The Intersection of ESOPs and Private Equity

As the M&A market continues to exhibit record valuation levels amid heightened competition, ESOPs have seen an uptick in interest from private equity firms as both an exit alternative and as potential acquisition targets. According to the National Center for Employee Ownership, there are about 7,500 ESOPs covering 13.5 million employees.

ESOPs can and do pay fair market value and, under certain circumstances, compare favorably to more traditional transition alternatives. In addition, ESOPs provide an exit with certainty to close and an abbreviated process timeline. Some private equity firms have been known to avoid ESOPs due to the mistaken belief that majority stock ownership by an ESOP means the company is operationally controlled by the trustee or its employees. The ESOP trustee has a fiduciary responsibility to look out for the ESOP participants, but the board of directors and the company’s senior executives manage the day-to-day operations of the business.

ESOP-controlled companies may offer many of the same opportunities for a private equity acquirer to effect operational improvements as traditional privately held businesses. In addition, acquiring an ESOP-owned company is typically associated with minimal earn-outs and fewer seller representations than traditional processes. Similar to a non-ESOP deal, lenders will be focused on free cash flow. However, from a fiduciary’s point of view, the ESOP trustee will be focused on the financial fairness of the deal to ESOP participants.

For private equity firms looking to sell to a newly formed ESOP, the structure can provide attractive price, terms and conditions. An ESOP structure provides certainty of close relative to non-ESOP sale alternatives, and potential warrant participation can offer compelling post-closing rate-of-return attributes. In addition, there is less likely to be business disruption in a sale to an ESOP vs. a traditional M&A process. In order to finance the deal, the portfolio company would borrow senior and subordinated debt on a tax-advantaged basis. “Gap” financing would be provided by the seller in the form of seller notes, a 401(k) raise or junior capital.

For private equity firms looking to invest in an ESOP company, the capital can be structured as debt with warrants (structured equity) or via an LLC (to avoid S-Corp complexities) in order to achieve an optimal internal rate of return. A drop-down LLC structure can be utilized to achieve the benefits of a pass-through structure while avoiding the complexities of warrants and derivatives.