There are attractive opportunities for management teams to purchase their companies from larger organisations, in particular where the business has become non-core. This appeals to vendors as business continuity is ensured, with the potential to retain some upside through an equity holding.
Below, we provide a review of the process, the funding options and the key elements required for a successful transaction.
Key features for a successful MBO
Buyouts originated in the 1970s as large organisations restructured and disposed of non-core activities. Existing, or new, management teams backed by financiers rapidly became an important component of the disposal process.
Across the business spectrum, several factors are required for a successful buyout. These are:
- A quality business with predictable cash flows and growth potential. In particular, can a management team demonstrate that the development of the existing business has been constrained due to the ownership structure?
A high quality management team with a motivated leader . Does the team need to be enhanced in the marketing or finance area, or is there the right balance of skills?
- Committed financial investors for both debt and equity . A buyout requires a strong partnership between all parties to overcome inevitable hurdles.
- An appropriate financial structure in terms of debt, equity, working capital and capital expenditure . A balance must be found between the attraction of leverage from an equity return perspective and achieving a realistic business plan. The failure of the Le Meridien hotel group buyout was due, in part, to the overambitious growth projections and the large amount of debt on the balance sheet. This became more evident after September 11 2001 , which resulted in a sharp downturn in the tourism industry.
- A clear exit route, either via a trade sale or a flotation, within a ‘3 to 7’ year time frame. The timing depends on the sector and on business performance. A clear exit goal has the benefit of focusing the management team on the task to be accomplished.
Detailed planning and positioning of the MBO opportunity is required at the outset. It is essential at the earliest opportunity for the management team to state its intentions to the vendors to ensure transparency, and for the MBO team to be considered seriously in the sale process.
The key objective for the management team during the ‘4 to 8′ month sale process is that the business’ performance continues to improve.
At an early stage, the senior members of the MBO team need to develop the new business plan. Typically, it differs from the business strategy agreed with the present shareholders, in particular regarding the growth and exit strategies. The plan provides the basis for discussions with potential equity and debt providers and is instrumental in providing the confidence required to invest in the project. At this stage, a financial advisor can provide the management team with assistance on developing the plan, and can give guidance on positioning it effectively for external financiers.
The planning process also clarifies the resource requirements including the key personnel and the amount of finance needed for working capital and for capital expenditure purposes. A typical plan includes a review of the business and the market opportunity from both a domestic and an international perspective. An analysis of the competitive environment and the marketing and distribution strategy is also required, together with the current and prospective customer base.
The growth opportunities and strengths of the management team are highlighted in the plan. However, it is equally important to emphasise the risks and the actions to be taken to mitigate those risks. The plan needs to be backed up by ‘3 to 5’ year financial projections and the relevant assumptions.
Finally, structuring the business for a future potential exit needs to be considered at an early stage. An example of a rapid exit was Homebase, the UK DIY store chain. Sainsbury’s sold the business to a private equity sponsored management team in early 2001. The business was then restructured and sold in November 2002 to GUS. This was a very profitable deal for both the management and for their financiers. The management benefited from Sainsbury’s desire to dispose of the business rapidly and from the upturn in the retail market. A focused strategy led to a sharp improvement in business performance prior to the eventual disposal to GUS.
Structuring the Capital
Whilst no two transactions are identical, there are several key components to the capital structure of a MBO. There are a number of layers of finance with returns commensurate to the risks of providing the funding. The key components can include:
- Senior debt . This is provided by a bank or a syndicate of banks. It has the highest ranking capital in the balance sheet and consequently the lowest servicing costs. The interest rate charged depends on the maturity of the debt, the agreed covenants and the risk profile of the business. A balance has to be struck between the amount of debt and the serviceability,particularly in a downturn. For a business with a stable cash flow, a 50%leverage is comfortable. This percentage can be increased especially when there is a large asset base.
- Mezzanine debt . This is subordinate to the senior debt and ranks higher than equity. It provides a higher return to reflect the increased risk. This debt may have a portion of equity warrants attached in order to improve the risk return profile for the lender. Typically 10-15%of the capital is in the form of mezzanine debt.
- Preferred equity or loan notes . This is provided by private equity investors and/or institutions.This class of capital ranks before equity and is typically convertible into ordinary shares.
- Ordinary equity . Management usually holds this class of equity. It is the highest risk, but provides the largest potential return.Management would tend to hold 15-25% of the ordinary equity at the outset with ratchets based on reaching agreed milestones. The vendor may also retain some of the upside in the MBO in the form of ordinary equity or loan notes.
Based on the business plan, the first step is to determine with the lenders the maximum level of senior debt that the company can accommodate comfortably. The other elements of the capital structure would be negotiated individually, but as part of the overall financing package.
Due Diligence Process
One of the main attractions to a vendor selling a business to the management team is the reduced level of due diligence required by the purchasers rather than a sale to an external party. This speeds up the execution process. Similarly,the level of warranties and indemnities provided by the vendors is typically lower, as the management team has a better understanding of the business than an external purchaser.
However, prior to agreeing to finance a transaction, banks and institutions conduct a thorough due diligence both on the business plan and the management team. A review of the financials, legal, tax and operational issues is undertaken by a team incorporating lawyers, accountants and, possibly, consultants. A holistic view of results from the due diligence process needs to be taken after which the negotiations can be finalised with the vendors.
No business venture is riskless, but an effective due diligence process can highlight the key issues that need to be addressed.
Whether the company is private or public, the directors’ responsibility is to ensure that any strategic transaction involving the transfer of ownership is carried out in the shareholders’ best interests. The involvement of the management team as a potential purchaser of the business creates the potential for a conflict of interest between their fiduciary duties to investors, who want the highest price for their shares, and the larger profits that the executives stand to make the lower the price of the buyout.
In these situations, the role of non-executive directors is crucial to ensure that objective decisions are being taken that will be in the interest of all shareholders. An example was the public to private transaction of Debenhams, the UK department store group, in mid 2003. Permira, the private equity investor submitted a bid on the condition that it could work with the management team. The intention was to deter rival bidders. The initial bid was recommended by the board, but to deflect criticism, the directors of the company were extremely keen to have another party enter the bidding to demonstrate that the process was transparent. This led to a payment of £1m per week from the company to the Texas Pacific and CVC consortium to prepare a rival bid. TPG won the battle and the management team was forced to resign. This highlights the importance of a transparent process, particularly in a public situation. It is also clear that there are always risks for the management team in aligning itself with one particular investor group.
Careful preparation, a well developed business plan, the formation of theright team and a transparent process are all critical for a successful MBO.
The time is now right for companies to consider divesting non-core businesses with the incumbent management team a serious contender.
The views expressed in this newsletter are those of DC Dwek Corporate Finance Limited and are provided for information purposes only.