ESOP firm performance pre- and post-market peak: empirical evidence.

Henry, Steve ; Kavanaugh, Joseph ; Stretcher, Robert 等

INTRODUCTION

Ownership in a company is generally regarded as a key motivational tool to reduce agency problems. It should develop within employees and managers, through ownership, the desire to maximize shareholder value rather than to pursue self-serving objectives, such as building managerial fiefdoms, under-investing in capital assets, or allowing other agency problems to materialize that divert or destroy shareholder wealth. Therefore, many companies provide access to ownership in the company as a benefit of employment in a variety of ways. Companies can offer employees a chance to own stock in the company by granting employees stock options that give employees the right to purchase stock at a specified price over a pre-determined time frame. Companies can also allow employees to purchase stock at a discount through formal Stock Purchase Plans. A third option, authorized under the Employee Retirement Income and Security Act of 1974 (ERISA), provides for the establishment of Employee Stock Ownership Plans, or ESOPs. These plans offer substantial advantages to the employee and the employer beyond those available through either stock options or stock purchase plans.

In general, the adoption of an ESOP is considered a productivity and value enhancing action, increasing market price and creating wealth for the firm's owners and employees. This view is supported by most empirical work performed subsequent to the 1974 legislation that created the plan. However, in addition to increased value derived from reduced agency problems, ESOPs can provide significant tax savings to the company, benefiting both current stockholders and employees.

TAX BENEFITS OF ESOPS

Profitable companies have an obligation to pay taxes, but the government encourages companies to grow so they can hire more employees and provide greater stability to the economy. The government accomplishes this through various business tax incentives. A reduction in taxes provides liquidity to companies for growth and potentially more profitability. The original concept of the ESOP was to promote stock ownership among rank and file workers of US companies to make the capitalist system stronger, and lawmakers became convinced that tax benefits "should be permitted and encouraged under employee benefit law" (NCEO, 2005). Through the years, the legislature passed various enhancements to the original 1974 legislation, including the leveraged ESOP, in order to encourage firms to establish these plans. As a result, firms can now enjoy substantial tax savings from ESOPs.

Most recently, the Reconciliation Act of 2001, exempted employees' elective deferrals to their retirement plans from the calculation of total employer contribution to defined-contribution plans such as ESOPs and 401(k)s. In addition, the maximum contribution percentage was raised to 25% from 15% of total eligible pay. The act also allowed the firm to take a tax deduction for reasonable dividends paid on ESOP shares when employees elect to reinvest the dividends in additional shares of stock (Girard, 2002). The company remained eligible for a tax deduction equal to the value of stock contributions, and the company can deduct 25% of the principal and interest payments due on loans that provide funding for ESOPs. These new allowances further augmented the initial tax benefits provided by the 1974 ERISA and by subsequent legislation.

NOT WITHOUT COSTS

The benefits of an ESOP do not come without some potential costs to its participants, some affecting employees and some affecting the firm and its value. The employee, as an owner, may have a different sense of motivation from that of a worker. This motivation should increase shareholder value since the employee's personal wealth is now impacted directly, and the employee has a personal stake in increasing efficiency and productivity. Additionally, the employee's wealth can grow tax-free during employment since employees' shares held in the trust are not taxable until distribution upon retirement or termination. On the other hand, employee motivation, and therefore profits, can be impacted by the fact that the employee cannot obtain the reward of stock ownership until leaving the company (Hirschfeld, 2002). Furthermore, the employee suffers from a hazardous lack of diversification since retirement, as well as job security, are dependent upon the fortunes of the employing firm. ESOP restrictions prevent diversification of employees' portfolios outside the company until the employee either has been in the ESOP for ten years or is near retirement age.

With motivated employees and tax incentives providing opportunities for growth of the firm and increased profitability, ESOPs may provide shareholders with increased value; however, economic or industry conditions may not always result in a profitable firm. This exposes everyone in the organization to losses when downturns occur. When the company's performance lags, employee shareholders are exposed to market losses in an investment that they cannot divest while employed by the firm. As employees' wealth declines due to factors beyond their control, the sense of pride in ownership may diminish, resulting in the return of agency problems that the ESOP was intended to alleviate. Despite this, the firm must continue to provide the prescribed ESOP benefits.

