As overall M&A activity in the U.S and around the world cools off, new ESOP formations continue to show high levels of activity, even amid turbulent macro conditions. In this month’s edition of What’s Next, Chris and Chase share their insights on how the market for ESOP transactions can be so resilient, and what the industry at large is focused on heading into year-end.
Transcript
Chase:
Hello, and welcome back to What’s Next, hosted by Acuity Advisors, the show where we help middle-market business owners understand and monetize the value of what they’ve built. I’m your host, Chase Hoover, and I’m back today again with my co-host Chris Kramer. Chris, good morning.
Chris:
Good morning, Chase. How are you today?
Chase:
Doing very well, Chris. We’re fresh back from the California Western States Chapter of the ESOP Association Annual Conference. Chris and I thought it would be a great idea to get on here and just do a quick debrief on the major takeaways, themes, and topics of discussion that had the ESOP community buzzing over the last week’s conference. Around 300 or so attendees this year, which is great to have everybody back after COVID. There are various learning tracks available at these kind of conferences, whether you are an employee of an ESOP company or an advisor to ESOP companies or a C-suite executive. They provide various levels of learning, but in terms of the major topics of discussion, the big thing that stood out to me, Chris, was really that if you look around in the news these days, whether it’s the Wall Street Journal or just your local paper, hearing a lot about the economy and the probability of recession on the horizon.
One of the aspects that is front and center for us is that the mergers and acquisitions environment is supposedly cooling off. The biggest picture takeaway I have from this week is that while that may be true for third-party M&A, whether it’s private equity or something with a strategic buyer, the ESOP community is still seeing a lot of activity, a lot of interest in new transactions, and I think there’s probably a lot of reasons for that. Does that resonate with you from the conference as well?
Chris:
Yes, absolutely. Along with our overall activity level, it really hasn’t slowed down much at all. A lot of challenges given the interest rate environment, given the inflation outlook and current levels of inflation, and given the uncertainty with recession always seeming to be looming, if you will, but certainly activity level is still incredibly high. I think it’s still a function of the aging Baby Boomer slash business owner population, and it’s sort of just part and partial to the natural transition of ownership that we’ve been seeing for 15 or 20 years.
Chase:
Right. Given the strong, let’s call it, demographic tailwinds, ESOP is still a reasonable option among other options for exit planning, maybe even a more attractive one when some of the buyers potentially for your business have stepped away and said, we’re going to see how this economic environment shakes out, or we’re going to sit on our dry powder for a quarter, a couple of quarters, wait until next year.
Chris:
Yes, I think the real question is why is that? In other words, why is the private equity business or even strategic buyer pool slowing down and exercising a lot more caution? I think there are a few reasons for it. One of them is that you have rising debt rates, and private equity primarily is driven by the rate of return. A lot of the models impart a fair amount of leverage into their acquisitions, meaning they borrow a lot of money and they make up the difference in terms of the equity that they’re putting in.
Meanwhile, they are beholden to their limited partner group and rates of return that they either are projecting or not maybe promised, but at least represented, are possible. To the extent that the debt costs more, either they’re going to have to suffer a lower rate of return or put less equity into a deal, which of course, depresses multiples. If they can’t compete with an aggressive multiple against an ESOP or another buyer, then they naturally are not going to prevail as well in the marketplace, or they don’t want to suffer a lower rate of return, the debt rates are up, and so they’re standing more on the sidelines as compared to, let’s say, an ESOP buyer.
Chase:
Yes, interesting. Flip that over to the ESOP context, where rather than have that discretion or hesitance to deploy capital or even pursue transactions, frankly, in an environment where they don’t expect to prevail, the ESOP stands ready to transact at any time, sort of is responding to the seller’s timing. It’s just that the timing of the transaction may have an impact on the value that it can ultimately buy the stock for, but the other side of that, to your point, is that ESOP transactions typically involve a fair bit of seller notes, where the actual seller of the stock is the one financing a lot of the leverage in the deal as opposed to the private equity fund that has to write the equity check and then go to their banks for the loan. I think probably there are some sellers out there who are thinking as the rates continue to go up, at least I as the seller, if I’m financing a big chunk of the deal, am actually going to get to earn the higher rate of interest on my note over time.
Chris:
Yes, that’s a great point. Typically, the way the seller notes are structured, there is a coupon or a stated interest rate that gets paid over the course of the time period the loan is outstanding, whether or not there’s bank debt. Then assuming there’s bank debt, once that’s repaid, the principal balance on the seller notes can be either repaid or refinanced, but the point of that is that debt, if you will, that subordinated note, does and should command a higher rate of return. The difference is that that rate of return, that differential, is typically in the form of warrants, which are a function of the future performance of the company.
Even in a rising rate environment, we can still structure transactions that both parties can live with because so much of it is contingent on future performance. Let’s face it, we’re all expecting that at some point, inflation either dissipates or normalizes. We’re expecting that if there is a recession, it’s not going to be a protracted one, so a three, five, seven, 10 year time horizon on a seller note can actually work out quite well as opposed to, let’s say, a private equity buyer where the lion’s share of the proceeds come in the form of cash, most of which is borrowed from a bank.
