Written by Jim Swabowski SVP of Wintrust ESOP Finance

The impact of rising interest rates is far-reaching. As a partner to middle-market companies that have an Employee Stock Ownership Plan (ESOP), a fundamental principle of our practice is to be proactive in capital planning with our clients. One such capital planning discussion surrounds the refinance of the subordinated seller debt that most likely entered the capital structure during the implementation of an ESOP.

As background, when an ESOP acquires ownership in a company, it is typically financed utilizing senior financing (bank debt), with the remainder financed via seller financing that is subordinated to the senior lender. Senior financing often accrues at a floating rate and is typically the tranche of capital that carries the lowest interest rate. Seller financing is akin to mezzanine debt, given its subordinated position to senior financing, and carries an elevated interest rate.

Additionally, in an ESOP transaction, we commonly see warrants attached to seller financing. A warrant is a form of synthetic equity that potentially provides future economic benefits to the warrant holder. While the all-in return on a seller note is frequently in the teens (in line with the returns of mezzanine debt), a warrant attached to a seller note allows the interest rate on the note to bear interest in the mid-single digits.

Prior to the last 18 months of upward movement in interest rates, virtually all senior financing carried a lower interest rate than the seller debt — making it a simple decision to refinance seller debt with senior financing as frequently as possible to reduce the overall cost of capital to the sponsor company. However, as interest rates have significantly increased, it is common for senior financing to currently carry a higher interest rate than that of seller financing.

While many companies initially struggle with refinancing debt, which will carry a higher interest rate than the debt being refinanced, the analysis is not as simplistic as comparing rates alone. Here are a few considerations:

The Impact of Warrants

One of the most significant considerations when analyzing seller financing surrounds the value of the warrants. In a rising valuation environment, which is the case for most ESOP-owned companies, the value of the warrant increases every year as the company valuation increases. In most cases, the warrant cannot be put to the company or called by the company until the seller financing is fully repaid. Therefore, the longer it takes to repay the seller financing, the more it may cost the company to redeem the warrant position.

Amortizing versus Non-Amortizing Debt

Seller financing is frequently structured as an interest-only loan with a fixed rate of interest, with the principal due at the maturity of the note. Bank financing typically amortizes over a period of five to seven years with a floating rate of interest. The carrying cost of these two tranches of capital varies beyond their stated interest rates. 

Let’s compare a five-year $5 million interest-only loan at a 5% interest rate to a $5 million loan that amortizes over five years at the same 5% interest rate. The interest over the life of the interest-only loan is $1.25 million, compared to just over $635,000 for the amortizing loan.

In fact, the interest rate on the amortizing loan would have to be nearly 9.85% to have the same amount of interest over the life of the loan when compared to the interest-only loan. Alternatively, the interest rate on the interest-only loan would need to be nearly 2.55% to have the same amount of interest over the life of the loan compared to the amortizing loan.

Floating versus Fixed

As noted earlier, seller financing is frequently structured with a fixed rate of interest, whereas senior financing is frequently structured with a floating rate of interest. Comparing the interest rate variance at a point in time could be very misleading, particularly in the current interest rate environment. Similar to the exercise above, it is important to consider the effective interest rate on bank financing over the life of the loan. The current yield curve (presented below) projects interest rates to decline by over 100 basis points (bps) in the next three to five years. If the yield curve expectations become a reality, the interest rate on senior financing will decline, which would either reduce or eliminate the interest rate variance between the seller and senior financing.