When a company decides to start an ESOP as a key benefit, the employee's rights are protected through ERISA laws, and the ESOP must be able to pay the employee for the benefit earned in the plan. In general, employee participants in the ESOP receive their benefit upon retirement from the firm, and the firm has the obligation to pay this benefit regardless of how the company is performing at the time. Therefore, when establishing an ESOP, the trustee must establish a mechanism to fund ESOP repurchase obligations. A sinking fund is often used for this purpose, although corporate-owned life insurance, or COLI, and cash contributions are also alternatives. The choice of refunding mechanism may depend on whether the firm is an S or a C corporation and the balance sheet implications of each alternative (Kornfeld, 2000; Hirschfeld, 2002; CPA Journal, 2002). The various choices must be researched carefully in order to implement the optimal, minimum expected cost alternative.

Additional costs for firms adopting ESOPs can be especially onerous, especially for privately held firms. Companies are required to continually maintain accurate valuations of the stock of the company that is held by the ESOP. This is simple when the firm is publicly traded on a stock exchange, since the trading price represents the fair market value of its shares. However, for private firms, an independent appraisal must be done annually so that the ESOP accurately reflects share value.

ESOPS AND FIRM PERFORMANCE

Past research has established that ESOP firms are likely to outperform non-ESOP firms. The positive benefit of establishing a class of employee-owners is often cited as a primary motive to establish an ESOP. The argument is that, through ESOP participation, employees will be more motivated, begin to think and act as owners. They will exercise fiduciary-like responsibility over the resources of the firm, minimize agency costs, and align their behavior with the goals of the firm. Essentially, they will perform in their own best interest--not as employees, but as shareholders. If this is true, then one would anticipate that an ESOP-based firm would outperform comparable firms in its industry group, yet the performance evidence is mixed.

In a study of 382 U.S. public firms that adopted ESOPs over the twenty-year period 1971-1995, Wah (1999) found that total shareholder return for ESOP firms exceeded those of non-ESOP firms by 6.9% and that average annual return on assets (ROA) for ESOPs was 2.7% higher than for industry peers without ESOPs. Kruse and Blasi (2002), in a study of 343 matched pairs of ESOP and non-ESOP closely-held firms, comparing performance differences from three years prior to three years after introduction of the ESOP, found differences in favor of ESOPs of 2.4% in sales, 2.3% in employment, 2.3% in sales/employee, and 4.4% in employee productivity. Lee (2003) found similar productivity gains of 4-5% associated with the introduction of ESOPs into Taiwanese electronics manufacturers, but noted that the effect does not appear immediately after introduction, often taking 3-4 years for the firm to realize the gains.

On the other hand, others have found that over a longer, four-year time period, many of the post-announcement effects erode, concluding, "ESOPs provide, at best, only a short-term boost to corporate performance" (Pugh, Oswald, and Jahera, Jr., 2000). This study found that only a few measures of firm performance increased significantly-return on equity, return on assets, and net profit margin-but only short-term. Further, it was found that firms that leverage their ESOPs show evidence of long-term market underperformance, and a long-term increase in their debt-to-assets ratio. This is in keeping with the proposition that firms that are takeover targets, often attributed to their history of poor performance, create leveraged ESOPs as a takeover defense. This puts more shares in the hands of "friendly shareholders" and also increases the debt load of the firm, itself a defense against takeover. Having survived the takeover, the firm continues under-performing, but now it has a more highly leveraged capital structure (Pugh, Oswald, and Jahera, Jr., 2000).

Iqbal and Hamid (2000) produced some very interesting results when they examined the longitudinal relationship between stock price changes and operating performance of ESOP firms. Their results suggest a causal relationship between the two variables, with stock price changes affecting performance. When stock price increases significantly or declines significantly, operating performance increases. When the changes are modest, either positive or negative, there is no significant impact on operating performance. They also found that this relationship "appears to be significant several quarters after the changes in stock prices occur"(Iqbal and Hamid, 2000). This has some intriguing behavioral implications. The authors conclude, "Ownership in itself may not be enough to improve firm performance. Rather, ownership has a positive impact on a firm's operating performance when there are significant changes in stock prices" (Iqbal and Hamid, 2000). This suggests a certain behavioral insensitivity to modest price fluctuations and that the value of 'ownership' only emerges in times of more significant price changes.

