A Smart Hedge Against Future Capital Claims: The Evolution of Capital Reserve Planning

By Rich Chapman, Managing Director

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Leaders of mature ESOP-owned companies must serve as sentinels for their employee stakeholders, keeping an ever-watchful eye on the demands of future capital claims.  Never before in the 40+ years of the ESOP industry have so many companies been more burdened— even derailed— by the weighty demands of continuous capital calls.  Vigilance in measuring and managing these liabilities is common practice.  Mastering them, however, has proven elusive.  Many companies are caught off-guard, having relied on projected cash flows and favorable economic conditions to meet their future obligations.  Of late, an increasing number of ESOP-owned companies are implementing a new financial discipline on the asset side of the balance sheet.  As a part of their overall capital reserve strategy, Private Placement Life Insurance (PPLI) has emerged as an efficient way to help finance the cost of these long-term liabilities.

The Capital Allocation Dilemma

Unlike a public company, the ESOP-owned company is the market maker for its own stock, thus risking cash flow adequacy when business disruption creates a strain on working capital and debt capacity.  In a review of our client ESOP companies, we found that over 30% of mature ESOP companies (more than seven years since inception) have established a capital reserve. And we suggest that percentage should be even higher.  Why?  Because the impact of business disruptions carry a double impact for the ESOP-owned company.  Not only is working capital strained and debt capacity impaired, but there is often a resulting spike in repurchase obligations triggered by layoffs, early terminations, and in some instances an unanticipated volume of diversification elections.

Impact of Economic Cycles on Operating Cash Flow 

Over the past 11 recessions (1945-2009) the peak-to-trough of the economic contraction lasted an average of approximately 11 months while the trough-to-peak of the recovery averaged 58 months, for a total economic cycle of 5.7 years.  Companies generally encounter cash strains in the later stages of a cyclical contraction and the early stages of a cyclical expansion.  Based on these historical periods of business downturns and recovery, Chartwell is advising its clients to maintain a capital reserve adequate to support the company’s anticipated capital claims (RO, synthetic equity, etc.) through a time of business disruption.  A provision in the range of 24-36 months should be sufficient to carry a company through most recessionary events, and also helps management sleep rest assured.

Matching the Off-Balance Sheet Liability

Retaining cash comingled with other corporate assets provides safety and liquidity, and it has heretofore been the most common investment allocation strategy by a majority of ESOP companies. This approach, however, is lacking any specific provision to match the off-balance sheet repurchase obligation.  Unique from any other investment approach, PPLI creates an off-balance sheet asset in the form of life insurance proceeds payable to the corporation.  Death benefit proceeds provide continual infusions of capital to the company over time, helping to sustain generations of ESOP ownership. From an appraisal viewpoint, a PPLI portfolio is valued the same as cash or cash equivalents.  In contrast, the future death benefits, which will provide a stream of inevitable gains to the company, are not included in the valuation.  As a new and non-correlated asset class, PPLI is ideally suited to “re-balance” the balance sheet by providing a match for the off-balance sheet repurchase liability.

Why PPLI is a Smart Capital Reserve Investment Strategy 

Larger corporations have been using institutional life insurance programs for decades.  In fact, recent reseach shows that over 70% of the Fortune 500 and nearly 80% of all commercial banks1 are utilizing this approach to finance the rising costs of employee benefit programs.  However, PPLI programs are just now reaching the middle market - and in particular the ESOP community - thanks to the development of suitable investment funds targeted to companies of this size.

PPLI is a portfolio of life insurance policies, owned by the company and acquired in seven investment tranches.  PPLI is not available to the general public, and is offered only to accredited investors and qualitfied purchasers.  The company may invite up to the top 35% of employees (based on payroll) to participate in the program. 

The policies are guaranteed issue - which means no medical underwriting - requiring only a few brief questions and a consent from the participant group.  PPLI is an institutional (vs. retail) life insurance vehicle, which means 100% of the premiums paid convert to an immediate long-term asset with no earnings charge.  The investment earnings and cost of insurance charges are totally transparent, eliminating the “black box” pricing inherent in many corporate-owned life insurance (COLI) programs.  Unlike general account COLI, premiums may be placed into a separate account, permitting the company to make investment allocation choices.  Of note to the companies who are less than one hundred percent ESOP-owned, earnings within the PPLI portfolio are not subject to S Corp tax distributions, creating a unique win-win;  tax savings cover the cost of insurance charges.  Likewise, for the C Corp, with investment gains of PPLI being tax-deferred, the company’s asset purchase is accretive to earnings and share value.

Safety, Liquidity, & Flexibility

Most companies are simply reallocating cash from available cash balances into a PPLI portfolio to create a new asset class (booked under other assets).  Because PPLI allows the invested assets to be directed into a seperate account, the risk classification is defined by the underlying asset classes chosen by company management.  PPLI may be liquidated at any time and for any reason, without a surrender charge.  Numerous banks will lend up to 100% against the cash surrender value of a life insurance asset, carving the corporate debt out of the operating line credit facility. Loans are also available from the insurance carrier at a net rate as low as fifty basis points, again by simply pledging the cash value as collateral.  As compared to a money market account or even a managed fixed income portfolio, the attributes of PPLI provide a compelling alternative that can be safe, liquid, and flexible, based on the chosen asset allocation.

Peace of Mind 

Leaders of successful ESOP companies have long searched for a hedge against ever growing capital claims.  With a well-constructed capital reserve investment program, management can take comfort in knowning the company has established a financial discipline to help meet its emerging RO and synthetic equity costs.  Integrating PPLI to match an off-balance sheet asset (insurance proceeds) with the off-balance sheet liability (repurchase obligation) is a smart move.  Coupled with the security of mitigating the risk posed by a down economy or downturn in corporate cash flow, a properly structured and documented capital reserve portfolio supports the long-term viability of ESOP companies. Because we know that in the long run, the long run is all that matters.

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