Late in April, a large contingent from the ESOP community gathered in Seattle to reconvene at the National Center for Employee Ownership’s first in-person National Conference since Spring 2019. In this month’s episode, Chris and Chase sit down to go over the major themes discussed among ESOP company leaders and advisors at the conference, and how recent economic and market trends are impacting the environment for new and existing ESOP companies in 2022.
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 again today with my co-host, Chris Kramer. Good morning, Chris.
Chris:
Good morning, Chase. Good to be here and do another podcast with you. We’re about a week back from the NCEO conference and I thought we’d spend a few minutes debriefing with our listeners a little bit about the conference, a couple of key takeaways, and then a little bit of a preview of what’s ahead for the remainder of the year in terms of association conferences. For those of you that are not familiar with NCEO, it’s the National Center for Employee Ownership, and it’s one of the preeminent organizations that’s here to provide education and information to businesses that are either interested in or have gone through some kind of a stock-based compensation program or in some other way are promoting employee ownership. NCEO does a couple of conferences each year.
The primary one is the national conference that we just returned from. It was in Seattle this year after a three-year hiatus. Well, two, I guess, but this is the third year, two years they were dark and we had about 1,350 attendees. Acuity Advisors was one of the sponsors and had a booth there. We sent six of our professional team to Seattle for about three days and overall had a great time, learned a few things, and reconnected with a lot of friends and colleagues.
Chase:
Yeah, it was absolutely a great time to see everybody as I’m sure is the case for a lot of our listeners. This was the first chance for many folks to get back together and see each other in person, which is really candidly, just how we prefer to do business. So it’s great to be back. But, real quick, before we get into the takeaways, looking at the remainder of the year in terms of not only NCEO, but just the overall sort of ESOP Conference/learning opportunities, how does the rest of 2022 shake out in terms of where folks can go either in person or online to sort of jump in on some of these learning/networking opportunities for ESOPs?
Chris:
So I mentioned NCEO does the national conference They also do a thing called the Fall Forum and that’s both for existing ESOPs, but also business owners that might be exploring an ESOP, might have heard about it, or want to learn more about it. This year the Fall Forum is in St. Louis and it’s going to be held from September 26th through the 28th, so that’s another great opportunity to learn more about ESOPs.
The other organization that we belong to that has been around for a number of years is The ESOP Association. They have a little bit more of a lobbying focus, but are also very heavy in education and they do two national conferences. One actually adjourned last week. We did not attend this year, but there were some good takeaways there as well. That one’s always in Washington, D.C. The other national conference that we’re very active in attending is in Las Vegas and they call that Employee Owned. This year the Vegas conference is being held from November 9th through the 11th.
In addition, each chapter has its own conference or most of them do and we happen to be in the Western States chapter, which is, I think the largest in the country. Our chapter conference is held every year in late September, or early October and this year it’s September 28th through the 30th. It’ll be held at the Loews Hotel in Coronado, so we’ll be very active and present at that conference as well, probably have a speaking slot or two. So that’s kind of the summary of the rest of the year in terms of the actual conferences. Lots of online opportunities for webinars and other ways that you can learn more about ESOPs, but we hope to see you at a future conference, and like I said, a lot of times Chase or I are doing some public speaking and trying to educate our friends and colleagues and the ESOP community at large.
Chase:
So if you’ve got a wide-open calendar for the final week of September, you can fly out to the NCEO Fall Forum in St. Louis, Missouri, Monday to Wednesday, and then fly back possibly on Chris and I’s flight and go to the California Western States conference down in San Diego. So potentially a bit of a weather change, but could be kind of an action-packed week. So that all being said, let’s get to some of the major takeaways from the NCEO Conference in terms of what the advisory and ESOP company community is seeing out in not only the transaction space, but just overall issues, challenges, and situations facing the ESOP community.
I mean, overall, as we sit and record this today, it’s Tuesday in early May and a lot of the discussion of late has been around, of course, inflation, seeing what the Fed did with interest rates last week, and in the ESOP community, given the prevalence of leverage in implementing these transactions, anything around debt or the economy or the stock market overall is frequently creating buzz, but what were some of the major themes you took back from the conference, Chris?