The 12th Annual Economic Performance Survey conducted by the Employee Ownership Foundation, the 501 (C) (3) affiliate of the ESOP Association, surveyed nearly 1300 member firms in July 2003. Results based on 320 responses indicate that for 2002, 80% of ESOP firms outperformed three major stock indices: DJIA, NASDAQ Composite, and S&P 500. Another 8% outperformed at least one index and only 3% performed worse than all three indices. Financial performance data for 2002 compared to 2001 is also reported, and the results were uniformly positive (PR Newswire, 2003). These findings are in alignment with previous findings from a 1992 survey conducted by the National ESOP Association in which they observe, "ESOP firms have weathered the recession better than their non-ESOP counterparts" (Research Studies, 1992, p.15). It is important to note that these results are based on accounting returns where firms can take advantage of the tax incentives, such as dividend distributions policy, principal and interest deductions on ESOP loans, provided under ERISA rules.

The performance of such firms on a cash-flow basis is less certain. At least one study (Ducy, Iqbal, & Akhigbe, 1997) examined the ESOP three-year pre- and post-implementation economic performance of publicly traded firms using operating cash flow (OCF) rather than accounting returns. They determined that industry-adjusted performance of ESOPs deteriorated on all three measures utilized: OCF to market value of assets, OCF to sales, and OCF per employee. This study clearly suggests that additional studies are needed to examine the cash-flow performance of ESOP and non-ESOP firms on a paired comparison basis (Kruse & Blasi, 2002). While accounting returns are important for highlighting the effects of the incentives contained in the ERISA authorization, cash flow is a major determinant of organizational survival and the creation of shareholder wealth.

An NBER working paper explored the role of human resources policies and the motivation of ESOP employee-owners and concluded that to understand how employee ownership works successfully "requires a three-pronged analysis of: 1) the incentives that ownership gives; 2) the participative mechanisms available to workers to act on those incentives; and 3) the corporate culture that battles against the tendencies to free ride" (Kruse, Freeman, Blasi, Buchele, and Scharf, 2003).

Other studies have also found that participation in decision mechanisms is key to ESOP performance; ESOPs without significant member participation in decision-making do not outperform non-ESOP firms. (See Pendleton, Wilson and Wright [1998] for an extensive review of the literature supporting the linkage between participation in decision-making and ESOP firm performance.) As Kruse, Freeman, et. al. (2003) observe, "It is not ownership, per se, but the cooperative culture that can be fostered by employee ownership, that drives better workplace performance in ESOP firms."

RISK EFFECTS

None of the earlier studies have given consideration to the factors of risk in assessing ESOP performance and the creation of shareholder wealth (Conte, Blasi, Kruse, and Jampani, 1996). In the 1990s, a period of unparalleled prosperity and growth in the U.S., this did not emerge as an issue of major research interest. However, the recession of 2001-2003, the bursting of the 'dot com' bubble, the major correction in virtually all stock markets, and the collapse of Enron and many other firms that destroyed the wealth of many of their employees who were heavily invested in company shares, have all highlighted the need to consider inherent structural risk in evaluating ESOP performance.

A 1996 study examining the financial returns of public ESOP companies found systematic risk, or beta, to be lower for ESOP firms than for non-ESOP firms overall, and for both small and large firms when analyzed separately. Total risk, measured by the standard deviation of returns, was also lower for ESOP-sponsoring firms. This study found that the effects of ESOP adoption were most pronounced in small firms and that the ESOP effect among large companies was small or nonexistent (Conte, Blasi, Kruse, and Jampani, 1996), reducing financial returns by approximately three percent. This negative effect is significant for large firms, but marginal or insignificant in small firms. The finding of these "manager effects" is supportive of agency theory postulates, and also suggests that perhaps size is an important intervening variable affecting ESOP firm performance (Conti, Blasi, Kruse, and Jampani, 1996; Kruse, Freeman, Blasi, Buchele, Scharf, Rodgers, and Mackin, 2003).

HYPOTHESES

Prior research has found that, on average, firms with ESOP programs in place outperform non-ESOP peer firms. However, these results were obtained during periods of generally rising stock prices. This research examines whether or not this phenomenon persists in a bear-market environment. To examine whether ESOP firms consistently outperform non-ESOP firms, two empirical tests are run. First, average daily returns of the ESOP portfolio are compared to the average daily returns of the S&P 500 Index in the two years immediately before and two years following the market peak. The market peak, defined by the maximum daily closing value of the S&P 500 index, was identified as March 24, 2000. The null hypothesis states that, on average, the ESOP portfolio outperforms the market index.

