Post on 18-Apr-2018
The Process of Forecasting & Analyzing Repurchase Obligations: A Case Study
Presented by
Ms. Tina M. DiCroce ESOP Economics, Inc.
and Mr. Shawn Richard
Palmer-Donavin Manufacturing Company
Agenda
• Introduction to the Repurchase Obligation
• Background on Palmer-Donavin Manufacturing Company (“Palmer-Donavin”)
• The Forecasting Process
– Defining the issues
– Gathering data
– Developing assumptions
– Modeling a “base case” and additional scenarios
– Analyzing results/developing conclusions
• Concluding Thoughts
Introduction to the Repurchase Obligation
• An ESOP’s repurchase obligation is defined as the ESOP plan sponsor’s legal obligation to fund participant distributions by buying back shares of ESOP stock at fair market value
• Forecasting repurchase obligations is a critical part of the process of planning for future liquidity requirements
Why you need to plan for repurchase obligations
• The repurchase obligation can represent a significant liquidity requirement that affects cash flow, earnings, and potentially the value of the company’s stock
– Many appraisers now ask for repurchase obligation projections
• With advance planning, you can develop strategies for meeting these obligations that are consistent with corporate goals such as:
– Benefit levels
– ESOP sustainability
– Availability of stock for future participants
Definition of RO study
• A long-term projection of ESOP distributions and the associated cash requirements that a company will face
• Not just a set of numbers – it is a process that is intended to provided answers and potential solutions
• Ideally, it is also an analysis of strategies for managing and funding the resulting obligations
• It is an important component of financial planning for ESOP sponsors, and a tool to help you make informed decisions about how best to manage and fund your repurchase obligations
Some of the things you can learn from a Study
• Number of shares to be repurchased
• Cost of repurchase obligations
• Repurchase obligations as a percentage of covered compensation
• Sufficiency of planned contribution strategy
• Effect of redemptions on ESOP ownership level
• Flow of shares available for future participants
When should you do a Study?
• Do first Study early in the life of the ESOP
• Review assumptions annually
• Update as necessary – Whenever there are material changes in your business
or the Company’s strategic plans
– Assumptions or census change significantly
– ESOP is considering transaction that will affect repurchase obligations
• Otherwise, update every 2 to 3 years
Palmer-Donavin Manufacturing Co.
Palmer-Donavin Manufacturing Co.
• Highlights – Founded in 1907 as a manufacturing company
– Transitioned from manufacturing to distribution
– Two distinct business units • Wholesale building materials distribution
• Residential entry door fabrication
– 470 employees in 8 locations serving 13 states
– Family oriented company with very tenured employees
– Long history of Appreciation Pay and Profit Sharing
– Became employee owned in 2006
ESOP Transaction
• ESOP formed in 2006 – Leveraged Transaction
– Acquired 100% of Company in the initial transaction
– Allowed employees to purchase ESOP shares using profit sharing money
– Used subordinated shareholder notes to help finance
– Made a $1,000,000 initial contribution which created non-leveraged shares
– 250 participants
– Company is taxed as an S Corporation
– Continued our 401K with company match
Complicating Factors
• Very rich plan (415 and 404(a) issues)
• Leveraged shares
• Non-leveraged shares
• PS Transfer Shares – Participant directed money in the plan
– Additional voting rights
– Additional diversification rights
Since 2006
• 2007 – 2009: recession & recovery period
• 2010: Completed first RO Study, started to integrate RO forecast w/financial planning
– Paid off all external debt!!! • 2012: Acquisition of Seal-Rite door 12/31/2012
• 2013: Divestiture of the HVAC business; engaged ESOP Economics for updated Study, modeled additional scenarios on our own
• 2014: Acquisition in Oct ’14
• Share price has increased every year since the initial transaction
Palmer-Donavin Manufacturing Co: Repurchase Study
• Completed first study in 2010 • Why we did a study?
– Important planning tool so you know your future liabilities and you can plan your funding method
– Specifically requested by FBT – Part of the study is developing future business
assumptions, which is also very helpful; stimulates thinking in areas you may not look at as you focus on daily operations
• Licensed Telescope software in June 2010 to model additional scenarios internally
• Began integrating RO forecast / output from Telescope into financial model
• Engaged ESOP Economics for Study Update in 2013 to incorporate the acquisition and divestiture
The forecasting process
• Define issues and questions to be addressed
• Gather data
• Develop assumptions, including repurchase method & funding strategy
• Model a “base case” forecast
• Analyze results & identify potential strategies for managing & funding the RO
• Model additional scenarios
• Develop conclusions & present results
Defining the issues
• How big are the repurchases and when will they occur?
• Can we afford to meet the repurchase obligations and still grow the business?
• Is the current funding strategy adequate?
• What are the implications of the ESOP acquiring more shares?