Chris:
I was going to say all around these issues, but probably more and more focused on inflation and its impact on interest rates. The lender community was abuzz with certainly a lot of let’s just call it turmoil in their industry, but fortunately, and I guess maybe not surprisingly, they’re still very active in the market to lend money. In other words, they want to get deals done, they just may have to alter some structure, obviously, in a rising interest rate environment, floating rate notes or variable rate notes are a little bit more attractive to a bank. Also, the cost of hedging in a rising interest rate market tend to be higher in a very rapidly, either rising or certainly changing market. So we heard a little bit about those issues, but very positively high amount of activity, not really afraid to keep lending in light of a lot of uncertainty.
Chase:
Yeah, totally heard the same, particularly from the lenders out there. Basically, if you recall back to early COVID, call it March, April of 2020, the diagnosis or the prognosis rather was really kind of full stop until everybody could figure out which way was up and we’re obviously a far bit removed from that now and the lending community is looking at their interest rate dynamics and their credit boxes and basically what we’re hearing is the lights are all still green. They’re still very active.
They want to finance new transactions, whether that’s for an acquisition or re-leveraging or they want to lend to ESOP companies, it’s just that they may have to jump through an extra hoop or two on their side to structure the deal, and, of course, in a rising interest rate environment, all else being equal, it might be a little bit more expensive in terms of the cost to service the debt and to your point, Chris, that if you’re willing to let the rate on that debt vary or float as opposed to being fixed, then obviously, if the rates continue to rise, that may not be your advantage. But, on the other hand, if you want to use some kind of swap instrument, which is very common among our clients, a derivatives contract to sort of synthetically fix the rate of interest, the bank is going to charge you a pretty penny for that just given where they expect interest rates to go.
Chris:
One of the other things that is very evident and it’s similar to what some of our business owner clients experience in terms of end consumers as well, in terms of let’s say quotes for things or pricing or commitments, et cetera, is that the pricing is changing rapidly, right, so interest rates are potentially rising more rapidly than they have really in the last certainly, five plus years. So to the extent that you don’t have a lot of momentum in your transaction or you have gaps in time or the transaction is delayed for some reason or it’s just frankly, taking longer than it should, you may well have a commitment letter, either terminate or have to be revised by the bank.
You may also see some valuation impact if the rates are rising rapidly because as most of you know, as rates rise, interest rates are rising, that’s negative to value, right, and so what we’re seeing is that some business owners are a little bit surprised or negotiations are getting a little bit more tense either between the trustee and the seller or potentially the bank and the company. Sometimes on the seller notes as well with the sellers and the trustees just around this uncertainty with the interest rates and the rise in rates, let’s say even over a three or four month period where it might be 25 or 50 basis points, and that can be enough to materially change the economics of a transaction.
Chase:
That’s a great point and it sort of begs a little brief explanation of sort of how it is that these ESOP deals tend to be negotiated between a trustee team, who’s sort of acting as the buyer and the seller in these situations. And frequently when we’re in the role evaluation advisor, the way it unfolds is we do our initial diligence, we develop a range of value, and we enter negotiations with the seller, and if all progresses smoothly, and we come to an agreement there’s sort of a signed term sheet with the price in it among various other terms and from there, the effort either begins or begins in earnest to complete the due diligence process from a legal perspective, and actually draft the definitive agreements and accomplish anything else on the closing checklist that has to happen between a signed term sheet and an actual closed transaction and in certain businesses, whether it’s a sophisticated business model or something with a lot of contracts, something with existing lending agreements, there can be a lot of complexity that arises in that kind of interim phase.
And in the last few years, generally, that hasn’t been a problem because to your earlier point, Chris, interest rates haven’t been varying wildly from month to month, whereas now, let’s say, as we sat here today, we were to sign a term sheet with the goal of closing June 1st or maybe even June 15th. Well, if we hit snags or there’s a delay, or for whatever reason, we have to push that closing to July 30th or God forbid, August 31st, further out into the year, there are several more opportunities for the Federal Reserve to hike rates between now and then and if that’s the case, we, as the valuation advisor have to bring our opinion forward.
