make sense for private equity firms that want to exit from solidly performing portfolio companies that may not provide a big pay off due to a lack of interested strategic buyers or lack of a high growth story. Since an ESOP can pay no more than fair market value, companies that offer cost or other synergies to strategic buyers are likely to get a premium in a well run auction process, and therefore PE sellers will be more attracted to selling via an auction. In addition, an ESOP sale sometimes may not result in a complete cash-out of the private equity seller. If the private equity seller cannot accept a debt instrument issued by the company as part of the consideration, an ESOP might not be the right tool. 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. The tax benefits of the ESOP structure, while significant, should not be the only consideration.

FW: Why has the use of ESOPs as an exit strategy become popular in recent years? What advantages does this method have over trade sales, IPOs or recapitalisations, for example?

Brown: I believe that this is because there is more awareness in the private equity world that ESOPs can be a viable exit strategy and have significant tax enhancements where appropriate. The increase in long term capital gains rates has only magnified this awareness.

Carls: ESOPs have gained momentum in recent years due to an increased understanding of the benefits afforded by its structure as a corporate finance tool. Compared to traditional sales, recapitalisations or IPOs, ESOPs offer speed of execution, continued management control, the potential for proceeds to qualify for a capital gain deferral and tax benefits that create incremental cash flow.

FW: What tax benefits can an ESOP sale structure bring for the portfolio company’s PE backers?

Carls: In general, there are potential tax benefits to the sellers and to the company itself. Some funds are organised to pass through the ownership of the individual investments directly to the fund’s investors. As a result, the investors are eligible to elect to defer capital gains taxes arising from the sale of a portfolio investment through an IRC 1042 election when that portfolio company is sold to an ESOP. This is a very meaningful benefit for private equity fund investors, just as it is for private business owners. From the company’s perspective, the ESOP transaction is much more tax efficient, increasing the company’s cash flow and makes it easier to finance the transaction and tolerate the leverage post-transaction.

Brown: If the ESOP is a leveraged investor, contributions to the ESOP to enable the ESOP to repay its principal and interest on the debt are tax deductible. For an S corporation, the annual limit on the principal and interest deduction is 25 percent of the aggregate compensation of the ESOP participants -- with a C corporation, the annual limit is 25 percent of aggregate compensation for principal payments plus the full interest payments.

FW: What implications might the rise in the long-term capital gains tax rate have on using ESOPs to exit portfolio companies?

Brown: The increase in the long term capital gains rates has created more interest in tax-deferred sales to ESOPs in general, including the private equity world.

Carls:Quite simply, higher capital gains tax rates mean lower after-tax returns to investors. Buy-side investors may factor higher rates into their pricing of new portfolio investments, resulting in lower valuations for the selling PE investor. Where available to PE funds, a 1042 election to defer capital gains taxes can help moderate the impact of higher taxes and preserve some of the return that would otherwise be lost to the higher tax regime.

FW: In your opinion, what impact, if any, will the 3.8 percent Medicare surtax have on the use of ESOPs as an exit strategy?

Brown: In my opinion, the 3.8 percent Medicare surtax is an additional reason to consider a tax-deferred sale to an ESOP. This can be a large dollar savings in a company that has experienced substantial absolute dollar growth.

Carls:It can potentially have two very meaningful impacts. First, it essentially increases the capital gains tax rate by 3.8 percent points so investors in high-tax states, like New York, California and Illinois, will likely experience all-in federal and state capital gains and Medicare surtax rates above 30 percent on an outright sale of company shares. That is simply too large to ignore. An IRC 1042 election would defer the Medicare surtax just like it defers the capital gains tax. Secondly, the surtax potentially applies to the earnings of S corporations that are passed through to their shareholders who are not active in the conduct of the business. This designation would certainly seem to apply to all PE investors and require earnings distributions from the company to fund the investors’ higher levels of taxes. This factor could result in more PE owned corporations electing to be taxed as C corporations, which would make them eligible for 1042 treatment upon a sale to an ESOP.

FW: What advice can you give to PE firms on structuring and financing sales to ESOPs?