• What are the implications of amending the current distribution policy?
What questions are you trying to answer?
• Initial Issues: – Cash flow projections – Sinking fund – 404(a) considerations – 415 considerations – Setting precedents regarding distribution options and
the consequences of each • Most recent Issues:
– Cash flow projections – 415 Considerations – Impact of acquisitions on the ESOP – Tying projections to our strategic plan
Palmer-Donavin Manufacturing Co: Defining the Issues
Gathering data: What data will you need?
• Plan Document, SPD, Amendments, Distribution Policy (if separate from Plan Document)
• Most recent allocation file
• Historical allocation files (to perform an analysis of historical turnover rates)
• Most recent valuation report
• Business plan/financial forecasts
• ESOP loan amortization schedule
Developing assumptions: variables that affect repurchase obligations
• Plan provisions / distribution policy
• Demographics / actuarial assumptions
• Financial assumptions
• Repurchase method
• Funding strategy Some of these variables in turn are affected by the company’s
business and financial strategy and by exogenous variables (the economy, the industry, etc.)
Plan provisions
• Eligibility & vesting rules
• Allocation method
• Accounting method / rebalancing
• Distribution policy • Segregating Accounts • Diversification rules
• In-Service distributions • Retirement age(s)
Plan provisions: distribution policy
Main components of distribution policy: • Lump sum distributions vs. installments
• Immediate distributions vs. delays
• Segregating accounts at termination
Distribution policy: delays & installments
• Advantages – Company has additional time to develop the cash needed for
the repurchases
– Makes repurchases more predictable
– Reduces year-to-year variation in cash requirement
• Disadvantages – A percentage of the shares in the ESOP is in terminated
participants’ accounts
– Can result in higher distributions to participants, as terminated participants benefit from increases in stock value
• Unless accounts are “segregated” at termination
Delays and installments can be combined in various ways
Distribution policy: immediate & lump sum distributions
• Advantages: – Makes shares available to new participants – Most shares are held by active participants – Potentially lower distributions to participants, as terminated
participants do not benefit from increases in stock value
• Disadvantages: – No time to plan – could result in a “run on the bank” – Repurchases are less predictable – More year-to-year variation in cash requirements (and
potentially, benefit levels)
Distribution policy: segregating accounts
• Segregating accounts – a terminated participant’s account is cashed out of company stock as soon as possible; the account is invested in other investments until it is finally distributed
– Company can maintain distribution policy (with delays and installments) without having terminated participants share in stock value fluctuations
– The drawback – cash requirements are often equivalent to immediate lump sum distributions
Plan provisions: diversification & in-service distributions
• Diversification – Age 55 and 10 years of participation
– Up to 25% of eligible stock over the first 5 years, then up to 50% in the 6th and final election year
– Calculation is cumulative
• In-Service Distributions (an optional provision)
– Allows participants to take a distribution prior to termination from service
– Plan can dictate any age and/or service or participation requirements, as well as percentage of a participant’s account balance that is available to be withdrawn
Palmer-Donavin Manufacturing Co. Key Assumptions
• Plan Provisions – Diversification rights:
• PS Transfer shares • ESOP shares
– What assumptions are made regarding diversification?
– What impact does declining share value have?
– Distribution policy: • Our options • Our philosophy • Our obligations
Demographic/actuarial assumptions
• Age profile of existing population
- Will drive timing of age-related events like diversification & retirements
• Turnover rates/patterns
- Consider analyzing 3-5 years of historical census data for turnover, to develop assumptions for Study
• Death/disability
• Changes in size of workforce
• Salary Increases
• Age/compensation of future new hires
• Election rates of diversification rights
Palmer-Donavin Manufacturing Co: Key Assumptions
• Demographic assumptions – Employee Groups – Retirement Age
• Assumed a certain age for most participants • Specific assumptions for those already past NRA
– Turnover • Assumed turnover consistent with historical
averages (related to length of service) – Future changes in headcount and salaries
• Assumptions differed by employee group based on business plans
– Diversification election rates
Financial assumptions: stock value
• When developing assumptions about share value for the Study, it may be helpful to:
– Look to your internal financial projections – Understand the methodology used by your appraiser for
valuing the ESOP shares • If you have a built a financial model, or one has been
developed for you by an outside professional, integrate the repurchase obligations into the financial model to help develop stock value assumptions
• Adjust all related assumptions when adjusting growth assumptions
– For example, if you have adjusted your assumptions about share value for the Study, what other assumptions for the forecast need to be adjusted?
Stock value is a critical variable
Assumptions are inter-connected!