We have to issue that opinion to the trustee as of the date that the ESOP transaction is closed and if borrowing costs increase materially, forget for now about what might happen to the stock market between now and then just given what we’ve seen in the last few weeks, evaluation advisors may be kind of in a pinch where they may not be able to even honor their original agreed-upon values based on what happens in the interest rate market and that’s a risk.
Chris:
Yeah, it sure is and that’s another reason why, what you’re really after in a transaction is momentum rather than speed, but we always advocate planning well in advance to mitigate any potential surprise so that you can at least not have foreseeable delays, right. There are often unforeseen delays, but let’s mitigate the ones that we may have been able to predict or know about. I think that starts with a good advisor and a good team on both sides of the transaction and again, educated on, certainly if we’re talking about an ESOP, educated on ESOPs, knowing how each other operate, and knowing really what the gating items are and what requires more focus and attention earlier in the process.
Chase:
Yeah, absolutely and to that point about the interest rates going up and planning accordingly, one thing to keep in mind that we also heard a lot about at NCEO the other week was that while the lenders are certainly still at the table and very active, and this isn’t just limited to the banks, by the way, this is the sellers in their capacity as noteholders in most ESOP transactions, one point of focus, particularly for those industries, you may qualify as more cyclical. So anything feeding into residential construction, highly discretionary entertainment, travel, things that are not seen as “recession-proof.”
One of the areas of focus aside from valuation, which is always center stage is particularly around those loan terms in the event of a default because without getting too far into the weeds, leverage is ever-present in most of these ESOP transactions and so while everybody around the table, whether it’s the seller, the trustee, whoever it is, may be extremely confident that the business will weather any kind of short-term or medium-term recession, the reality is that in order to put an ESOP into place, the company’s typically going to incur a fair amount of debt and that puts an acute focus on the short-term performance and the ability to let’s say, meet covenants or meet debt service, or make interest in principal payments and so right now, those loan terms, those default provisions in the event that there is a pullback in 2022 or 2023 are really center stage and focus for a lot of trustees and lenders in particular.
And to that end, Chris, as you know, but just for our listeners’ benefit coming up on the podcast, we’re going to have several guests join us rather than just our typical you and I format along or to follow Mike Flesch, our first guest, a few months back, one of which is going to be a prominent senior lender, a banker in the ESOP community who’s frequently lending in on new ESOP transactions, as well as various other reasons why ESOP companies seek banking relationships and he’s going to be able to shed light on some of these current market conditions, as well as how the banks view it from their perspective because oftentimes the credit committee at a bank is a fairly black box operation and somewhat of a mystery to a lot of us outside of that industry and it’ll be great to get that insight.
Aside from that, we’ve got another guest coming up, Chris, they’re going to be joining us to talk a little bit more about another issue that’s prevalent on everybody’s minds these days, which is talent retention and recruiting. Just given where the labor market is and some of the dynamics in hiring and retaining key talent and to that point, how managers, business owners, and leaders can incorporate particularly stock-based compensation or incentives around the equity value of the business to provide meaningful retention mechanisms, but also opportunities for incentives for those leaders that really make the businesses run.
Chris:
That’ll be a great one. He is a good friend of mine. Chris Craig is his name, and he’s also going to talk a little bit about the talent pool at large and how to work with a retained search firm and why that’s important because more than ever is certainly senior talent is critical and speaks to value, speaks to a lot of other great dynamics of the business. So I think that’ll be a very useful podcast and you should be able to hear that in about two or three weeks.
Chase:
So lots of stuff coming your way on the podcast, hope to see any, or all of you interested in, or already a part of the ESOP community at some of these NCEO and ESOP Association events later on this year, and until then, thanks again for tuning in everybody and thanks, Chris.
Chris:
Thank you, Chase.
Chase:
And now for the quick fine print. This podcast is for general informational purposes only. It does not create an advisor-client relationship between Acuity Advisors and the listener or reader, and is not intended as advice for a specific situation. And while we were informed that in light of the sponsorship of NCEO, this podcast would have to suffer some fairly severe budget cuts we are still grateful nonetheless to our ever present and very kind sponsor Acuity Advisors. Take care, everybody. See you next time.