H0: [r.sub.ESOP] > [r.sub.S&P500]

HA: [r.sub.ESOP] = [r.sub.S&P500]

Next, average daily returns of the ESOP portfolio is compared to the average daily returns of the peer portfolio over the same two time periods. The ESOP portfolio is expected to out perform the peer-group portfolio.

H0: [r.sub.ESOP] > [r.sub.PEER]

HA: [r.sub.ESOP] = [r.sub.PEER]

DATA AND METHODOLOGY

To test the hypotheses, an initial sample of 170 publicly traded U.S. firms with employee stock ownership programs in place as of 12/31/2000 was identified from the database of the National Center for Employee Ownership (NCEO). The sample excludes firms from the financial services sector and includes only U.S. based firms (ADRs are excluded.) For each sample firm, the Compustat database provided total market capitalization and primary SIC code as of May 2001.

We utilize a matched-pair methodology according to that advocated by Spiess and Affleck-Graves (1995) and Barber and Lyon (1997) to estimate buy-and-hold returns to shareholders of ESOP firms. For each sample firm, a peer firm was identified as the firm closest in total market capitalization to the sample firm, within the same three-digit SIC code. While there were instances in which the same control firm was identified for two or more sample firms, care was taken to ensure that none of the control firms were also part of the sample. Each firm's buy-and-hold return over the sample period was calculated as the geometric average of the daily returns from CRSP. Daily return data were available for each firm and for the S&P 500.

The analysis consists of two parts. First, a straightforward comparison of average daily returns to ESOP firms is made with those of the broader market as measured by the S&P 500. Second, a size- and industry- matched portfolio approach is used to analyze the performance of ESOP firms versus comparable non-ESOP firms.

RESULTS

Results of the analysis are given in Table 1. Consistent with results of prior research, the Panel A reveals that in 4 out of 5 years (both pre- and post- market peak) the stock market performance of ESOP firms exceeds that of the S&P 500 index. This finding supports the prevailing theory that the presence of an ESOP motivates employees to "think and act as owners of the business" (Kruse, Freeman, Blasi, Buchele, Scharf, Rodgers and Mackin, 2003).

A surprising result emerged, however, when the portfolio of size- and industry- matched peers was added to the analysis. We found that with the exception of the 3/25/1999-3/24/2000 period, no significant performance differences exist between ESOP firms and their peers, as seen in Panel C of Table 1. However, during much of our sample period, both of the constructed portfolios outperform the market index by a significant margin (Panels A and B). That is: in the same four years out of five (3/25/1999-3/25/2002), both the ESOP firms and the comparable non-ESOP firms outperformed the market. This is true both in up- and down- market environments.

Table 2 provides another view of the results in the form of cumulative annual returns for the three portfolios. Again, it can be seen that during each year of the 1999 - 2002 period, both ESOP firms and non-ESOP peers outperformed the broader market.

Taken together, these findings suggest that the widely-reported superior performance of ESOP firms may not be a direct result of the existence of the ESOP.

CONCLUSION

In summary, this research finds that the superior performance of firms with active ESOPs persists both in up- and down- market environments. ESOP firms in our sample outperformed the S&P 500 index by a significant margin both before and after the market peak of March 2000.

However, we also find that similar performance characteristics exist for a size- and industry-matched portfolio of firms that do not operate ESOPs. While the source of the observed superior performance is not yet apparent, a number of explanations come to mind. For example, it may be that firms adopting Employee Stock Ownership Programs tend to differ from market averages in terms of size or risk characteristics. These traits are also exhibited in the peer group firms. Regardless, the results of this analysis do tend to suggest that the source of the superior performance of ESOP firms is something other than the presence of the ESOP itself. The source of superior performance thus remains a question for further study.

REFERENCES

Barber, Brad M. & John D. Lyon (1995). Detecting long-run abnormal stock returns: The empirical power and specification of test statistics. Journal of Financial Economics 43(3), 341-372.

Conte, Michael A., Joseph Blasi, Douglas Kruse & Rama Jampani (1996). Financial Returns of Public ESOP Companies: Investor Effects vs. Manager Effects. Financial Analysts Journal July/August 1996, 51-61.

Ducy, Mary, Zahid Iqbal & Aigbe Akhige (1997). Employee Stock Ownership Plans and Cash Flow Performance of Publicly Traded Firms. American Business Review. June 1997, 31-36.

