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PRIVATE EQUITY + ESOPS The PE+ESOP Buyout
www.longpointcapital.com
The Best Liquidity Solution in Specific Situations ?
Employee Share Ownership and Private Equity Transactions
Sponsored by Rutgers School of Management
and Labor Relations
April 23, 2018
WHAT IS A PE+ESOP BUYOUT ?► A PE+ESOP Buyout is Essentially a Traditional Private Equity Buyout with
Additional Tax and Employee Benefit Advantages
► Similar to a Traditional Private Equity Buyout, the PE+ESOP Buyout can
► Generate significant up-front cash proceeds for the owners
► Retain significant upside for the owners
► Plus provide significant tax benefits and employee retirement benefits
► A PE+ESOP Buyout uses a proven ESOP (Employee Stock Ownership Plan) structure
to generate tax savings and employee benefits.
► ESOP transactions have been successfully used for more than 40 years. Over 10
thousand ESOPs covering over 13 million employees are operating in the U.S.
► Long Point Capital has successfully pioneered the PE+ESOP Buyout structure to
complement its strategy of investing in founder and family-owned middle market
companies.
Two ESOPs created by Long Point Capital have recently been sold, generating over $50 million in cash proceeds for employees.
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WHAT ARE THE BENEFITS OF THE PE+ESOP BUYOUT
► Tax Savings for the Seller – Allows the seller to defer or eliminate the capital gains tax, potentially generating over 40% more after-tax proceeds than a traditional private equity buyout.
► Cash Flow for the Company – Reduces or eliminates corporate income taxes,providing more discretionary cash flow for growth, debt pay down, or currentpayments to investors.
► Employee Motivation – Creates a valuable employee benefit plan through an ESOPwhich can be tailored to attract and retain employees.
► Seller Legacy – Publicized as a sale to the employees, not as a sale to a private equity group.
► Exit Options – The PE+ESOP structure deleverages rapidly, often allowing for a redemption of the outside investors without a sale. Unlike most private equity transactions where the company is sold almost every five years, the PE+ESOP may remain in place as an employee-owned company for an indefinite length of time.
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IT SOUNDS TOO GOOD TO BE TRUE, WHAT IS THE CATCH?
► Complete Tax Advantages May be Achieved Only in Limited Situations► All tax advantages can be generally be realized if the company is owned by
individuals or trusts and is organized as a C-Corp, or as an LLC (depending on the structure).
► The transaction can be designed to achieve some but not all of the benefits if the company is organized as an S-Corp.
► Auction Sale Process Discourages its Use
► An auction sales process is designed to maximize the pre-tax valuation with minimal complexity.
► The PE+ESOP Buyout is designed to maximize after-tax proceeds, but requires additional complexity to structure.
► ESOP Misperceptions Lead to Incomplete Evaluation of Transaction► Misperceptions of ESOPs, generally regarding corporate governance and financial
confidentiality, often lead to a dismissal of the transaction before a thorough evaluation has been completed.
► Clients may be required to engage special ESOP legal and accounting advisors to provide expertise on the transaction if their traditional advisors lack the properexperience.
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SO HOW DOES THE PE+ESOP BUYOUT WORK ?
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ESOP 101 - HOW DOES THE PE+ESOP BUYOUT DEFER OR Eliminate CAPITAL GAINS TAXES FOR THE SELLER?
Tax savings are generated through an Internal Revenue Code 1042 Exchange *
► Seller can DEFER capital gains taxes if:
−
−
Stock of a C-Corp. held by an individual or trust is sold to an ESOP
Proceeds are reinvested into qualified replacement property (QRP - stocks or
bonds of domestic companies) – typically a portfolio of high quality corporate
bonds
Cash may be generated by borrowing against the replacement property
portfolio
−
► Seller can ELIMINATE capital gains taxes completely if:
► Sellers retains the replacement property until death, at which time the
property transitions to heirs with a stepped-up tax basis
* The Internal Revenue Code Section 1042 exchange is analogous to the IRC Section 1031 exchange which is
widely utilized in real estate transactions to defer capital gains.
