As pre-’08 buyouts enter their prime exit years, the lackluster M&A environment is presenting challenges to solid ROI on portfolio company sales. While IPOs and sales have proven successful for large firms with large portcos, the exit terrain is unfriendly for most others. General uncertainty in both strategic and financial camps — despite the large pools of capital held by both  – has made traditional exiting difficult.

Instead of performing another recap in the hopes of a brighter future, Will Bloom of Chartwell Capital Solutions has encouraged many private equity firms to consider an Employee Stock Ownership Plan, or ESOP.

Although ESOPs have traditionally been directed toward exiting business owners who want to preserve their legacy, the strategy is proving valuable to many private equity firms as well.

Bloom explained, “In the broadest sense, an ESOP may be viewed from the perspective of a seller as a tax-advantaged, self-sponsored LBO.” He continued, “[It] might not be the best option for your top performing or lowest performing portfolio companies, but for the few in the middle — the solid companies with nice cash flow that, for one reason or another, just don’t attract the right buyers — an ESOP could be a great exit alternative and opportunity to secure a better relative–value return.”

Exiting through ESOPs

An ESOP can afford an appealing exit strategy for a previously stalled process. Bloom explained, “The structure [of an ESOP] would allow a firm to lever up and provide capital return to LPs, while retaining an appropriate amount of capital in a form that is attractive to them — ultimately, the PEG may reduce its risk position by moving up in the cap structure, obtain a current yield, and receive synthetic or real equity instruments that may offer material economic upside. The option is typically much more appealing than performing a div recap and hoping the market improves over time.”

In addition to the favorable structure of the exit, ESOPs might be able to offer a reasonable pay day as well. “ESOPs can offer a very competitive, fair market value price,” said Bloom. “While it cannot pay strategic value since it offers no synergies, it can compete with any other private equity firm. While it might lose in the process – like any other financial bidder could – it is often not because of the pricing.”

If a private equity firm is considering an ESOP, it also does not need to come at the expense of the traditional process. Bloom explained that a private equity firm could easily run a dual-track process — “On one hand, they can…try and find a traditional financial or strategic buyer. Or, on the other hand, they could consider an ESOP structure where they can control the transition of equity out of business by transferring it to the employees.”

As a matter of fact, a private equity firm can exit through an ESOP to another private equity firm. Bloom explained, “If the exiting PE firm is not looking to retain capital in the business, they could optimize liquidity by taking as much out of the cap structure via junior capital investors. A ‘structured equity’ security would provide the junior capital provider with comparable or better returns for the risk, better relative value, compared to traditional preferred equity positions. The investor would take effective operating control of the company and have an investment with favorable coupons and warrants.” This type of investment has grown increasingly popular recently.

Impressing Your LPs

In addition to offering a solid exit strategy for some of the companies sitting in your portfolio, an ESOP could attract the attention of your LPs. “LPs would likely be interested in this type of creativity, explained Bloom. “Unless you are a PEG in the top tier (10-15%) of performance, you may consider a strategy to differentiate yourself from the pack. Many firms came into existence in the early 2000s when LP capital was readily available. Now, as LP capital is more scarce or selective, firms outside that top tier must convince LPs to invest in their next fund.”

“Uniqueness and creativity are things that LPs are looking for now. I certainly think that firms that are open to learning more about how they can incorporate tax advantage structures to gain a better relative-value will have a better chance to obtain capital, which has become more limited in recent years.”

ESOPs in the Future

Bloom expects the interest in ESOPs will further develop with time. “The macro factors are positive for ESOPs,” he explained. “As the baby boomer generation begins to retire and consider next steps for their company; we believe the significant wealth transfer over the next 15 years will create many opportunities for both PE and ESOPs.”

Supporting the demographic shift, the heightened sensitivity to tax concerns has made ESOPs quite appealing. Bloom added, “Given the likely future of the tax environment, ESOPs are becoming more attractive for transitions and exits because of their tax advantages.” He continued, “With a tax-free entity, you can grow the equity at a faster pace with the additional cash flow, whether through deleveraging or reinvestment into the business.”