The Employee Ownership Update
September 30, 2010
Very Low Default Rate for ESOP LoansNew data from the National Center for Employee Ownership show that ESOP companies have an exceptionally low rate of defaults on their acquisition loans. The rates appear to be substantially below those of private equity firms and leveraged buyouts in general, although there are significant limitations on the comparability of the data.
To assess ESOP default rates, we 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. Twenty-seven providers responded. Among them, they represent a few thousand ESOP companies.
For the 2009-2010 period, the estimated defaults typically ranged between 1% and 2%, but some providers reported no defaults and one reported that 15% had defaulted. For the prior period, ESOP defaults were vanishingly small. Almost all these providers have at least 10 years of experience in the field. Annualizing their estimates would result in rates well under 0.3% per year, or about 1% to 2% over the whole time period, again with a few exceptions. One of the largest plan administration firms in the country actually calculated the rate for its hundreds of clients and found that it was 0.13% annually.
Making comparisons with non-ESOP data is tricky. A 2010 Moody's study found that of 186 private equity owned companies, 19.4% defaulted between January 2008 and 2009. Prior Moody's data from 2006 found a 14.2% rate for Ba-rated firms and 42.9% for B-rated firms (there were no data for firms with better ratings). The Private Equity Council, however, used a different definition of default by excluding debt-swaps, which Moody's called defaults. They reported a default rate of 2.8% in 2008 for private equity-backed companies and 6.2% for companies in general for LBOs. Prior research has arrived at similarly wildly different numbers.
These studies are also limited in that they typically rely only on public company LBOs. Moreover, ESOP law prevents lenders to ESOPs where a loan payment is missed from accelerating the debt and creating a full default. For this and other reasons, ESOPs are more likely to restructure troubled loans than just give up on paying them. Many ESOP loans are also seller notes, adding another layer of complexity. Finally, although the providers probably service as much as half of all ESOPs, we cannot be sure that they are representative of the universe of ESOP companies, and, conceievably, could overrepresent more successful ones.
So while comparisons must be made gingerly, the absolute data remain impressively small. Notably, for instance, the two bank respondents, both from major ESOP lenders, report essentially no defaults.
Small Business Jobs Act of 2010 Temporarily Shortens Built-In Gains Tax Holding PeriodWhen a C corporation converts to S status, the S corporation is taxed on all realized gains that had been built in at the time of conversion unless a holding period has been met. This normally is 10 years, but was shortened to seven years for gains realized in tax years before 2009 and 2010. The recently signed Small Business Jobs Act of 2010 shortens that to five years if the fifth year of the built-in gains potential recognition period precedes the company's tax year beginning in 2011. For qualifying ESOP companies that have converted to S status, this could allow them to sell some assets and not pay the "BIG" tax.
Looking for Burn Rates?Many companies issuing equity awards want to know what their industry practices are for "burn rates." Burn rates are the percentage of shares available each year under the company's various individual equity plans. Institutional Shareholder Services (ISS), a firm that advises institutional shareholders on how to vote on corporate governance, pay practices, and other matters, sets annual recommended standards for what it considers acceptable. The group recommends voting against "equity plans for companies whose average three-year burn rates exceed the greater of: (1) the mean plus one standard deviation of the company's GICS [industry] group segmented by Russell 3000 index and non-Russell 3000 index...; or (2) two percent of weighted common shares outstanding."
The table referred to provides mean burn rates and standard deviations by industry group. It is included in ISS's U.S. Corporate Governance Policy Updates at this link. The guidelines are updated annually. The most recent were released in November 2009.
Author biography and other columns in this series