The 2012 year-end flurry of ESOP transactions created an above average number of new ESOPs and increased ownership in existing ESOP companies. This is great news for the economic benefit of broad-based capital ownership but it is now time to think about what lies ahead for ESOP transactions in 2013. Important drivers for transactions have always been business confidence, equity valuations and availability of capital. Factors somewhat more unique to ESOPs include fiscal policy, the regulatory environment and an understanding of the productivity benefits of broad-based ownership generally.
In thinking about the year ahead, Pilot Hill Advisors offers the following outlook for ESOP activity in 2013:
- Gradual improvement in business confidence with a dash of guarded optimism
- Modest increases in valuations at the lower end of the valuation range and stable values at the higher end
- Increased bank lending to middle and small market companies with better terms. Rates will remain at historically low levels throughout the year
These expectations suggest to us the net number of new ESOP transactions will again increase in 2013.
Economic forecasters from financial institutions, government agencies, think tanks and the popular press suggest U.S. GDP growth will range from 2% to 3% in 2013. While this growth rate represents the most sluggish rebound since WWII, the passage of time has helped improve business conditions. Two of the big uncertainties during 2012 were the presidential election and fiscal cliff concerns. The presidential election is behind us and a major showdown on fiscal policy has been temporarily deferred. We are left to wonder the implications of increased earnings coupled with slower growth.
Various business confidence surveys show continued, albeit tepid improvement. The PMITM Index issued by the Institute for Supply Management indicates improved optimism in the manufacturing sector. This survey is a leading economic indicator that gauges supply side sentiment via monthly inquiries regarding new orders, backlog of orders, new export orders, inventories, employment and prices. The overall confidence trend since 2010 has been positive though the trend line has decreased somewhat during the last year.
The Conference Board also publishes an index of business confidence with its Measure of CEO Confidence, a survey of top CEOs regarding their near-term outlook on economic conditions. The January 3rd survey showed improvement during the latest quarter, but is still below the average confidence line. Lynn Franco, Director of Economic Indicators at The Conference Board commented, "CEO Confidence improved in the final quarter of 2012, despite the cloud of fiscal uncertainty. However, CEO sentiment remains pessimistic by historical standards. Regarding inflation expectations for 2013, CEOs expect moderate price increases."
The CEOs' short-term outlook in this survey is more upbeat than last quarter. Currently, 23% of business leaders expect economic conditions to improve over the next six months, up from 12% last quarter. Expectations for their own industries are also more optimistic, with 19% of CEOs anticipating an improvement in conditions in the months ahead, up from 15% in the third quarter.
Other surveys offered similar messages of near-term growth with upper ranges capping out at 3.5%. Numerous authors cite the uncertainty regarding the Federal Government's financial position, leadership and tax reform all having a dampening effect on economic activity.
Valuations in 2012, as measured by cash flow multiples, were at or above those of 2011 for each transaction Pilot Hill Advisors completed during 2012. However, two proxies we monitor showed mixed signals last year.
One index for valuation is the total market capitalization of all NYSE listed stocks. Though this is not a perfect year-by-year comparison, since companies are added to and removed from the Big Board, it does include about 2,800 of the largest companies in the United States. Extrapolating the Big Board value increases suggests the equity value of privately-held businesses has also increased. Since 2009, the total value of these securities has climbed to $14.1 trillion, an increase of 53%. During the 2011 to 2012 timeframe, the NYSE market capitalization increased 19%.
Merger and acquisition valuations, as measured by cash flow multiples (Total Enterprise Value/EBTIDA) told a somewhat different story during 2012, declining from 9.3x to 8.7x, in 2012 according to summary analysis of M&A data from S&P's Capital IQ.
Pilot Hill Advisors expects valuations in 2013 to increase modestly for those companies with lower cash flow multiples. We believe since more time has elapsed since the financial crisis, appraisers will have an easier time discounting older financial results. This, in turn, makes management forecasts more credible since many businesses have had time to adapt to the new activity levels and the general uncertainties of that period. We also think this group suffered more value dilution and thus have more upside as their financial and market positions improve.
We also found valuations for companies at the upper end of the value spectrum did not suffer as much value degradation during the recession and appear to have already benefited from the slow economic rebound. For this group, we expect the value multiples to be fairly stable, though we do not rule out increases for those companies with unique market positions or unique competitive advantages.
Most ESOP stock purchases are leveraged and the availability of bank credit plays an important role in the creation of new transactions. Many companies that were offered bank credit immediately after the credit crisis chose not to borrow given the expensive terms, restrictive covenants and their general uncertainty of business activity. During 2008, loan issuance by commercial banks decreased by 55% and as late as April 2009, The Wall Street Journal published an article, "Bank Lending Keeps Dropping," which echoed a continued reduction in aggregate bank lending. Thankfully, market conditions have improved considerably since then.
The Federal Reserve Senior Loan Officer Opinion Survey released in January reported bankers have been loosening credit standards modestly, reducing loan spreads and, not surprisingly, are reporting increases in loan demand. The FDIC recently reported that its insured institutions had total net income of $37.6 billion in Q3:2012 (the most recent report), a $2.3 billion improvement from the same period last year. This represents the 13th consecutive quarter that earnings have registered a year-over-year increase. We expect the improving health and profitability of the banks will ultimately translate into increased commercial and industrial lending in 2013.
The capital raising efforts of Pilot Hill Advisors during 2012 showed many banks remain cautious with collateral advance rates and overall leverage. But we also experienced renewed interest from other lenders offering higher leverage multiples and better terms and achieved results not seen for several years.
The recent increases in personal tax rates will mean lower proceeds from any taxable sale of stock. Structured properly, an ESOP sale offers a technique for deferring capital gain taxation indefinitely. Assuming the same sale price, the owner selling stock to an ESOP would keep at least 28.3% more of their sale proceeds than if they sold to a third-party. This savings could be more when state taxation is included. As a result of these tax increases, we expect to see more tax-deferred ESOP transactions taking place in 2013 and in many instances combined with a 100% S-ESOP structure.
Another area of interest is the regulatory environment. The IRS and DOL share oversight of ESOPs and each are concerned with fairness and making sure retirement benefits are paid to those entitled when they are due. DOL initiatives are in place to ensure compliance with the letter and spirit of the law and include reviewing fiduciary due diligence, ensuring appropriate equity valuation methodologies and identifying transactions that could be construed as self-dealing by the selling shareholders. Prudence, as always, dictates continued diligence on the part of ESOP advisors, trustees and appraisers.
Every tax-payer and tax-exempt entity is watching closely for discussions on an 'overhaul' of the U.S. tax code to begin. Much airtime was given to this topic in last year's presidential election though no clear timelines were, or have been, established. Defined contribution plans, which include ESOPs, allow employee-savers to exclude from income their ESOP benefits and put off taxation on any appreciation until the savings are drawn for their retirement. In theory, these benefits could be eliminated or diluted with new tax legislation; however it is hard to fathom the federal government doing so given the solvency concerns of the existing retirement programs.
New ESOP transactions, properly structured, can generate good returns for sellers - due to their tax leverage; for employees – since the retirement benefit is company funded; and for the providers of capital - since all debt service is repaid on a pretax basis. ESOP-owned companies also show improved productivity and growth when compared to companies without broad based ownership. ESOPs are also readily combined with other ownership transition strategies, so the ability to develop creative exit strategies abound.. Be sure to call Pilot Hill Advisors to learn more or discuss how an ESOP might be structured at your company.