Chase:
Yes, it makes perfect sense. I think the only other reason, just among the possible drivers of the resilience in the ESOP transaction market relative to other types of exit strategies, is that the tax incentives haven’t changed. Relative to a private equity deal, which might be pretty compelling in terms of cash at closing, but there might be a pretty significant bite taken out from capital gains tax, the ESOP transaction, when you look at it on a net proceeds basis, assuming there’s involvement of some of the tax deferral strategies you can use on an ESOP, probably still or perhaps even more relatively compelling in terms of what the seller can expect to actually realize after the taxes are all paid.
Chris:
Not only that, but it’s actually getting a little bit better. What Chase is referring to is the ability to defer, or if structured properly, avoid the tax on the capital gain in an ESOP transaction under Code Section 1042. Without belaboring it and giving you all the details, one of the requirements is that the company currently has to be structured as a C corporation. If you’re an S corp, which most of you probably are if you’re listening, there are some ways that we can revoke the S selection or do some other reorganizations to get you to a C corp at least to do the deal, but there is some legislation that’s out there, and it’s been out there for quite a while, by the way, but it seems like it may be getting a little bit more traction, whereby a shareholder of an S corporation can qualify for that deferral or avoidance with the certain structure under 1042 without revoking and being a C corp. That’s another good development in the ESOP space.
Chase:
Long been the holy grail of hope, I think, for the ESOP advisor community.
Chris:
I’m sitting here with my fingers crossed right now, but yes, that’s correct.
Chase:
On that note, let’s talk about some of the other regulatory or legal developments in the ESOP community lately, typically a hot button at these types of conferences. Hear from some of the leading litigators and corporate transactional attorneys as to what the tea leaves are saying out of Washington and the other DOL, IRS, ERISA, and other regulatory agencies. What are the big movers and shakers in that department?
Chris:
Unfortunately, as a regulated structure, if you will, ESOPs historically have faced a number of litigation challenges either by the Department of Labor or by Plaintiff’s Bar, most of which, with a properly structured ESOP, have been, call it what you will, a nuisance lawsuit or extortion or what not. Most of the time, unless the facts are somewhat egregious, which is very rare, these cases end up settling because carriers don’t want to take them to trial because of risk and cost. Even though companies or sellers may want to dispute or fight the allegations, they often don’t get the chance because these cases settle.
There was a recent case, the Bowers case, that was pretty well-known in the ESOP community and much talked about, whereby the sellers were accused of some things effectively, and overpayment was alleged on behalf of the trustee and the sellers got sucked into this lawsuit over many years. Without boring you with the details, went to trial and they basically prevailed on all counts, if you will. It was almost a complete vindication that the deal, in fact, was a “good deal.” The ESOP did not overpay and it was actually adjudicated, not settled. That was kind of a glimmer of hope in the struggle to avoid or push back against some of these frivolous lawsuits that we’ve been seeing in the community. That’s a good one.
Side note to that, but an important one, historically, we’ve all been operating in the ESOP community under what’s been referred to as proposed regulations put forth by the Department of Labor some 30 plus years ago. Proposed meaning they’ve never been finalized, and along with that, the Department of Labor has never really given good guidance, for example, like the IRS does, in terms of their pronouncements to give the community a way to try to comply with the numerous regulations. We’ve been left on our own, and then they do what we call regulate through litigation basically, which is patently unfair to the companies and to the sellers and trustees and the community at large.
Recently, the ESOP Association has put forth a petition, if you will, to require the Department of Labor citing a somewhat arcane clause in one of the laws passed many years ago. I don’t recall what it is, but basically this petition to force the Department of Labor to finally give us clear guidance so that we can do what we want to do, which is conform to the regulations and be in compliance and do what we’re all trying to do, which is promote ESOPs within the confines of the law that’s in place.
Chase:
I think that would be some long overdue guidance, and again, not entirely as fingers crossed long awaited as the S corp 1042 topic you mentioned a few seconds ago, but I think we as the professional services and really the broader ESOP community overall, would really appreciate and breathe a deep sigh of relief if the Department of Labor would actually formalize, clarify, however, you want to characterize it, the lack of clarity that’s been out there for decades now, candidly.
Chris:
Our goal is to have a bunch of our litigator friends not have a whole lot to do, unfortunately, but so far that really hasn’t been the case. The Defense Bar is alive and well and busier than ever, unfortunately.
Chase:
Speaking of the DOL, this may be a stretch of a segue, but one of the other topics that I thought was coming up somewhat frequently at this conference was one that we expect and are not surprised to see in center stage right now, which is the idea of management incentives and retaining key talent. In the ESOP community, given the tax advantages that are available to companies that are owned solely by the ESOP, in an S corporation structure, there’s a real focus on what we call synthetic equity, which is basically equity-linked cash incentives, so think of stock appreciation rights, restricted stock units, phantom stock, basically just not common stock, but nonetheless designed to incentivize the management team based on the value of the company.
