With over $302 billion raised in 2007 alone, Private Equity Groups (PEGs) have solidified themselves as a powerful force in the M&A market. The continued proliferation of PEGs, and monies flowing into the funds they control, has led to intense competition for acquisitions. As we move through 2008, weathering its uncertain economy and tenuous credit market, we expect to see strategic buyers playing stronger roles in the M&A market. PEGs will need to find new ways to compete using creative deal structures to off-set tighter credit markets. One alternative structuring method that may be effective is the use of an Employee Stock Ownership Plan (ESOP) as an acquisition tool. While PEGs have already begun to embrace ESOPs as a divestiture tool, there is less experience in using the ESOP structure as an acquisition strategy. Publicly featured last year in the controversial privatization of the Tribune Company, ESOPs have also proven to be a successful strategy for the middle market PEG for several reasons including tax advantages, borrowing capacity and cultural benefits.
Tax Appeal to Owners of Target Companies
The most compelling competitive advantages to ESOP-enabled acquisitions are tax benefits. If owners of the target company sell to an ESOP, they may have the opportunity to defer all capital gains tax from the sale of the company stock through section 1042 of the Internal Revenue Code. If the deferral is not available, the worst case scenario triggers capital gains, as opposed to assets sold to a third party which would typically be taxed at a blended rate of capital gains and ordinary income.
This gives the PEG using an ESOP component an immediate competitive advantage in an auction process by putting more after-tax dollars into the sellers pocket while offering the same purchase price as competing buyers.
Tax Shield Increases Borrowing Capacity at Target
Going forward, the target company presents a much lower post-transaction tax profile when purchased using an ESOP strategy. The company has the ability to make pre-tax contributions to the ESOP, which increases cash flow for the company while ESOP debt is still outstanding. This cash flow can be used by the company for debt service, capital expenditures or other general corporate purposes. This enhanced cash flow may also lead to increased leverage provided by third party lenders. Savvy providers of credit see the enhanced cash flows generated by the ESOP strategy and realize that the company can handle a larger debt load.
Attractive Choices for PEGs
Increased borrowing capacity allows the PEG the following advantages without compromising return:
- Reduce the amount of equity capital in the dealReserve more dry powder for post-transaction acquisitionsIncrease bid to win auction
- Any combination of the above
The original thesis behind ESOP legislation was that it is good to put equity capital into the hands of the employees who help create more of the same. One of the biggest challenges PEGs face when completing acquisitions is smooth transition of ownership. The use of the ESOP incents the employees financially which has proven to have positive effects on retention, recruitment and productivity. The use of the ESOP puts the motivations of the PEG and the employees in complete alignment and creates a unified organization from top to bottom. These benefits often play out as revenue growth and increased profitability, a benefit to all shareholders. As the competitive landscape continues to present challenges to PEGs in acquisitions, strategic advantages and creative structures become more important. When structured properly, ESOPs can provide both.