For a small but growing number of private equity firms, there’s a new way to spell exit: E-S-O-P.

Employee stock ownership plans, or ESOPs, long used as a succession tool for founder-led businesses, are emerging as an alternative path to liquidity as traditional PE exits become harder to execute.

An ESOP structure lets companies effectively buy themselves, using future cash flow to fund the transition. For a sponsor looking to exit, it can provide a full or partial off-ramp until other options emerge.

“ESOP-backed transactions are gaining traction because they offer an exit in a market defined by longer holds, fewer buyers, and continued pressure to return capital,” said Shawn Cole, president and co-founder of executive search firm Cowen Partners.

PE firms often invest alongside ESOPs, recapitalize ESOP-owned businesses, or help set up employee ownership structures, explained George Barsom, managing director at M&A advisory firm Auxo Capital Advisors. Examples of private equity firms exiting through an ESOP, however, are hard to point to, at least in public disclosures, he said. “A lot of those situations tend to be private and negotiated quietly.”

The overall shift, however, reflects a broader change in dealmaking as more firms rethink how and when they exit investments.

“ESOP-owned companies can create a pathway for liquidity while allowing the business to continue compounding value until broader exit conditions improve,” Barsom said.

At its core, the ESOP model flips the traditional exit. Rather than selling to a third party, companies transition ownership internally, with employees gaining equity over time through a trust—often financed by the company’s own earnings.

That approach is proving particularly useful when buyers and sellers can’t agree on price. ESOPs offer a workaround: liquidity today, with upside deferred.

Kyle Feng, head of M&A at Alton Industry, said the structure is increasingly viewed through a financial— not just cultural—lens.

“ESOPs are not just an HR strategy but a capital structure tool,” he said. “By embedding employee ownership into the shareholding structure, it ensures internal cohesion, making investors less concerned about operational risk and less dependent on short-term exit timing.”

Tax savings drive deals

Tax benefits are a key reason these deals are gaining traction.

A hybrid PE–ESOP structure can help bridge valuation gaps and improve deal economics because tax advantages—including potential deferral for sellers and deductible ESOP contributions—effectively lower the cost of the transaction, said Gil Mermelstein, CEO of West Monroe, which itself operates under a hybrid employee-ownership and private equity model.

In certain structures, the impact is even more pronounced. When an S-corporation is owned by an ESOP, the company can avoid federal income taxes altogether, freeing up additional cash flow to service deal debt or support a higher purchase price.

Those benefits can make deals viable that might otherwise stall in the current M&A environment, Mermelstein said.

The model tends to work best in cash-generative, people-driven sectors—particularly industrial services, specialty manufacturing, engineering and professional services, and certain business services niches where employee retention and continuity are critical to performance.

“Employee ownership can create a differentiated value proposition,” Mermelstein said.

Fee model disruption

ESOP deals remain complex—and that complexity is a limiting factor.

“These transactions require careful coordination among multiple stakeholders,” Barsom noted. “The long-term success depends heavily on predictable earnings and disciplined capital allocation.”

Cole added that not every company is a fit. Businesses with high leverage or inconsistent earnings can struggle under the additional debt often used to finance ESOP transactions, creating potential fragility if not structured properly.

Unlike a conventional sale, the valuation must support fair market value, the fiduciaries must determine that the transaction is compliant and the structure must satisfy the tax rules governing leveraged ESOP loans, Cole said. “That level of scrutiny makes ESOP deals far more difficult to force through, especially when a company is overleveraged or the economics are not truly sustainable.”

Governance is another challenge. “In most of these partnerships, private equity maintains operational control and board oversight, while the ESOP holds a minority ownership stake through a trust,” Mermelstein said.

The economics can also shift in ways that give sponsors pause.

Peter Sanchez Guarda, a finance attorney and founder of consulting firm Turnkey Family Office, said ESOP transactions can disrupt one of private equity’s core profit engines: fees. In a traditional buyout, firms generate returns not just from equity gains but from management fees, financing spreads and transaction-related charges.

“In order to make it attractive enough, they participate in other ways besides equity,” Sanchez Guarda said, pointing to subordinated debt, advisory fees and warrants as alternative return drivers.

Complement, not substitute

Few expect ESOPs to replace traditional exits, but Barsom said they are becoming increasingly part of the toolkit.

As exits take longer and certainty becomes more valuable than upside, firms are showing a greater willingness to experiment with structures that once seemed unconventional, Mermelstein added.

“ESOPs will likely grow meaningfully as a private equity liquidity option, but they will probably remain a niche or opportunistic pathway rather than a mainstream exit channel,” Mermelstein said. “The direction of interest is positive, but structural constraints will likely keep them from becoming a dominant PE exit route.”

*Mergermarket reported earlier this week that private equity firms are also increasingly investing in employee-owned companies, drawn by stable cash flow and workforce alignment.