Why ESOPs and captives continue to break ground in construction
As baby boomers retire, construction companies are turning to ESOPs and captives to unlock liquidity, manage risk and retain employees.
What many are calling the largest wealth transfer in history is under way. While that term is generally used to describe the generational transfer of personal wealth, there’s a parallel in business. As the baby boomer generation enters retirement, companies now owned by boomers seek ways to turn their equity into liquidity. The ready availability of private equity has fuelled liquidity events in a wide range of industries.
While the construction industry is seeing a growing share of liquidity events using private equity dollars, many construction companies are considering other approaches. That’s due in large part to the complexity of finances within construction companies, especially those undertaking large projects.
Beyond the fact that those projects are typically highly leveraged, and the value of their projects can vary wildly based upon the economic environment, large contractors are often saddled with legacy liabilities – including some that might yet be unknown. That can lead to hesitancy on the part of strategic buyers such as private equity firms, limiting current owners’ exit strategies.
Choosing ESOPs
Those limited options for liquidity events frequently lead construction companies to turn to employee stock ownership plans (ESOPs) as an alternative to other types of transactions. Given the importance of those companies’ labour forces, especially at the supervisory level, ESOPs also offer a way to reward valued team members for their part in the companies’ success. In addition, turning to an ESOP means the company’s name and hard-earned reputation can endure in the marketplace, which often appeals to founders and other owners who derive a great sense of pride from the companies they built and want to see continue.
“The discipline and data needed to operate an ESOP are just as applicable to establishing and sustaining a captive insurer.”
ESOPs were a major trend in the construction industry a decade and a half ago, and after a brief slump, have made a significant resurgence. They’re not without their challenges: notably, the amount of leverage can negatively impact a company’s bonding capacity in the near term - but their advantages typically outweigh any negatives.
A key issue in creating a successful ESOP is addressing executive risk. Most transitions from legacy ownership to an ESOP engage an independent trustee to oversee the structure of the transaction. Identifying and managing executive risk is normally a priority for those trustees, given the potential for unforeseen claims. Trustees often request limitations, such as naming them as an insured party while designating the ESOP’s policies as primary, shielding trustees from unforeseen claims.
What is a captive?
Construction company captives are licensed, regulated insurance companies established in a domicile in compliance with the laws and rules of that domicile. They’re structured as legal entities that are separate from the companies that create them, usually when commercial insurance coverage for the specific risks they face is unavailable or becomes prohibitively expensive.
Unlike commercial coverage, in which construction companies pay regular premiums as an expense for a set period, the money paid into the captive is essentially an investment. While it continues to be classified as a business expense for tax purposes, in most cases, that investment becomes the reserves of the captive, used for paying out claims.
“In one of the tightest labour markets in recent memory, having an ESOP suggests a higher-than-normal interest in the wellbeing of employees.”
When the amount of claims is lower than expected and reserves are prudently invested, the construction company can use the surplus for any number of business purposes – such as enhanced worker-safety programmes that generate further savings and surpluses.
Well suited for captives
While establishing a captive insurer is a sensible strategy in most industries, the nature of construction companies makes them especially well suited to this approach. Given the broad range of risks with significant potential meaningfully to affect operations and profitability, successful construction company owners tend to become sophisticated at recognising, quantifying and managing those risks, whether that involves preventing and minimising the impact of worker injury claims or dealing with the inherent price volatility of key commodities such as steel and timber.
Successful ESOPs are generally well organised businesses with rich data and better-than-average loss profiles. Additionally, their employee-owners normally develop strong recognition of their own roles in cost control and enhancing profitability.
Those traits make construction ESOPs particularly well suited for using the captive insurance strategy. The discipline and data needed to operate an ESOP are just as applicable to establishing and sustaining a captive insurer. They both require a strong sense of control, transparency, business processes and risk profiles, along with a desire to adopt best practices and a focus on reducing avoidable costs.
ESOPs and captives are effective long-term strategies that can be deployed to help construction businesses manage risks and exposures while addressing the needs of their employee-owners. While the two strategies might not overlap, they’re clearly complementary, so a company that is a good candidate for an ESOP is usually equally appropriate for a captive programme.
Looking after employees
In one of the tightest labour markets in recent memory, having an ESOP suggests a higher-than-normal interest in the wellbeing of employees and a willingness to reward them in ways that support their long-term financial health. That can help companies with both attraction of new employees and the retention of their existing team.
Using captives to manage critical risks and reduce costs builds upon those objectives while diversifying how and where the companies deploy their cash. Companies and their employee-owners also benefit from predictable costs, more effective loss controls and being able to retain and redirect profits.
Advantages such as those explain why we’ve seen a significant uptick in construction companies making use of the captive strategy. Fannie Mae’s (the U.S. Federal National Mortgage Association) recent updates to mortgage requirements also boosted the value of the strategy by making the rules more favourable for captives.
Value of expertise
Whether a construction company chooses to transition to an ESOP, a captive or both, the value of outside expertise cannot be understated. Some legacy owners of construction companies opt to pursue ESOPs as a way to obtain higher sale prices than they’re likely to find in the marketplace, but that can backfire for the employee-owners.
Others try to save money by choosing not to work with an investment bank or an independent trustee. ESOPs can be tricky to structure and implement, and a poorly designed programme can lead to negative year-over-year impacts on share prices, undermining the business and its new owners.
Similarly, captives might seem like an easy strategy for addressing risks, but the do-it-yourself approach is rarely a wise move. The complexity and ever-changing nature of construction risks call for specialised expertise that might not be available internally and the wide variety of structures, domicile options and the other aspects of initiating a captive make engaging, experienced and knowledgeable consultants mandatory.
Drawing upon that outside expertise dramatically increases the likelihood that both an ESOP and a captive programme not only effectively address current challenges, but that the company will be poised and able to adapt to new and unforeseen types of risks.
The above information does not constitute advice. Always contact your insurance broker or trusted adviser for insurance-related questions.
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