Private Equity Groups & ESOPs: An Unlikely Duo

Private Equity Groups and Employee Stock Ownership Plans (ESOPs) are often thought to be as incompatible as oil and water, but when examined further, there are actually a number of ways they can work quite well together. ESOP-owned companies have flexible capital structures, can provide market returns for investors, and multiple exit options. All of these characteristics are compatible with private equity, which can make ESOP-owned companies a great fit for private equity investors.

ESOP-owned companies and those who control them (ESOP trustees and company directors) can consider a variety of capital structures when taking on outside investors. Whether it is at the inception of the ESOP or when the ESOP is mature and in need of capital to grow, the ESOP-owned company can typically provide investors a range of ways to invest. ESOP companies are organized as S or C corporations, which at first glance seem inflexible receivers of institutional capital, but with a little creativity, institutional investors will discover they can invest using debt with synthetic equity or directly into equity in the case of a C-corp or a drop-down LLC. If the investor and the ESOP-owned company want to make it work, there is likely a structure that will satisfy the needs of both sides.

Why Private Equity Groups Like ESOPs

Private equity investors are often attracted to ESOP companies because of their superior performance in the marketplace. Many ESOP-owned companies outperform their peers for a variety of reasons, and when acquirors approach them, it is typically to buy out the ESOP. However, many of these investors enhance their return by just investing alongside the ESOP, thereby preserving the ESOPs tax advantages. An ESOP trust, the shareholder that holds the stock on behalf of the ESOP participants, typically does not have additional capital to invest in the company, so when the need for more capital arises, they look for outside investors. That’s when the company must offer a competitive market return to investors who will invest via equity or subordinated debt alongside the trust. By structuring the investment properly to preserve its inherent tax advantages, the ESOP company can preserve its enhanced cash flow, which makes it a superior competitor and vehicle for growth. This additional cash flow enhances the ROI for the outside investors and the ESOP participants.

Finally, the ESOP can help reduce one of private equity’s largest risks of investing: the exit. ESOP trusts stand by as willing buyers of stock or synthetic equity at fair market value. Having a willing buyer in hand as their investment period comes to an end can save the institutional investors time and money as they decide to exit. Even if they decide to take the company to market and set up a competitive bidding process, the ESOP itself can be a bidder, thereby maintaining a competitive environment that ensures a positive result for the private equity group.

Private Equity Can Be Your Friend

If you are part of an ESOP or considering forming an ESOP, remember that private equity can be a valuable tool to provide growth capital or additional liquidity in a transaction. There are many options when it comes to ESOPs.  Their flexibility as an exit strategy is one of their most attractive characteristics.

If you have comments or questions about this article, or would like more information on this subject, please contact us.  Or visit our ESOP Planning Library to find additional resources to help guide you through the ESOP planning process.