Carls: Given the complexities of ESOPs, PE firms should work closely with highly qualified advisors who specialise in ESOP transactions. The integrity of the transaction, with respect to price and terms, will be imperative for the PE firm to avoid taking on undue risk. When an ESOP buys stock there are unique tax advantages to the Company. More cash is available to service debt, which increases the sponsor company’s debt capacity. Having a bank that understands these relationships is critical to the financing process.

Brown: It is important to find an advisors who are experienced in ESOP transactions to help the PE firm to wade through the tax and structural issues and describe the various options for structuring to them in plain English. There also some fiduciary issues under ERISA that need to be discussed in order to have a full understanding of what is necessary to successfully complete the transaction.

FW: Could you outline the potential disadvantages and pitfalls of using ESOPs as an exit strategy? What particular issues should PE firms prepare to manage?

Carls: Proper planning with qualified ESOP advisors will mitigate most if not all pitfalls of using an ESOP as an exit strategy. The most notable risk in selling to an ESOP is that the transaction will be challenged post-closing on the basis that the price paid exceeded fair market value. One way to manage this risk is to establish proper and reasonable expectations about price early in the planning process. It is common to involve a qualified valuation advisor and ESOP fiduciary early on. The ESOP trustee will negotiate on behalf of the ESOP as buyer. If the structure of the initial transaction includes the special concerns of the ESOP trustee, it will lessen the risk of obstacles throughout the negotiation process. If such care is not taken in the structuring phase, then the PE firm may face unforeseen obstacles which can result in higher cost and greater deal risk.

Brown: Great care to assure that the ESOP is being treated fairly from a financial point of view is needed in order to reduce the risk that the US Department of Labor or a plaintiff class group does not successfully challenge the transaction after closing. These usually means that the ESOP needs to have an experienced independent trustee with its own legal and financial advisors and a well-documented transaction.

FW: In your opinion, what is the outlook for private equity sales to ESOPs going forward? Do you expect to see any future regulatory or legislative changes that might affect the process?

Brown: In my opinion, the prospects are reasonably good. For PE firms looking for liquidity and seeking an opportunity to defer the new higher long-term capital gains rates, a sale to an ESOP can be an optional choice where feasible. This is still an extremely underutilised corporate finance vehicle because PE firms and their advisors may not fully understand the tax benefits.

Carls:In many cases, ESOPs could represent a viable alternative for PE firms when selling portfolio companies. However, in most cases the ESOP option is altogether not considered. I believe the outlook for PE sales to ESOPs is excellent because the primary obstacle is familiarity and understanding of the alternative. An increasing number of PE firms are taking interest in the ESOP option and we are optimistic that the more the strategy is employed, the more PE firms will take notice. The legislative and regulatory landscape contributes to the notion that ESOP transactions are highly complex. While the risk of adverse changes in legislation does exist, we do not expect any changes that would negatively affect the use of ESOPs as an ownership transition vehicle.

Regina Carls is director of the ESOP (Employee Stock Ownership Plan) Advisory Group at JPMorgan Chase & Co. She is dedicated to helping bankers and their privately held clients evaluate the benefits of selling stock to an ESOP and therefore creating liquidity for the owners in the transaction. Ms Carls has been with Chase for more than 20 years. She is also a member of the ESOP Association, headquartered in Washington, D.C, and serves on their Banking and Finance Committee. Ms Carls can be contacted on +1 (630) 221 2116 or by email: regina.l.carls@chase.com.

Gregory K. Brown is a partner at Katten Muchin Rosenman LLP. Mr Brown has 37 years of experience in Employee Benefits and Executive Compensation, including extensive work with ESOPs and ERISA. He has authored and co-authored numerous articles; is a frequent speaker on ESOPs and all areas of employee benefits and executive compensation; and has represented clients as an expert witness on behalf of clients’ ESOP/Employee Benefits Plans both regionally and nationally. He has been a member of IPEBLA since 1995 and a former Steering Committee member. Mr Brown can be contacted on +1 (312) 902 5404 or by email: gregory.brown@kattenlaw.com.

THE PANELLISTS

Regina Carls

JPMorgan Chase & Co.

Gregory K. Brown

Katten Muchin Rosenman LLP