The Problem
Why have ESOPs declined? That's complicated.
United Airlines. Enron. Tribune Publishing. The most catastrophic ESOP mismanagement looms large in the public imagination. Media coverage has hardened a narrative that ESOPs are fundamentally flawed financing tools, beset by abusive sellers who strong-arm their workforce into financial concessions or even bankrupt their employees' retirement accounts.
But ESOPs are not inherently flawed.
The problems that have plagued them are, in fact, the result of a confluence of related, reinforcing factors that are much less easily grasped than the media's depiction of corporate greed exploiting workers. When these factors are addressed, we believe ESOPs will be poised to flourish.
But ESOPs are not inherently flawed.
The problems that have plagued them are, in fact, the result of a confluence of related, reinforcing factors that are much less easily grasped than the media's depiction of corporate greed exploiting workers. When these factors are addressed, we believe ESOPs will be poised to flourish.
Perhaps the single biggest problem affecting the viability of ESOPs is a lack of clear and specific guidelines. What defines a 'fair price' in a deal? What constitutes 'abuse'?
Because ESOPs fall under ERISA, the Department of Labor oversees and enforces their regulation, which, effectively, burdens a labor-focused agency with the task of evaluating complex financial transactions.
Compounding this ambiguity is the absence of a statute of limitations, which empowers the DOL to unwind completed deals after the fact—and makes many investors reluctant to assume the risk of liability.
Because ESOPs fall under ERISA, the Department of Labor oversees and enforces their regulation, which, effectively, burdens a labor-focused agency with the task of evaluating complex financial transactions.
Compounding this ambiguity is the absence of a statute of limitations, which empowers the DOL to unwind completed deals after the fact—and makes many investors reluctant to assume the risk of liability.
Under current regulations, financing an ESOP usually requires a combination of funds from traditional banks, junior financing investors, and, often, creative strategies to pick up the slack. However, there are restrictions on the makeup of that financing. For example, funding sources that are not subject to state taxation receive preferential treatment.
Overall, incentives like that are offset by the fact that junior financing investors take on 100 percent of the downside risk, but are only entitled to a fraction of the proportional gain. The asymmetrical nature of risk and reward for junior financing strands ESOPs with limited sources to secure junior funding.
Overall, incentives like that are offset by the fact that junior financing investors take on 100 percent of the downside risk, but are only entitled to a fraction of the proportional gain. The asymmetrical nature of risk and reward for junior financing strands ESOPs with limited sources to secure junior funding.
As a result of ambiguous guidelines and scarce financing options, structuring an ESOP is an incredibly complex undertaking — one that takes roughly five times longer than a typical M&A transaction.
Every ESOP is overseen by a trustee who acts on behalf of the employee-owners, and it is their duty to navigate this ample complexity. For many trustees, this means creating heavy compliance processes that minimize potential litigation, but do not necessarily support their goals of protecting the investment. As a result, the industry has seen a mass exodus of ESOP trustees.
Every ESOP is overseen by a trustee who acts on behalf of the employee-owners, and it is their duty to navigate this ample complexity. For many trustees, this means creating heavy compliance processes that minimize potential litigation, but do not necessarily support their goals of protecting the investment. As a result, the industry has seen a mass exodus of ESOP trustees.
Under ERISA, ESOPs are required to pay out employees upon retirement. But, for ESOPs with an older workforce and no unallocated liquidity, this can have disastrous consequences, when many employees retire concurrently and place acute strain on the trust.
Investors could play an important role in delivering the required liquidity, but, for all the reasons discussed above, the investment industry remains wary of investing in ESOPs.
Investors could play an important role in delivering the required liquidity, but, for all the reasons discussed above, the investment industry remains wary of investing in ESOPs.