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ESOP 101 – EXAMPLE OF USE OF 1042 EXCHANGE IN A PE+ESOP BUYOUT
► Assumptions► Company has a $100 million equity value with $0 tax basis► 30% capital gains rate
► Tax Deferral► Sell stock to a newly formed ESOP► Reinvest proceeds into QRP, diversified portfolio of bonds and stocks► $30 million capital gains tax deferred by electing 1042 exchange► Cash may be generated by low-cost borrowing against the portfolio value
► Tax Elimination► Upon death, the portfolio is transferred to heirs at a stepped up tax basis of
$100 million► Heirs may then sell portfolio immediately for $100 million and owe $0 capital
gains tax
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ESOP 101 - THE PE+ESOP BUYOUT MAY GENERATE SIGNIFICANTLY HIGHERAFTER-TAX PROCEEDS FOR AN OWNER
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ESOP 102 - HOW DOES THE PE+ESOP BUYOUT ELIMINATE / REDUCECORPORATE INCOME TAXES AND INCREASE FREE CASH FLOW?
► The PE+ESOP structure generates more free cash flow through the reduction oftaxes in one of two ways:► “100% S-Corp ESOP” - If the company can be structured as an S-Corp. (i.e. a
flow-through entity) at the close,► Corporate income taxes are eliminated by selling 100% of the company
to a newly created ESOP Trust (a tax-exempt entity) for a note.► As an S-Corp, the corporate income tax liability flows through to its
shareholder, the ESOP Trust, which is a tax-exempt entity and therefore does not pay taxes
► “100% C-Corp ESOP” - If the company can only be structured as an C-Corp. at the close,► Corporate income taxes may be significantly reduced through the
increase in ESOP-related deductions.
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ESOP 102 – IF THE COMPANY IS OWNED 100% BY AN ESOP, HOW DOES APRIVATE EQUITY FIRM GENERATE AN EQUITY RETURN?
► The Private Equity firm invests in Structured (aka Synthetic) Equity,which consists of a subordinated note combined with out-of-the-money warrants.
► The Structured Equity security is designed to generate an equity return comparable to the return that would be generated in a traditional private equity buyout.
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ESOP 102 - THE PE+ESOP BUYOUTHIGHER FREE CASH FLOW (FCF) For The Company
MAY GENERATE
► PE+ESOP Buyouts structured as 100% S-Corp ESOPs generate significantly higher free cash flow due to the elimination of taxes.
► Higher FCF creates a lower risk profile for the Company – quantified through a lower equivalent leverage multiple.
$100MM Transaction Value - Example of Free Cash Flow $100MM Transaction Value - Leverage Equivalence
Private Equity Buyout PE+ESOP Equivalent PE Buyout * Private Equity Buyout PE+ESOPEquivalent
EBITDAMultiple
EBITDA
$16.7EBITDA
$16.7EBITDA
$24.1EBITDA
MultipleCapital Structure Capital Structure
3.6 2.5x x
* Based on 2017 tax law, i.e. 40% corporate tax rate. The EBITDA required for a tax-paying private equity buyout to generate the same FCF as a PE+ESOP transaction.
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Interest & Taxes$3.6
Free Cash Flow$13.1
Interest & Taxes$8.0
Free Cash Flow$8.7
Third Party Debt$60.0
LPC Equity$20
Seller Equity$20
Third Party Debt$60.0
LPC Equity$20
Seller Equity$20
Interest & Taxes$11.0
Free Cash Flow$13.1
ESOP 102 – THE PE+ESOP BUYOUT PROVIDES A MORE ATTRACTIVECREDIT PROFILE FOR A SENIOR LENDER
► The higher free cash flow may allow a Senior Lender to:► Stretch and lend more to the company than it would lend to the same
company that is a tax-payer, or► Provide more flexible rates and terms since the company should be
perceived as a better credit.► The PE+ESOP Buyout requires a sophisticated lender to understand the structure
► The 100% S-Corp ESOPs are 100% debt financed companies► The capital structure consists of both senior lender debt and junior
subordinated debt (structured equity)► The senior lender will require the junior debt to be appropriately
subordinated to the senior lender’s debt► The investment by a private equity group typically increases the confidence of
the senior lender due to history of working with leveraged credits and ability to invest additional capital
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ESOP 102 - HIGHER FCF PROVIDES FLEXIBILITY FOR THE COMPANY
► The higher free cash flow provides significant flexibility to the Company.► The additional free cash flow may provide:
► More capital for growth, and/or► More capital to deleverage rapidly, and/or► Current cash yield on the structured equity notes
► The higher free cash flow in a PE+ESOP Buyout reduces the risk on theCompany when compared to a traditional Private Equity Buyout.
