Employee Stock Ownership Plans (Esops) were designed as a vehicle to help US employees save money for their retirement, but to be tax efficient the plans required that sales of stock under the plans are rolled into so-called qualified replacement property (QRP). The challenge in 2016 was that very few QRPs existed, amid tough eligibility requirements. JP Morgan solved the problem with an innovative structured note that unlocked the market and went on to sell more than $100 million.
An Esop is a qualified retirement plan that buys, holds, and sells company stock for the benefit of employees. People looking to realise the value held in their stock normally sell their securities back to the plan. However, just as in disposals of public stock, the sale is a tax event and triggers a payable obligation on the part of the seller. Sellers can only receive tax deferment if the proceeds are invested in a QRP (a transaction referred to as an Esop 1042 Rollover), but there has been only a handful of QRP-eligible issuances in the past decade.
“QRP issuance is a specialised and nuanced product,” says Nkonye Okoh, executive director and head of structured product distribution for private banks in the US at JP Morgan. “That has meant issuance has been restricted to a few corporates, which offer the product on a periodic basis.” United Parcel Service and Procter & Gamble are among issuers.
Supply that was always anaemic has declined even further in recent years, leading to the real possibility that the asset class would cease to exist, effectively depriving investors of the only way to achieve tax deferrals on the proceeds of their Esop sales. The scarcity was particularly ill-timed because of the huge number of start-ups that have been launched over recent years.
“I suspect the start-up boom in the US will lead to a large number of people receiving private shares in companies, which will create demand for QRPs,” says Okoh.
A JP Morgan client in early 2016 approached the bank to ask whether it had a solution for the QRP crisis. The bank decided to investigate and embarked on a long period of due diligence as it worked out whether it was in the right legal, tax and regulatory position to offer a solution. Following an intense period of work, the answer came back in the affirmative. The structuring team was then able to switch its attention to building a product that would protect the bank and meet the requirements of investors.
We collaborated extensively with our colleagues to deliver a product in a constrained marketplace of limited issuers and optionsNkonye Okoh, JP Morgan
A key element of QRP notes is their long maturity. The structuring team worked closely with JP Morgan’s corporate and investment bank treasury department to ensure the bank was comfortable with the long format, as well as to determine the appropriate funding value for the notes. Once the funding was in a place the bank spent several months looking at alternative structures and liaising with internal partners and clients. Because QRP notes are often used as collateral to raise liquidity, a key requirement was that the value of the note would stay close to par throughout its life.
“We understood clients may margin the notes, so consistency in the note value was important. With that in mind the client elected to include a floating feature, which decreases duration risk, hoping to limit volatility in the mark-to-market of the notes,” says Okoh. “To add further stability, the notes included a put feature, which meant the client could sell the note back at a predetermined price, guarding against the negative impact of rising interest rates.”
The note was designed with a 30-year tenor and paid an annual coupon of 50 basis points for the first five years and Libor plus 20bp in years six through 30. The first QRP structured note was placed at the end of October – the culmination of many months of work.
“We collaborated extensively with our colleagues to deliver a product in a constrained marketplace of limited issuers and options,” says Okoh.
The success of the project was reflected in the fact that JP Morgan’s private banking client achieved more than $100 million of sales in the months following launch, and the product was recognised by market participants as a genuine innovation in the structured product market, which also has the power to fuel a renaissance in QRPs.
“They received my vote since it was an innovative solution to a problem faced by one of their clients,” says one investor. “While most firms can create a structured note tied to a variety of indexes, the investment created by JP Morgan required a great deal of heavy lifting to first determine if it could be done. With many small business owners looking to retire in the coming years, this is a great solution for those individuals.”
The week on Risk.net, April 7–13, 2018Receive this by email