Transcript Document

ESOPS IN THE CAPITAL MARKET:
THE ZELL-TRIBUNE TRANSACTION AND OTHER
USES OF LEVERAGED ESOPS BY PRIVATE
EQUITY AND MEZZANINE FUNDS
April 29, 2008
Edwin G. Schuck, Jr.
Chair, California Corporate & Tax Practices
500 So. Grand Avenue, 19th Floor
Los Angeles, California 90071
(213) 683-5376
[email protected]
AGENDA:
Opportunities for Private Equity and Mezzanine Funds
to Use Capital Markets Leveraged ESOPs
 PEG takes a public company private (Zell-Tribune)
 Public or private company divests or “spins off” a
subsidiary to management and/or a PEG
 Closely held company sells to a PEG
 Closely held company sells to management and PEG
 PEG sells portfolio company to management
2
What Makes a Leveraged ESOP a “Capital
Markets” Leveraged ESOP?
 Investments in leveraged ESOP transactions by
PEGs, Mezzanine Fund Investors and private
investors
 Such investments typically are in subordinated
unsecured “mezzanine” debt and/or detached
warrants or other “capital appreciation”
instruments
 S corporation warrants must have FMV strike
price but can be “penny” warrants if the investor is
routinely in the business of lending; C corporation
warrants can be “penny” warrants
 Stock purchased by the ESOP can be financially
structured to be high value/low equity percentage
to reduce other equity holders’ dilution
3
What Makes a Leveraged ESOP a “Capital
Markets” Leveraged ESOP? (cont.)
 Senior lenders are often themselves capital markets
players who will place the mezzanine and equity on a fee
basis
 Management is incentivized outside the ESOP with
“synthetic equity” awards and “rollover” of existing
equity and/or deferred compensation balances
 ESOP trustees are often sophisticated and well-advised
financial institutions who understand the role of private
equity and the role of the ESOP initially as co-investor
and ultimately, on the “exit,” as (i) a possible buyer
from the PEG, (ii) a co-seller with the PEG or (iii) the
sole remaining shareholder after the PEG is redeemed
 PEGs can take public companies private using ESOPS
4
What Makes a Leveraged ESOP a “Capital
Markets” Leveraged ESOP? (cont.)
 S corporation ESOP tax savings generate enhanced cash-




flow and liquidity – tax savings alone prior to exit can
equal the debt incurred in the acquisition
S corporation ESOP tax savings can then finance the PEG
exit by paying off the mezzanine debt so that new senior
debt is available to redeem the warrant
Public or private companies can dispose of subsidiaries in
a management-led leveraged ESOP buyout using PEG
financing
PEGs can both acquire and dispose of portfolio
companies using leveraged ESOPs
Other qualified defined contribution plan balances can be
moved into an ESOP to provide additional financing;
overfunded defined benefit plans can roll over excess
funds into an ESOP under some circumstances
5
What Is a Leveraged ESOP?
 A Leveraged ESOP is a tool of corporate finance that can be
used by PEGs and other capital markets players to enhance
returns on both buy-side and sell-side transactions
 An ESOP is an Employee Stock Ownership Plan that is a
“qualified” deferred compensation plan regulated under
ERISA and the Internal Revenue Code
 An ESOP is similar to a profit sharing or 401(k) plan but is
designed to invest primarily in company stock – there are
no diversification requirements except for long-term
participants
 An ESOP can borrow from related persons without penalty
– and thereby becomes a “leveraged” ESOP
6
Leveraged ESOPs: There Are Four Principal
Tax Incentives to Use Them
 Section 1042 capital gains deferral and ultimate elimination
for non-C-corporation sellers of nonpublic C corporations
 Effective deduction of ESOP loan principal (and interest)
 Deduction of dividends paid on ESOP-held shares
(C Corporations)
 S Corporation ESOP: flow-through of corporate income to
shareholders – no corporate-level tax except for any tax on
10-year built-in gains (“BIG”) of a former C corporation –
and ESOP shareholder pays no shareholder-level tax –
qualifying straight debt, options and warrants are not
treated as stock and so holders pay no shareholder-level tax
7
Section 1042 Permanent Capital Gains Tax
Deferral for C Corporation Shareholders
 Permits shareholders (other than C corporations)
of non-public C corporations selling shares to an
ESOP to defer indefinitely capital gains tax on the
sale
 ESOP must own at least 30% of value of all
company stock after sale
 Selling shareholders must within one year
purchase qualified replacement property
(“QRP”)—stock or debt of any domestic operating
corporation – sellers get over 90% tax-free
liquidity with a secured margin loan on QRP
specially designed to have a FMV equal to its face
amount (“floating rate notes”)
8
S Corporation ESOPs, Qualifying
Warrants and Other Equity Options
 S Corporation income flows through to shareholders – generally no







