Private equity funding and ESOPs are traditionally opposing strategies, but private equity could become a more active supporter of employee ownership through ESOPs in three ways:
Traditional private equity investors deciding to make reasonably priced highly leveraged loans to ESOPs as in the recent loan by the Healthcare of Ontario Pension Plan to fund the Taylor Guitars transaction
As we have described elsewhere, one large private equity fund, KKR, has moved aggressively into the employee ownership space, but not via ESOPs. KKR deals are structured so that employees get individual equity grants as part of the transaction. When the companies then go public or are sold again, the employees can cash in their awards. Typically, employees have ended up with about 10% of the equity value, a stake that has translated into tens of thousands of dollars per person. When KKR took Gardner Denver public in 2017, $100 million was granted to employees (about 40% of one year’s pay). Other companies where KKR has used this model include C.H.I. Overhead Doors, Flow Controls, and Hyperion.
Private equity firms (PE firms) could buy a company as they do traditionally, but then sell to an ESOP as an exit vehicle. There are potentially important advantages to doing this. They don’t need to find a buyer, and it would be easier to retain employees after the initial buyout if they knew an ESOP was coming. Investors could get a capital gains tax deferral on the sale if they reinvested the money in other stocks and bonds. But there are large barriers, too. The ESOP can only pay what a financial buyer would pay to buy the company. Even if the sale to the ESOP would be a good deal for the PE investors after taxes are taken into account, they may not want to put up with all the extra regulatory issues involved with ESOPs.
Even if they are willing, however, the deal could be difficult. Since most PE deals are leveraged, an ESOP buyout, which would also need to be financed mostly or entirely with debt, could be impractical. PE firms probably would prefer an easier exit.
A more practical approach would be to buy a controlling interest in a company but share part of the ownership through an ESOP. In the optimal model, the ESOP would buy 100% of the common stock and become a non-taxable entity. The PE investor could get warrants, the right to buy shares in the ESOP company for some years into the future at the price at the time of their investment. If the share value goes up, as it usually does in an ESOP, the investor exchanges that right for the cash value of the difference between the share price at purchase and the share price at the time it is cashed in. Models of this indicate the PE investors could get a very good return this way.
Another option is to participate in a joint venture with an ESOP company. The ESOP company would set up a subsidiary firm and, usually, own a majority of the stock. The PE firm would buy the remaining shares. Employees in the subsidiary would be in the ESOP. The PE firm would be bought out several years later. This has been done in a handful of cases, but is not something well known in the PE community.
The most likely option, however, is what the Ontario pension fund did—providing debt financing. PE investors are typically looking to double their money in about five years. That requires an interest rate of almost 15% per year. The Ontario fund took an interest rate of 10%. The argument, well backed by research, is that, first, ESOP buyouts have an extremely low default rate—two per thousand per year. So the risk is far less than traditional highly leveraged PE deals. Taylor Guitars is a very strong company with a great brand and ownership culture, making its chances of success even better. Second, the investment can meet the “S” (social) goals under ESG (environment, social, and governance) guidelines some funds have set up, including PE firms.
There are a handful of private investment firms focusing on ESOP deals, such as Mosaic, Long Point Capital and American Working Capital, but the total number of transactions from these investors remains very small.
Recently, a new entry in this market has been impact investment funds. The largest investment so far has been by the Kendeda Fund, which announced in 2020 that it would invest $24 million to promote conversions of companies to employee ownership. The funds were provided to four organizations that focus primarily on worker cooperatives, especially for low-income workers in industries such as home health care, laundries, retail, or child care. The most notable example of this strategy has been in Cleveland at the Evergreen Cooperatives. Evergreen has launched three businesses employing over 250 people and has recently used funds from Kendeda and others to acquire and convert two others.
A handful of other impact investment funds have moved into this space, often focused on lower income employees or workers of color.