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ESOP 103 – REGULATORY ISSUES► Regulatory Issues
► ESOPs are regulated by the Internal Revenue Code and ERISA, so careful adherence to IRC and ERISA rules is required
► Typically, an institutional trustee is selected to represent the interests of the ESOP and to insure compliance with applicable regulations
► Private Equity aligned with ESOP and Trustee primary objectives
► Valuation - Private equity establishes a market-based valuation for the company
► Governance – Private equity establishes governance procedures to maximize growth in equity value which benefits both the investments by the ESOP and the private equity firm
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ESOP 103 –CORPORATE GOVERNANCE AND CONFIDENTIALITY► ESOPs are “employee-owned companies”, not “employee-managed companies”► In a PE+ESOP Buyout, the Company is governed by a traditional board of directors
comparable to a private equity buyout► The Trustee is not required to be represented on the board► Employees are not required to be represented on the board
► Confidentiality of information may be maintained for the PE+ESOP Buyout transaction as well as financial results of ongoing operations► The only information required to be provided to each employee is the number of
shares that have been allocated to the employee through the ESOP, and an annual valuation of those shares
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ESOP 104 – TRANSACTION PROCESS AND TIMING
► The PE+ESOP Buyout transaction process requires the same time to close as a traditional PE Buyout transaction.
► The ESOP review of the transaction will leverage Private Equity’s due diligence
► An institutional trustee will be engaged, who will hire legal counsel to review documentation and valuation counsel to advise on valuation
► To achieve a timely closing, the closing work streams will be run in parallel► Due diligence► Financing► Legal documentation► ESOP diligence and documentation
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ESOP 104 – WHAT ARE THE ESOP BENEFITS FOR THE EMPLOYEES
► What is an ESOP ?► An ESOP is an employee retirement benefit plan. In an ESOP, a company sets up
an ESOP trust fund, which borrows money from the company to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan to the company.
► Who Participates and How is the Stock Allocated ?► Generally all full-time employees over 21 participate in the plan.► Shares in the trust are allocated to individual employee accounts. Allocations are
typically made on the basis of relative pay (subject to maximum pay limitations).► Employees must be 100% vested within three to six years, depending on whether
vesting is all at once (cliff vesting) or gradual.
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ESOP 104 – ONGOING MANAGEMENT OF AN ESOP COMPANY
► In a PE+ESOP Buyout, the Company is managed to create equity value, similar to any private equity buyout.
► In order to provide equity incentives for key members of the management team, theCompany may issue SARs (stock appreciation rights), similar to stock options.
► Given the ownership by the employees, management also has the opportunity to create an ownership culture through proper employee education, if desired.
► The Company will incur annual administrative costs related to the ESOP
► A institutional trustee will be engaged and will require the engagement of a valuation firm to provide annual valuations of the ESOP stock.
► An ESOP administrator will be engaged to provide the stock allocations and valuations to the employees, similar to the role of a 401k administrator.
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LONG POINT CAPITAL IS THE LEADING PRIVATE EQUITY FUND INVESTINGPE+ESOP BUYOUTS
► Long Point Capital has completed seven PE+ESOP Buyouts
Industry
LPC Legal Counsel
Senior Lender
ESOP Trustee
Trustee Counsel
21
Sunbury Textile Mills Atlantic PlywoodHire Counsel I
Mestel & Company The Saxton Group Torrent Resources UMA EnterprisesEYP Architecture &
Design
Upholstery Fabric
Proskauer RoseK&L Gates
Comerica Bank
LaSalle Bank
Morgan Lewis &Bockius
Building Products
Nutter McClennen& Fish
K&L Gates
Citizens Bank
GreatBanc Trust
Morgan Lewis &Bockius
Legal Services
K&L Gates
Fifth Third Bank
Wilmington Trust
Morgan Lewis &Bockius
Restaurants
K&L GatesRopes & Gray
Fifth Third BankGE Capital Corp
GreatBanc Trust
Greenberg Traurig
Stormwater Solutions
K&L GatesRopes & Gray
Fifth Third Bank
Wilmington Trust
ESOP Law Group
Home Accents
K&L GatesRopes & Gray
Fifth Third Bank Union Bank
Huntington Bank
GreatBanc Trust
Greenberg Traurig
Architecture
K&L GatesRopes & Gray
Key Bank
GreatBanc Trust
K&L Gates
DRAFTLONG POINT CAPITAL TEAM
For more information, please contact any of the professionals below.
New York Office747 Third Ave., 22nd Floor New York, NY 10017
Tel: (212) 593-1800
Michigan Office26700 Woodward Ave. Royal Oak, MI 48067
Tel: (248) 591-600022
Norm Scherr Vice President
Daniel Ron Vice President
Eric Von Stroh Managing Director
Ira Starr Managing Director [email protected]
Meahgan O’GradyAssociate
Niall Garrahan Associate
