Default Rates on ESOP Loans, 2009-2013
Based on an NCEO analysis of 1,232 leveraged ESOP transactions at three large banks, 1.3% of ESOP companies in the sample defaulted on their loans in a way that imposed losses on their creditors for loans in effect between 2009 and 2013 (or an annual rate of 0.2%). The defaults accounted for 1.5% of the total value of the ESOP loan portfolio for these companies during this period. The bank data were only available for defaults imposing losses; the data presented here do not include defaults that resulted in loan restructuring where the loans were ultimately repaid or were being paid on the new schedule.
In a parallel analysis, the NCEO also asked ESOP appraisal firms to provide us data on defaults among the ESOP companies they appraised between 2009 and 2013. Eighteen firms responded out of the 40 ESOP appraisal firms we asked to provide data. The firms were selected because they were members of the NCEO's directory of service providers. Previous NCEO data indicated that directory members account for about half of all the ESOP appraisals. The eighteen responding firms were able to report data on 845 companies over the study period. Of these, 9 (1.1%, or an annual rate of 0.2%) defaulted in a way that imposed losses on their creditors, while 26 (3.1%, or an annual rate of 0.6%) had to restructure their loans but had repaid or were repaying their loans currently. Both the bank data and the data from the appraisal firms come from a wide variety of companies. The loan sizes ranged from less than $1 million to well over $50 million, and companies were in a variety of industries, including especially manufacturing, wholesale, and construction. The number of people employed at the businesses ranged from under 50 to several thousand.
Implications
These default rates seem strikingly low given the economic turmoil of 2008-2011, a period that overlaps and immediately precedes the data represented here. It is not possible, however, to make valid comparisons to data for defaults on leveraged buyouts of non-ESOP companies. While there are some studies of default rates for private equity firm leveraged buyouts, these firms make very different risk assessments in their transactions. Reported default rates for these transactions have ranged from a few percent to 19%, depending on the study and how defaults are defined, but the most parallel transaction to an ESOP is a management-led leveraged buyout of a closely held company, and credible data on such transactions do not exist. Estimating the default rates on ESOP loans is essential to evaluating two of the most common criticisms of ESOPs, namely
- That they are excessively risky
- That appraisals tend to be too aggressive, causing ESOPs to overpay for the shares
Both criticisms suggest that the default rates on ESOP loans should be high, which does not seem to be the case with the loans included in this sample.
Reliabililty of the Results
The results from the banks do not represent a random sample of all ESOP loans, and it is possible that there are systematic differences between the ESOP loans represented by the three banks in this study and loans from other sources. One of the banks in particular describes itself as particularly conservative. The NCEO's most recent count of the number of ESOPs indicates that there are just over 3,000 currently leveraged ESOPs, so the bank data constitute just over 40% of all ESOP loans. The data from the valuation firms represents a smaller portion (28%) of ESOP loans, and it is possible that valuation firms that do not specialize in ESOPs work with a set of companies with different characteristics and different levels of commitment to employee ownership than the companies represented here.
On the other hand, the convergence of the default data from the banks and from the appraisers provides more confidence in the result than would be the case if the two sources were significantly different. Of course, there is overlap in the samples in that some of the companies in the bank sample would be clients of the appraisers. The convergence is further supported by earlier work. In 2010 the NCEO asked major ESOP providers (lawyers, plan administrators, and two major banks) to estimate the percentage of their clients that had defaulted on their ESOP loans in the 2009-2010 period and in all prior years. The twenty-seven providers that responded represented a few thousand ESOP companies. For the 2009-2010 period, they reported that the defaults typically ranged between 1% and 2% for the responding providers, but some providers reported no defaults and one reported that 15% had defaulted. For the prior period, they reported lower ESOP default rates. In aggregate, their results suggest annual default rates under 0.3%, and one large plan administration firm that did a careful analysis reported a default rate of 0.13% annually. This work has substantial limitations: each responded provided estimates rather than actual numbers, and the number of total number of ESOP transactions represented was not available.