Navigating Financing Issues Involved in ESOP Transactions: A Q&A with ESOP Experts
The coronavirus pandemic has shifted business as we knew it, and while there are plenty of challenges, opportunities continue to exist for those looking to sell their company using an Employee Stock Ownership Plan (ESOP). There are several nuances and complexities involved in such transactions, however, such as navigating the financing considerations.
Following up on the interviews he conducted this spring, Levenfeld Pearlstein partner David Solomon posed a series of questions to various contacts in the ESOP community to glean insight into ESOP financing in today’s environment. The firms that participated in this survey were all asked the same questions. We share their responses, edited for clarity, below so that other industry leaders and advisors can gain insight and learn from each other.
Question #1:
What are the key considerations in financing an ESOP transaction in the current environment?
John Solimine, Verit Advisors
Some of the key considerations to financing an ESOP transaction in the current environment include pivoting to a fully virtual deal process, where transactions are reviewed, processed, diligenced, documented, and closed without the principals ever meeting face-to-face. We have seen this work surprisingly well. There is also an enhanced appreciation for the importance of comprehensive underwriting and due diligence. Lenders are taking a more deliberate and thoughtful approach to assessing borrowers’ resilience to adverse economic conditions and unexpected surprises. This involves sensitivity analysis and downside scenario modeling. Depending on the industry sector and end markets, there is a heightened level of business, customer, supplier, and financial diligence at both the lender level as well as with third parties. We expect more thorough and thoughtful lender diligence processes to continue and remain given the current environment.
Julie Williams, PNC Bank
The pandemic has had wide-ranging impacts on businesses due to numerous factors, including but not limited to, industry, end markets, and capital structure. While some businesses have benefited and have experienced a higher level of growth and cash flow due to COVID-19, others have been severely harmed and will continue to face challenges for the foreseeable future. Unsurprisingly, the degree to which the current environment will impact the financing of an ESOP transaction may also vary widely. A company’s ability to finance an ESOP transaction in the near term will be impacted by facts and circumstances that are industry- and company-specific as well as by the overall credit market.
The current economic environment, coupled with general market uncertainty regarding the timing of an economic recovery equates, broadly, to greater risk as banks make investment decisions based on their comfort level in the future performance of the borrower. In spite of these conditions, for businesses with strong underlying fundamentals, banks are willing to deploy capital for general corporate purposes as well as leveraged transactions, including ESOPs. Accordingly, capital is available under the right circumstances and with the right risk/return profile. However, capital providers will be focused on corporate credit quality as well as allocating capital to situations that present favorable risk and return characteristics. It will be imperative that the bank understands the full impact of the pandemic on the company’s recent and expected future performance. The greater the certainty around your future performance, the better your position will be in obtaining financing that will meet the objectives of selling shareholders.
Regina Carls, JP Morgan
The underwriting criteria for ESOP financings in the current environment continues to be consistent with the criteria employed in a non-Covid environment. However, additional scrutiny will be placed on how Covid has impacted the business/industry and what the outlook is both short and long term. Banks continue to look at historical and project performance to assess sustainable cash flow to support a transaction, availability of collateral as a second source of repayment, and balance sheet leverage resulting from the transaction as key criteria in underwriting a new financing request.
Question #2:
How do you anticipate the COVID-19 pandemic to affect the amount of debt and the terms that lenders will request for ESOP transaction financing?
John Solimine, Verit Advisors
The term sheets that we are seeing for ESOP transactions have similar or only slightly lower leverage levels or amounts of available financing as compared to pre-COVID. We’ve seen a resurgence in new lending activity as referenced above with lenders actively competing for new ESOP financing opportunities. The amount of available financing is certainly highly situational and tied to the size of the company (i.e. EBITDA level), asset and earnings profile, and underlying industry given the COVID impact. Management teams must have an ability to develop thoughtful financial projections and earnings sensitivity analysis given any future uncertainty. From a structural standpoint, we are also seeing more structured amortization or repayment schedules as well as excess cash flow recaptures in order to evidence strong deleveraging early in the credit facility.
