Planning for Repurchase Obligation

Transcription

1 Planning for Repurchase Obligation New England Chapter Spring Conference March 23, 2018 Jeanine Pendergast SVP, ESOP Client Advisor Spinnaker Trust Joseph D. Verri CRPS Senior Vice President- Financial Advisor Brad Sprague Strategic Accounts Team Manager Systems Engineering

2 Agenda What is Repurchase Obligation? What is Diversification? How to plan for both Drafting an investment policy Our investment obligations Questions

3 About Spinnaker Trust Founded in 2001 Headquartered in Portland, ME ESOP established in currently owns 10% 34 Employees Provides ESOP Trustee Services throughout New England, NY and NJ Wealth Management Firm with more than $1.5 billion in assets under management

4 About Systems Engineering Founded in 1988 Headquartered in Portland, ME with an office location in Manchester, NH 100% Employee Owned since Employees Specialize in IT Projects and Managed Services Cross-Industry Expertise: Education, Healthcare, Legal, Accounting, Municipal, Manufacturing, Retail

5 Get Ahead of IT What is Repurchase Obligation The obligation the Company has to liquidate participant account balances ESOP invested primarily in Company stock Company stock is not liquid (hence a marketability discount in your valuation) Participant holds a put option for the shares in their account Funds to exercise the put required to come from the Company Participants want the value of their account (cash), not the shares of stock they hold

6 Lifecycle of a Share Unallocated Shares Active Participants Purchase Shares Contribution to Participant Account Diversification / Termination

7 Repurchase Obligation Triggers Retirement Termination Disability Death Diversification

8 Diversification Defined Tax Reform Act of 1986 requires participants the right to choose to liquidate part of their account balance in an attempt to diversify their retirement assets Eligibility Age Requirement: 55 years Service Requirement: 10 years of ESOP participation How much can be diversified? Current value of 25% of highest number of shares ever in account At age 60, another 25% (total of 50%) Results in a large increase in repurchase obligation in year 10 and 15 of the ESOP Retirement Termination Disability Death

9 Diversification Experience Systems Engineering s first diversification occurred in 2017 Approximately half the participants diversified half the money Carrying Repurchase Obligation as a liability negatively impacts the valuation Retirement Termination Disability Death

10 Get Ahead of IT Quantifying the Obligation Perform a Repurchase Obligation Study Many TPAs Repurchase Obligation focused firms What is a Repurchase Obligation Study Long term forecast of future cash needs to liquidate participant accounts What information is used: Actuarial data (turnover rates, death rates, etc.) financial assumptions (stock price change, future contributions, payroll changes, diversification rates, etc.) distribution policy from Plan Document

11 Get Ahead of IT Why should we Plan To attempt to ensure sustainability of ESOP Plan for proper allocation of capital Repurchase obligation requires cash impact operating cash flow, business decisions and value Plan for target benefit levels (can avoid large spikes) Plan to attempt to avoid large swings in stock price due to nonoperating activity Identify the need to amend distribution plan provisions/policy To attempt to manage annual obligations to avoid the tail wagging the dog

12 Example of Target Benefit Levels Without Planning With Planning Year Cash stock Total Cash Stock Total 1 3% 3% 3% 3% 2 3% 3% 3% 3% 3 4% 4% 8% 6% 4% 10% 4 4% 4% 6% 4% 10% 5 1% 4% 5% 6% 4% 10% 6 10% 5% 15% 8% 5% 13% 7 2% 5% 7% 6% 5% 11% 8 4% 6% 10% 5% 6% 11% 9 2% 6% 8% 6% 6% 12% 10 18% 7% 25% 8% 7% 15% 11 3% 7% 10% 5% 7% 12% 12 7% 8% 15% 4% 8% 12% 13 4% 8% 12% 4% 8% 12% 14 8% 8% 3% 8% 11% 15 21% 9% 30% 8% 9% 17%

13 Get Ahead of IT It s never too early When should we Plan Participant balances are small while the ESOP is young Companies often think that the obligation is small and they can easily fund from cash flow Stock price can tend to increase dramatically as the ESOP matures Account balances increase often as the age of the population increases Can result in a large obligation quickly