Girard, Bryan (2002). Tax Reform Alters ESOP Landscape. Journal of Accountancy 193(6)

Girard, Bryan (2002). Is There An ESOP in Our Company's Future? Strategic Finance 83(11), 48-52

Hirschfeld, Christopher C (2002). ESOPs As An Estate Planning Vehicle for Business Owners. Journal of Financial Planning, November 2002, 92-97.

Iqbal, Zahid & Shaikh Abdul Hamid (2000). Stock Price and Operating Performance of ESOP Firms: A Time-Series Analysis. Quarterly Journal of Business and Economics 39(3).

Kornfeld, Judith (2002). ESOP Repurchase Obligation Issues in S Corporations. Journal of Pension Benefits, 30-32, reprinted with permission from the website of The National Center for Employee Ownership.

Kruse, Douglas, Richard Freeman, Joseph Blasi, Robert Buchele, Adria Scharf, Loren Rodgers & Chris Mackin (2003). Motivating Employee-Owners in ESOP Firms: Human Resource Policies and Company Performance. NBER Working Paper No. 10177. Issued December, 2003.

Kruse, Douglas & Joseph Blasi (2002). Largest Study Yet Shows ESOPs Improve Performance and Employee Benefits, reported on website of the National Center for Employee Ownership [www.nceo.org]. 2002.

Lee, Ya-Ting (2003). The Productivity Effects of Employee Stock Ownership Plans: Evidence from Panel Data of Taiwan Electronic Companies. International Journal of Management 20(4).

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The National Center for Employee Ownership, Oakland, CA, 2005. http://www.nceo.org/library/history.html

Pendleton, Andrew, Nicholas Wilson &Mike Wright (1998). The Perception and Effects of Share Ownership: Empirical Evidence from Employee Buyouts. British Journal of Industrial Relations 36(1), 99-123.

Pugh, William N., Sharon L. Oswald & John S. Jahera Jr. (2000), The Effect of ESOP Adoptions on Corporate Performance: Are There Really Performance Changes? Managerial and Decision Economics 21, 167-180.

Spiess, D. Katherine & Affleck-Graves, John (1995). Underperformance in long-run stock returns following seasoned equity offerings. Journal of Financial Economics 38, 243-267.

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Steve Henry, Sam Houston State University

Joseph Kavanaugh, Sam Houston State University

Robert Stretcher, Sam Houston State University

Darla Chisholm, University of Houston

Table 1: Comparison of Average Daily Returns

Panel A: ESOP firms vs. S&P 500 index

 Dates ESOP SPX p-value

3/24/1998-3/23/1999 -0.000220 0.000637 0.05
3/25/1999-3/24/2000 0.000929 0.000806 0.81
3/27/2000-3/23/2001 0.000602 -0.001071 0.00
3/26/2001-3/22/2002 0.001393 0.000110 0.00
3/25/2002-3/24/2003 -0.000603 -0.000981 0.34

Panel B: Size- and Industry- matched peers vs. S&P 500 index

 Dates Peers SPX p-value

3/24/1998-3/23/1999 -0.000204 0.000637 0.08
3/25/1999-3/24/2000 0.001498 0.000806 0.19
3/27/2000-3/23/2001 0.000726 -0.001071 0.00
3/26/2001-3/22/2002 0.001132 0.000110 0.01
3/25/02 -0.000724 -0.000981 0.56

Panel C: ESOP firms vs. size- and industry matched peers

 Dates ESOP Peers p-value

3/24/1998-3/23/1999 -0.000220 -0.000204 0.99
3/25/1999-3/24/2000 0.000929 0.001498 0.03
3/27/2000-3/23/2001 0.000602 0.000726 0.71
3/26/2001-3/22/2002 0.001393 0.001132 0.31
3/25/2002-3/24/2003 -0.000603 -0.000724 0.65

Table 2: Cumulative Annual Returns

 Dates ESOP Peers SPX

3/24/1998-3/23/1999 -6.88% -6.49% 14.74%
3/25/1999-3/24/2000 25.62% 45.17% 20.41%
3/27/2000-3/23/2001 14.68% 17.78% -25.38%
3/26/2001-3/22/2002 38.80% 29.67% 0.78%
3/25/2002-3/24/2003 -16.39% -19.01% -24.76%