Julie Williams, PNC Bank
There is not a ‘one size fits all’ answer to the question of how the COVID-19 pandemic will affect your ability to obtain financing for an ESOP transaction. Fundamentally, banks will assess the ability of the borrower to repay its debt from cash flows generated from the business and the amount of collateral available to support the loan. For businesses that were negatively impacted by COVID-19, there is likely less certainty (i.e., greater risk) associated with the future cash flows of the business. Thus, for these businesses, access to capital from banks may be limited or reduced compared to pre-pandemic and, notably, pricing will reflect the elevated risk profile.
Some businesses, however, are recovering, unaffected, or positively impacted by COVID-19. Regardless of the case, lenders will be focused on understanding certainty of cash flows and mitigating known risks, which may result in the bank proposing a more conservative credit profile, shorter amortization, requirement for greater collateralization, and/or tighter covenant structures. Therefore, it is reasonable to expect that access to credit or credit terms and conditions may be less favorable for some businesses compared to pre-pandemic. However, for businesses with strong fundamentals before the pandemic and strong and/or predictable expectations for the future, banks will continue to lend with competitive terms that are often favorable to the borrower even relative to pre-pandemic conditions.
Regina Carls, JP Morgan
Depending on how Covid has impacted a business, banks may look to a lower opening leverage profile at close, however every situation will depend on the facts and circumstances involved for the particular company. Generally speaking, the greater the uncertainty of the impact, the lower opening leverage will be in most circumstances, given banks underwrite to sustainable cash flow which is harder to assess the greater the uncertainty. We are seeing shortened tenors in situations where heightened uncertainty continues to exist. While pricing terms will also be primarily driven by unique facts and circumstances, generally speaking, pricing spreads increased and tenors decreased when the pandemic first broke out. Over the course of the past few months, we have begun to see a narrowing of spreads.
Question #3:
What do you see being the return characteristics of Senior and Junior Debt (including Seller Notes) in ESOP transactions in this market?
John Solimine, Verit Advisors
The return characteristics for senior debt and junior debt are dependent upon the size of the borrower and underlying leverage profile. Senior bank debt pricing is typically in the L+300 -500 bps area for cash flow financing with a slightly lower LIBOR spread for asset-based or ABL financing structures. Banks are also introducing a LIBOR floor in the 75-100 bps area for some situations. Uni-tranche debt, typically provided by non-bank lenders with a higher leverage profile, is priced in the high single-digit area (L+750-900 bps) with lower pricing available for larger borrowers. Junior debt or mezzanine debt is typically in the 12%-14% total coupon (cash + PIK + warrants).
Seller notes in ESOP transactions are typically structured with a current pay interest rate and warrants to provide incremental yield enhancement given the deep subordination in the capital structure. Seller notes typically carry a current interest rate in the low to mid-single-digit area (many set at the AFR) with warrants to yield a low- to mid-teen all-in return opportunity commensurate with third-party mezzanine debt rates.
Julie Williams, PNC Bank
Generally, returns to capital providers (or pricing for the borrower) are determined relative to the risk associated with the investment. Senior debt is associated with the least amount of risk in the capital stack and thus has a lower return profile, whereas lenders who are deeply subordinated typically accept greater risks, such as lower payment priority, lower or no collateral securing the investment, and fewer rights in the event of bankruptcy or liquidation in exchange for a higher return profile.
COVID-19 has severely impacted a significant number of companies, resulting in broad economic uncertainty. Ambiguous conditions and greater market volatility generally yield increased risk for lenders.
As risk grows, lenders require a higher price to mitigate and balance the economic return to be commensurate with the risk profile of the investment. Consequently, under current circumstances, pricing across all tiers of capital has trended upward in many, but not all, cases. Borrowers can alleviate the impact of price increases by demonstrating strong fundamentals. When visibility into the future and the full impact of COVID-19 becomes clearer, we would expect this reduced risk to be reflected in downward pricing adjustments.
Regina Carls, JP Morgan
In general, return characteristics haven’t changed overall during the pandemic as banks continue to require deals meet a minimum return on capital. What has changed in many situations, however, is the risk profile of many companies that have been impacted, which factors into the risk rating assigned to a company. Risk ratings in turn impact the overall return as these ratings determine the amount of capital a bank needs to set aside. The lower the risk rating, the more capital required, which results in increased pricing, all things being equal, to achieve the minimum required return on capital.