Stock Value Combined with Demographics,
Distribution Policy, and Funding Method
Repurchase Obligations
Earnings and Cash Flow
Palmer-Donavin Manufacturing Co: Key Assumptions
• Financial assumptions – Growth in share price – Turnover Rate – Payroll growth
• Cyclical business – downturns every 5-7 years
• Long-term growth rate
Repurchase method: redeem vs. recirculate
• Repurchase obligations can be handled by: – Having the company buy back the shares
(“redeeming”), or – Within the ESOP, using cash from contributions and/or
dividends/ S corporation earnings distributions (“recirculating”)
• The repurchase method you choose affects: – Number of shares owned by the ESOP – Number of shares to be repurchased over time – Tax treatment and cost of repurchases – Size of participants’ accounts – And potentially, the value per share of the company’s
stock
You can change from redeeming to recirculating or combine the two methods
Funding strategy
• Pay-as-you-go-funding
• Pre-funding inside the ESOP
• Creating a cash reserve on balance sheet
• Releveraging
Typical funding methods:
Palmer-Donavin Manufacturing Co: Key Assumptions
• Funding Strategy – “Pay-as-you-go” up to 23.5% of covered payroll
• IRC 404(a) deductible limit is 25% of covered compensation
• Palmer-Donavin also sponsors 401(k) plan to which it makes matching contributions averaging ~1.5% of covered payroll annually
– Pay S Corporation Earnings Distributions to the shortfall
– Considered re-leveraging in some years but now may not have to…
– Also considered a combination of redeeming/recycling but ultimately decided it was best to recycle all shares – and why
A note on developing assumptions
• Your projections will only be as good as the assumptions on which they are based
– Ever heard the phrase, “garbage in, garbage out?”
• Assumptions need to be: – Reasonable – Internally consistent – Consistent with other financial planning
• Get “buy-in” on the assumptions from key members of management
Good assumptions are essential!
Model a “base case” forecast
• Incorporate plan provisions, assumptions, current repurchase method and funding strategy into model and run forecast
• Check results for accuracy and reasonableness: – Do the results make sense?
Analyze results/identify alternative strategies
• What are the answers to the questions that you initially identified?
• What other issues have emerged from the projections?
• Can repurchases be handled without interfering with growth?
• Should changes be considered in the plan or in distribution rules?
• What is the best method for handling repurchases?
• What funding methods are appropriate?
Model additional scenarios
• Analysis of the “base case” scenario may suggest additional scenarios/strategies to be explored
• You won’t necessarily be able to determine the impact of making changes without modeling the alternatives
• Results and potential strategies should be “stress-tested” by looking at a range of assumptions
Palmer-Donavin Manufacturing Co: Analyzing results
• Results of the study – confirmed some tweaks to assumptions were necessary
– Adjusted retirement ages, etc. • After “tweaking” assumptions, we finalized a base case
– In 2018, our repurchase is higher and in 2025, the number doubles due to the number of projected retirements
– Found that our repurchase goals are achieved • Planned funding strategy is sufficient • Cash requirement will be manageable
– However: Base case scenario did show a “haves vs. have-nots” effect
• S distributions allocated pro rata to share balances
Palmer-Donavin Manufacturing Co: Additional scenarios
• In the base case, financial assumptions were a problem…
• Being overly conservative in financial projections can have the exact opposite impact on your repurchase study. Your obligations are under-reported
• Having internal model has also helped stress-test different strategies
– Different growth assumptions, etc. – Impact of acquisitions to existing shareholders…is it
dilutive?
Develop conclusions/present results
• What have you learned from the analysis?
• What are the pros and cons of the alternatives?
• Prepare a final report, including a “Board-friendly” summary of the findings, which usually includes:
– Background information – Summary of the issues – Summary of the results and implications – Pros and cons of potential strategies – Recommendations and/or issues for further analysis
Remember . . .
• The repurchase study is not just a set of numbers. It is an analysis of potential problems and solutions.
• The study is a tool to help you make decisions about how you will manage and fund the repurchase obligations
Palmer-Donavin Manufacturing Co: Benefits of doing the Study
• Study provided visibility on future cash requirements so that excess cash could be invested efficiently (to grow the business)
• Helpful thinking through the assumptions • Understand the impact of distribution decisions before
making them • Make decisions or know that you need to make
decisions about some of these factors • Provides detailed information for use in workforce
planning (turnover, retirements, job growth, etc.) • Ties the ESOP to HR and Finance and Strategic
Planning
Final words of wisdom
• Don’t wait until the week before the board meeting to start the process – it takes time to do it right
• Developing good assumptions is critical – involve key members of management
• Understand how repurchase obligations are reflected in stock valuation and integrate into your financial model
• Stress test your strategy • Update your Study whenever ‘meaningful’ changes
take place or you would like to evaluate alternative strategies
Questions?
Shawn Richard, VP Human Resources Palmer-Donavin Manufacturing Co.
(614)324-7369 Shawn.Richard@palmerdonavin.com
Tina DiCroce, Director ESOP Economics, Inc.
215-606-3593 tina@esopeconomics.com