Releveraging has received much attention in the past several years as a strategy that can potentially control repurchase obligations. Proponents suggest that systematic use of releveraging may be the key to ESOP sustainability. Before assuming that releveraging is a “silver bullet”, however, you need to understand exactly how it works, what it can and cannot accomplish, and some potential pitfalls.
Releveraging comes in two basic flavors, with many potential variations. First is a periodic releveraging of a substantial portion of the ESOP as a way to smooth out and prefund future repurchase obligations. We’ll call this “Prefund Releveraging”. The second is releveraging as a “shortfall” funding method, i.e., a way to handle repurchase obligations in years that they are especially large. We’ll call this “Shortfall Releveraging”. We’ll examine these separately.
Prefund Releveraging involves a purchase by the plan sponsor of a substantial number of shares from the ESOP, followed by a sale back to the ESOP financed with an internal loan. Typically, a Prefund Releveraging transaction would involve 25% or more of the shares that are owned by the ESOP. When the company buys the shares from the ESOP, the participants’ accounts receive cash for shares, which can be thought of as prefunding some of the future repurchase obligations.
The shares that are purchased with the loan are released from loan suspense and allocated to participants’ accounts as contributions are made to the ESOP in subsequent years. Ideally, the loan should have a long amortization schedule – 20 to 30 years – in order to manage the allocation of shares in the future. (If higher allocations are desired in any year, larger payments on the loan can be made.)
What can a Prefund Releveraging accomplish? By replacing some shares in participant accounts with cash, it can reduce and “smooth out” future repurchase obligations. This is most effective if the shares are purchased through special diversification rights that are offered on a one-time basis to older participants with longer service, whose shares would have to be repurchased soonest. Future “lumpy” repurchases are replaced with more predictable loan payments to the ESOP, and the reallocation of shares may be managed to be consistent with desired benefit levels.
Of course, the company’s purchase of shares from the ESOP requires cash, which may require external borrowing or may reduce a cash reserve that has previously been accumulated. It is important to understand the potential valuation implications, and how any reduction in value may affect participants’ account balances. A second concern is whether the combination of loan payments and future repurchase obligations not delayed by the releveraging may exceed desired ESOP benefit levels. The only way to determine the effects is to model the future cash flow, contribution, and valuation implications.
Shortfall Releveraging is a way to cover repurchase obligations when they exceed the amount of current contributions, dividends or S distributions, and accumulated liquidity available to meet repurchase obligations. Of course, the plan sponsor could handle the excess repurchase obligations by redeeming those shares. However, redemptions would reduce the number of shares outstanding and would potentially cause value per share to rise, over time, at a faster rate than aggregate equity value, a consequence that most ESOP companies prefer to avoid. An alternative is to cover excess repurchase obligations with a loan from the company to the ESOP. The shares repurchased this way are placed in loan suspense and released as the loan is repaid through future contributions (and perhaps dividends/S distributions). This avoids reallocating a large number of shares to participants in a single year and is a way to manage benefit levels, while avoiding a reduction in the number of shares outstanding.
Shortfall Releveraging does not eliminate the need for cash to fund the repurchase obligations. The company must have the cash to redeem the shares that will be resold to the ESOP. As with Prefund Releveraging, this may have an effect on company value if it involves any external borrowing or removes reserves from the company.
Shortfall Releveraging is most effective when repurchase obligations exceed desired benefit levels for a limited number of years. However, if used consistently and in amounts that cause a continual build-up of shares in loan suspense, the strategy can backfire. Eventually, the entire contribution could have to be used for loan payments!
If you want to consider releveraging as a strategy for managing repurchase obligations, you should consult with your ESOP professional advisors to be sure that you understand all of the complex requirements of these transactions. You should also prepare a financial and repurchase forecast to be certain that you understand all implications of a releveraging strategy for the company, the ESOP and the participants.
 This, of course, is an ESOP purchase transaction with all the usual legal and valuation requirements that are required in an initial ESOP purchase – purchase and loan documents, a current valuation, and a fairness opinion. There are also potential fiduciary concerns, as in any purchase by the ESOP.
 The mechanics are a bit more complicated. The shares that will be repurchased through a loan must first be redeemed by the company and then sold back to the ESOP, with the purchase funded by a loan from the company. Since the trustee of the ESOP is purchasing the shares, the same type of documentation is needed as for any other ESOP purchase of company stock.
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