In recent months, possibly years, there’s been an ongoing discussion about what reasonable amounts are in certain business contexts that you ought to carve out or make available to a key leadership team when the employee stock ownership plan “owns the entirety of the company.” It came up a few times both in sessions and just over meals and drinks at the conference. How are trustees viewing this? I thought that there was some progress made in trying to get there to be more of a discussion around that.
Chris:
I think the trustees have always tried to impart where they can some amount of common sense, certainly business acumen. Unfortunately, the Department of Labor either chooses not to or is incapable of doing that. In their defense, they’re trying to regulate something that’s got a very, very significant amount of judgment associated with it. The value of a business, the reasonableness of equity awards to key leadership, and the amount of compensation, all those things are very, very subjective. Now, there are brackets around those issues and those topics, there’s data that’s out there that would support a certain position, but even within those confines or those parameters, if you will, very, very wide range of possibilities.
What we’re seeing is at least a recognition on the part of trustees that keeping and retaining and motivating certainly key people, if not all people, is an ever more important part from their perspective of preserving the value of the company that they’ve purchased. Whether it’s in a new transaction and looking forward, or whether it’s an existing company where maybe there’s a plan or an extension or an increase in the award levels of an existing ESOP.
In other words, there is growing recognition that management incentives are part and parcel to any reasonable compensation structure and management team comp package, if you will. The question is, how do we figure out what’s too much or what’s the right amount? That’s always going to have some judgment to it.
Chase:
Sort of a recognition or an acknowledgment of what’s been long held as standard in the private equity world, which is that the key management team, the buyer’s at least going to hope or potentially even require that those folks retain or gain some amount of equity in these transactions because they, as the investor, are highly aligned in terms of their incentives with that team and want them to be focused on raising the value of the company.
Chris:
But at the same time, whether it’s wages or whether it’s equity comp or any other input to cost, things in this sort “day and age, whether it’s driven by inflation or supply chain or labor shortage or whatever it is, seem to be costing more.” Companies seem to be less profitable as a result, at least in the short-term, and it certainly impacts value. Our position as advisors to trustees, among others, is as long as the ESOP isn’t technically paying for it, then they should be agreeable to the structure as it is in place, at least in a new transaction. If it’s after the fact, they have to consider either preserving and/or increasing the value of what they own. One great way to do that is to share some of the upside with the leadership team. There’s certainly nothing wrong with it. Private equity and strategic buyers and public companies have been doing this for years.
Chase:
I think that’s a key point and it speaks to something that’s really become best practice and fairly frequent in the ESOP world, which is that any equity incentive or potentially not any, but a lot of the significant majority of equity incentives for the management team are really based on what we might call performance hurdles or performance vesting. Such that if the ESOP really didn’t “pay for it, and that any upside above and beyond what the ESOP was entitled to or at least paid for really can be shared in that way.”
Driving home the private equity point, I think this is my last major takeaway, Chris, and then if you have any others to add, please do, is just that private equity, which has long been flirting with the world of ESOPs, mainly as a buyer of ESOP companies from the ESOP trusts, is sort of showing and demonstrating a bit more of an interest in participating, aside from just buying out the employee-owned companies. Whether it’s as a creditor or putting in an employee stock ownership plan as a minority investor alongside their buyout position. We’re just hearing more discussion, we’re meeting more folks at the conferences who are from the private equity world and want to learn more about and get involved with ESOPs.
Chris:
I think part of that too is a growing recognition that equity-based incentives, whatever form they take, need not be limited to key leadership. It’s a very altruistic, but just from a business perspective, practical goal to have everybody do better. One of the ways that rank-and-file employees can do better is by sharing in the ownership of a company. The best way to do that seems to be, at least right now, through an ESOP. I think private equity is, I don’t want to say finally, but certainly more recently recognizing that.
What I’d like to do though in closing is put another plug in for not just the California Western States Conference, which is how we got started in the discussion today, but other conferences, whether it be NCEO or the National ESOP Conferences, the next one, of course, which is coming up in November in Las Vegas. That’s both for company people, meaning rank-and-file or executives, business owners that might be thinking about an ESOP, and of course, the advisor community at large. It’s a combination of technical information that gets shared in the hallways and through, let’s say, breakout sessions, but it’s also company-to-company practical, “Hey, what’s really going on? How do we really handle this? What are you seeing that’s working where you’re networking with other like-minded people?” I just can’t emphasize enough how much learning and fellowship and networking and contact enhancing there is at these conferences.
If you’re an ESOP-owned company and you’re not attending the conferences, I would encourage you to do so. If you’re a business owner thinking about an ESOP, I encourage you to attend. If you’re an advisor and you’re either in ESOP space or thinking about it, I’d encourage you as well to attend. If any of this resonates with you or want to talk further, Chase and I are always available to drill down with you offline.
Chase:
Wholeheartedly agree. I think Jim Bonham and the other conference organizers would certainly appreciate the endorsement. With that, thanks everybody for listening in. Really appreciate it. Until next time. Thanks, Chris.
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