Employee-owned companies are among the best investments because of their outsized returns, but for private equity investors, buying these firms has traditionally been out of reach. Now, however, some PE investors are leveraging an innovative financing structure to share in the rapid growth of these companies through warrant transactions.

S Corporation employee stock ownership plans ( ESOPs) are a type of defined contribution retirement plan that Congress exempted from taxes in 1998 to encourage employee ownership. They are typically used to help a business owner sell all or part of their firm to cash out, to facilitate management succession or to allow employees to share the profits of their labor.

ESOP-owned S Corporation companies — there are approximately 3,000 in the United States out of 10,000 total ESOPs — tend to have stable management teams and cultures that promote innovation. That leads to strong returns — 62 percent more than other companies. A study by a major accounting firm found that the average S Corporation ESOP generated more than 50 percent greater returns compared to the S&P 500 total return index.

Such higher relative returns are desirable to PE investors. The historical problem for such investors, however, is that acquiring a company controlled by an ESOP means effectively buying out the very thing that has made the firm great in the first place — employees and managers motivated to grow profits as a result of their ownership.

Now, PE investors are using warrants to capture gains in the future value of the firm, as a corporate finance tool to invest in ESOPs. In recent months, we have seen deals concluded where PE investors took a stake in ESOP-controlled firms — previously, a seldom used strategy.

Read more at  Why private equity is investing in ESOP-controlled companies – The Business Journals