Eager lenders, rising values, helpful legislation all contribute to a compelling environment for ESOPs. Subsequently, this is a terrific environment for business owners to consider an ESOP as a liquidity strategy. Credit is plentiful and recent relief on S-Corp. restrictions provides owners greater structuring flexibility.
The financing environment has improved substantially in 2004. Across the board, senior lenders are underwriting to higher multiples of cash flow as loan defaults decline. Traditional bank lenders are experiencing increased competition from non-OCC regulated entities providing cash flow loans. Lenders’ appetite for large cash flow borrowers with coverage of 1.20 is strong. Loan Pricing Corp. reports that quarterly loan volume ended June, 2004 exceeded $440 billion for all borrowers, up 50% over prior year.
Aggressive second lien or “Term B” lenders have increased subordinated debt leverage to multiples not seen over the past five years. The search for higher yields have attracted more players into the mezzanine market, putting competitive pressure on pricing. While previous subordinated debt lenders underwrote to returns in the 20%+ range, larger deals are getting priced in the teens, some with no warrant positions.
Seller paper continues to rise in prominence. The absence of attractive yielding investment opportunities in the open markets has induced selling shareholders (owners) to consider taking a larger portion of their proceeds in paper from the sale of their own companies.
This lending environment empowers all financial buyers, including ESOPs, and has provided some lift to valuations.
Congress continues to make S-Corp ESOPs more attractive with legislation passed in October that permits dividends paid on ESOP shares to be used to repay debt. As ESOP trusts are tax exempt entities, the 100% ESOP owned S-Corp does not pay taxes. This effective tax shelter allows S-Corps to accumulate a war-chest of cash, and provides companies the flexibility to grow by acquisition or organic growth.
Through synthetic equity instruments, shareholders can receive appropriate compensation for taking back subordinated seller paper as part of their compensation. This may prove to be a sufficient incentive to the selling shareholders to ignore the 1042 tax deferral available for C-Corp ESOPs.
Mergers & Acquisitions
Overall volume and value of small M&A deals under $25 million are flat to slightly down for 2004 while transactions over $50 MM are seeing significant increases. The private equity groups continue to drive the M&A markets, facilitated by a more generous lending environment. However, publicly traded strategic buyers have returned to prominence and now represent a majority of the buyers.
The current dynamics of the capital markets make ESOPs a particularly attractive liquidity strategy for business owners. Fixed interest rates remain low while lenders are offering more generous terms. The valuations in ESOP transaction are tracking with the improved multiples being paid in traditional M&A transaction.