14 What are our Alternatives Pay as you go Company contributes the cash needed each year to fund the current year obligations Pre-Funding (Sinking Fund) Inside the ESOP Make excess cash contributions each year and build a fund inside the Plan to fund future repurchases On the Company Balance Sheet Set aside a certain amount of cash on the books to fund future repurchases Take on Debt Re-leverage Shares Pay participants with a note Sell the Company

15 What are our Alternatives Pay as you go Advantages Simple No pre-funding Flexibility (can recycle or redeem shares) Disadvantages Difficult to fund large distributions in a single year May hinder growth opportunities for Company due to spikes in demand on cash flow ( tail wagging the dog ) Demands for funding may not match actual cash flow

16 What are our Alternatives Pay as you go Pre-Funding (Sinking Fund) Take on Debt Sell the Company

17 What are our Alternatives Pre-Funding (Sinking Fund) Advantages Contributions are deductible (within limits) Tax deferred growth and protection from creditors Normalizes benefit levels Normalizes cash flow requirements Plans for recycling of shares (ESOP maintains same # of shares) Provides comfort to participants and management In ESOP Disadvantages Not as flexible (mainly geared toward attempting to recycle all shares) Reduces working capital and available cash flow for growth opportunities Becomes an asset of the ESOP (company may not access it for other uses)

18 What are our Alternatives Pre-Funding (Sinking Fund) Advantages Flexibility (to recycle or redeem) Normalizes cash flow requirements and keeps benefit levels lower Keeps asset on company books (can be used for other purposes) Provides comfort to participants and management Corporate Disadvantages Contributions to fund are not deductible Growth not tax free Not protected from creditors May result in excess working capital and increase stock value

19 What are our Alternatives Pay as you go Pre-Funding (Sinking Fund) Take on Debt Sell the Company

20 What are our Alternatives Take on Debt Advantages Debt repayments over time, but obligation may be in single year Re-leveraging spreads repurchase obligations over longer period of time Company can deduct interest expense Disadvantages May not be able to obtain financing Extra expenses (interest, cost to re-leverage) Refinancing, not eliminating obligation

21 What are our Alternatives Pay as you go Pre-Funding (Sinking Fund) Take on Debt Sell the Company

22 What are our Alternatives Sell the Company Advantages Eliminates company funding the repurchase obligation May increase participant balances Disadvantages Most likely results in termination of the ESOP Culture change, decrease in employee sense of stability More likely to result in pressure to increase stock value

23 Get Ahead of IT Systems Engineering Plan ESOP established in 2007 Internal note still being repaid (5 more years) Chose to create a sinking fund inside the ESOP Obtained a repurchase obligation study in year 1 Goal to have enough cash in the ESOP to fund 100% of estimated repurchase obligation related to diversification in the ESOP by 2017.

24 Get Ahead of IT How did we get there Had our first Repurchase Obligation Study performed in our first year as an ESOP Updated repurchase study each year Began to make quarterly excess cash contributions to the ESOP five years before our first Diversification event Adjust quarterly cash contributions as needed Employee benefit level around 14-16% annually

25 Get Ahead of IT Establishing an Investment Policy ESOP Administrative Committee hired an investment manager to invest the funds (chose our Trustee, since they are able to provide that service) Created an investment policy with guidance of investment manager Used the Repurchase Study as a guide to determine how much to keep in each investment bucket. Current year obligations in cash/cash equivalents Next 2-4 year obligations in short term bonds Over 5 years in balanced equity portfolio with a focus on preservation of principal (likely to never reach this bucket)

26 Get Ahead of IT Monitoring of Investments Obtain quarterly statements Investment manager presents performance quarterly Each meeting includes a discussion on whether the current portfolio is meeting the investment policy goals. Investments with in the portfolio will be changed as the ESOP Administration Committee deems it necessary. The buckets will be adjusted annually at the Repurchase Obligation changes.

27 Get Ahead of IT What would have happened if Systems Engineering had not planned They likely would have continued to use pay as you go Benefit Levels: % 2017 over 20% % 2022 almost at the 25% maximum Cash flow would have been potentially strained when they were in the midst of needing capital to open a second office to grow the Company May have needed to redeem some shares due to contribution limits It could have potentially jeopardized the Company (and therefore the ESOP)

28 Questions? Joe Verri Jeannine Pendergast, Spinnaker Trust Brad Sprague, Systems Engineering