federal corporate-level tax except for tax on BIG (if any) – no tax on
BIG after 10 years – BIG can be avoided with creative structures
ESOP as S-Corp shareholder pays no federal income taxes or UBIT
on its flow-through share of corporate income
Limited types of shareholders
One class of stock – non-voting common stock is permitted; also,
qualifying stock options, warrants and straight debt are not a
separate class of stock
No flow-through taxation to holders of qualifying “synthetic equity”
(restricted stock, restricted stock units, warrants, stock options,
SARs, phantom stock and other forms of deferred compensation)
No dividend deduction available
No section 1042 capital gains deferral available
Reduced contribution limits apply (irrelevant if 100% ESOPowned)
9
What are the Mechanics of “Capital
Markets” Leveraged ESOP?
 Company establishes an ESOP and an ESOP Trust
 Bank and/or sellers provide “traditional” outside
financing to Company (“outside loans”)
 Other, “capital markets,” outside financing sources to
Company: PEGs, mezzanine investors, private investors
(in the form of other “outside loans” and warrants),
other qualified plan balances
 Company lends money to ESOP (exempt “inside loan”)
 ESOP Trust purchases Company stock from
shareholders or from Company
10
What are the Mechanics of “Capital
Markets” Leveraged ESOP? (cont.)
 Stock purchased by the ESOP with the “inside loan” is held





in a suspense account within the ESOP
Company pays contributions and/or dividends to ESOP that
ESOP uses to repay “inside” loan debt from Company
As the “inside loan” is repaid, shares in the ESOP are
released from the suspense account to ESOP employee
accounts
Company repays bank and other outside loans, in effect with
before-tax dollars
Company or ESOP repurchases shares from employees after
employment terminates at the then FMV – therefore
Company must plan for repurchase obligation funding
An ESOP itself may be a seller or a buyer in a capital
markets “exit” (or may remain as sole shareholder after a
capital markets redemption “exit”)
11
Basic C Corporation Sell-Side Capital
Markets ESOP Transaction
Cash
Bank
Outside Loan Note
Company
Cash
PEG and/or
Mezzanine Funds
Cash
Shareholders
Sale of
Company Stock
Exempt
(Inside)
Loan
(Note & Pledge
of Stock)
ESOP
Cash
Special
Stock
Other Qualified
Plan Balances
12
Basic Capital Markets S Corporation SellSide ESOP Transaction
Cash
Bank
PEG and/or
Mezzanine Funds
Outside Loan Note
Company
Sale of
Company
Stock
Exempt
(Inside)
Loan
Note (& Pledge
of Stock)
ESOP
Shareholders
13
ESOP Loan Repayment
Deductible
Contributions
and/or
Dividends
ESOP
Company
Outside
Loan
Payments
Bank, Mezzanine,
PEG Lenders
and/or Shareholders
Inside Loan
Payments
Release of Shares Pledged
as Collateral and Share
Allocations to Individual
ESOP Accounts
14
A Typical C Corporation ESOP
Capital Markets Sell-Side Transaction
 In one or more Section 1042 ESOP transactions selling





stockholders sell most or all company stock to ESOP and get taxdeferred liquidity
Preferred “equity,” subordinated debt and/or warrants – warrants
can be “penny” warrants – to PEG, Mezzanine Investors, Private
Investors
Can use high-value/low-equity preferred stock to minimize
dilution of other equity
Stock options, phantom stock or other synthetic equity granted to
key management to allow key executives to own eventually 5-20%
of economic value of entity outside ESOP
The tax savings from tax-deferred sale and deductible debt
principal make the C corporation leveraged ESOP far superior to
an IPO secondary or a leveraged recapitalization on a net after-tax
proceeds basis
S Corporation election
15
A Typical S Corporation Capital Markets
Sell-Side ESOP Transaction
 ESOP buys relatively small amount of stock from selling