Question #4:
Besides seller financing and traditional bank debt, what other sources of financing are available for ESOP Transactions?
John Solimine, Verit Advisors
In addition to traditional forms of financing, we are seeing an increase in non-bank or other institutional debt financing alternatives interested and eager to finance ESOP transactions. Previously, these non-bank capital sources were focused exclusively on financing private equity-backed leveraged buyouts or sponsored transactions. In the past couple years, non-bank lending groups, credit funds, and other institutional financing sources have dedicated non-sponsored lending initiatives, which include ESOPs, management buyouts, and other company direct transactions. These capital sources include publicly traded business development companies, (BDCs), credit funds of large asset managers, insurance companies, and credit-focused institutional investors. In addition to debt sources, family offices, impact funds and private equity investors are interested in investing alongside an ESOP. In particular, we have also seen some private equity investors whose investment policy was previously to provide equity only in control situations now willing to make non-control investments. This is providing additional liquidity alternatives as well as operational and strategic expertise from an expanded pool of more flexible equity investors.
Julie Williams, PNC Bank
Generally speaking, all forms of capital are available to finance ESOP transactions. While it is most common that ESOP transactions are financed through some combination of senior and seller debt, circumstances might warrant the use of other third-party lenders and/or equity partners, such as term loan B or mezzanine lenders, private equity, or non-bank finance companies. These alternative capital providers may become more prevalent given the strain that COVID-19 has imposed on the recent performance and future outlook of many companies, combined with senior lenders’ appetite to provide financing under current conditions. This type of capital, if appropriate, might be useful in the near-term as these lenders can be more patient investors and can potentially offer more flexible structures during these uncertain times, whereas senior lenders may be restricted from taking on higher levels of risk.
While some recent opportunities have shown overall leverage levels decrease slightly, others have shown resiliency with leverage levels similar to the pre-COVID-19 environment. Additionally, some recent opportunities have shown the funding mix between traditional debt and other forms of capital shift to slightly more weight in the lower end of the capital structure as a result of the greater flexibility offered by junior capital providers.
Importantly, certain forms of capital may not be accessible or appropriate for all borrowers. Now more than ever it is important to partner with a lender that understands and can facilitate and execute on the financing of a complex ESOP transaction structure that might include alternative forms of capital.
Regina Carls, JP Morgan
Beyond bank financing, there are additional sources of external financing in the form of 2nd lien and junior capital. These forms of financing are intended to bring external capital to the transaction and in turn provide the seller greater liquid proceeds which would require a lower seller financing component to finance a transaction. Institutional 2nd lien and unitranche lenders typically go deeper in the capital structure than traditional banks, allowing sellers to receive greater liquidity, with a willingness to provide looser covenants and other structural terms that afford the borrower greater flexibility in managing leverage and fixed charge covenants. However, the cost for this flexibility is materially higher than traditional bank financing due to the increased risk.
Although seller financing has been the predominant source for non-bank financing, several junior sources have become available over the past several years and are becoming increasingly common as new capital sources have entered the market. Mezzanine, while a source of capital that has been available in the capital markets for decades, has been an increased source of capital in ESOP transactions in the last few years. Mezzanine financing provides a tranche of generally unsecured debt that sits between the senior and other more junior sources of financing. There is generally no principal amortization and it carries a higher cost reflective of the higher risk it carries lower in the capital structure.
Structured equity is another common financing source being structured into many ESOP deals. Structured equity is structured much like seller debt, however it will typically carry a higher cash pay rate of interest and a sizable PIK rate as well. In addition, structured equity may receive a sizable warrant position aimed at generating an IRR that would mirror a traditional private equity return. Structured equity will have an investment horizon that will often last longer than most PE investments with the exit being a refinancing of the face value of the subordinated debt instrument and warrant package.
For additional information on ways the coronavirus pandemic is impacting other industries and business needs, please see the following interviews and surveys:
Navigating the Current Landscape: A Q&A with ESOP Experts
M&A Market for Architecture, Engineering and Contractors: A Q&A with Industry Experts
Current Challenges and Opportunities in the Insurance Distribution M&A Market