shareholders
S corporation effects taxable redemption of all of the stock
held by selling shareholders for cash and possibly
subordinated notes (installment sale)
Subordinated debt and/or warrants are sold to PEG,
Mezzanine Investors, Private Investors
Stock options, phantom stock or other synthetic equity
granted to key management to allow key executives to own
eventually 15-30% of economic value of entity outside
ESOP
Company uses S corp. tax-free operation to accelerate debt
reduction
16
The Zell-Tribune Deal (12/07) –
A Buy-Side ESOP Transaction
 NYSE Company
 $8.4 Billion Market Cap
 Owner of 12 big city papers, including the
Chicago Tribune, the Los Angeles Times, Long
Island Newsday and numerous television
(including KTLA) and radio stations
 Owner of the Chicago Cubs and Wrigley Field
Stadium
 21,000 employees
17
Zell-Tribune: A Buy-Side
ESOP Transaction
 Largest ESOP deal in history
 First going-private transaction using a
leveraged ESOP
 High-profile capital markets transaction
using an ESOP
18
Zell-Tribune: Transaction Steps
Step One:
A. Tribune Company forms ESOP
B. Company lends $250 million to the ESOP, and the ESOP buys $250 million of stock at (a
discounted) $28 per share
Step Two:
Company makes tender offer to public at $34 per share. Company borrows initially
$8 billion from banks and redeems approximately 50% of the public shares, returning
approximately $4.2 billion in capital at $34 per share in the tender, using balance of
initial loan proceeds to pay off existing debt and for working capital
Step Three:
A. Cash-Out Merger: Company borrows another $4.2 billion from banks and squeezes out the
other 50% of the public at $34 per share ($4.2 billion) leaving the ESOP as the 100% owner
B. Zell invests $315 million and receives at par a $225 million subordinated unsecured
nonconvertible note (straight debt) and at $90 million an immediately exercisable 15-year
warrant to purchase 40%, fully diluted, of the Company’s equity for $500-$600 million
C. Company makes the S election – Zell’s subordinated straight note and warrant are not
treated as outstanding stock
D. Management is awarded 8% synthetic equity, fully diluted (phantom stock)
19
Zell-Tribune:
Post-Transaction Capitalization
Trustee
$225 Million
Banks
ESOP
100% Common Stock
(52% Fully Diluted)
Unsecured
Straight
Note
$250 Million
Zell
Management
8% Phantom Stock Units
Tribune
Corporation
$90 Million
15 year Warrant 40% Fully Diluted
$500 Million Initial Strike Price
increasing by $10 million per year
to a maximum of $600 million after 10 years
20
Zell-Tribune
Post-Closing Capitalization (cont.)
Owner
Investment
Instrument
Ownership
ESOP
$250 Million
Stock
52% fully diluted
Zell
$225 Million
Subordinated
Note
-0-
Zell
$90 Million plus
$500-$600 Million
Strike price
15-year
Warrant
Management
Future Services
Phantom
Stock
8% fully diluted
Banks
$12.2 Billion
Senior
Secured Notes
-0-
40% fully diluted
21
Zell-Tribune
Corporate Governance: the Tribune ESOP
 ESOP owns 52%, fully diluted
 Independent Trustee



Acts for the exclusive benefit of the employees
Acts to maximize the long-term value of plan assets
Directed by ESOP Administrative Committee after initial transaction
 The Trustee cannot be an advocate for employees
on issues such as pay, layoffs, or other work-related
issues
 The Trustee votes the shares as directed by the
“named fiduciary,” subject to “pass-through” votes
to participants only for mergers, sales of
substantially all the assets of a business,
recapitalizations and reincorporations
22
Zell-Tribune
Corporate Governance: the Board
 Zell was elected to the Board and is its Chairman
 The President and CEO of the Tribune remains on
the Board
 The representatives of the Chandler Trusts have
resigned from the Board
 The majority of the board is independent
23
Zell-Tribune: Post-Closing Events
 ESOP annual contribution is 5% of payroll – union members




included
a 3% cash balance plan was also adopted for employees
Defined benefit plans are fully funded. No wage concessions
Tribune is now selling assets to pay down debt in a
depressed economy – using a creative joint venture format
structured to avoid tax on BIG during 10-year post-election
period
Example is sale of Long Island Newsday to Newscorp using
an LLC joint venture structure where Tribune retains a small
(5%) stake and gets tax-free cash from Murdock – cash is
tax-free because of debt guarantee
24
Zell-Tribune: Post-Closing Events (cont.)
 Estimated 10-year tax savings from the ESOP S
corporation structure is about $1.4 billion
 About 40% of those tax savings will accrue to the
Zell acquisition entity
 Tribune also benefits from “benefit replacement”
(replacing current defined benefit cash
contributions with non-cash ESOP contributions)
– about $265 million net present value savings at
WACC over 10 years
25
SUMMARY:
Opportunities for Private Equity and Mezzanine Funds
to Use Capital Markets Leveraged ESOPs
 PEG takes a public company private (Zell-Tribune)
 Public or private company divests or “spins off” a
subsidiary to management and/or a PEG
 Closely held company sells to a PEG
 Closely held company sells to management and PEG
 PEG sells portfolio company to management
26
ESOPS in the Capital Market: Conclusion
 PEGs and mezzanine fund investors are presented
with the opportunity to invest in innovative new
transaction structures using leveraged ESOPs to
enhance their IRRs
27