ARTICLE ON MANAGEMENT BUYOUTS - BUSINESS DAY - MARCH 2007

The MBO, an idea whose time has come

The management buyout (MBO) and private equity investment are increasingly topical. MBOs not only involve mega-deals by global consortiums, they also facilitate changes of ownership at private company level. Our contributor Kevin Homann, an MBO specialist at Spirit Capital, explains the fundamentals of these leveraged transactions in a private company environment …

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Kevin Homann

Management Buy-Outs have ceased to be a novelty or a last resort by a private business owner who has been disappointed by outside bids. Today, they are a mainstream option whenever a change of company ownership is contemplated.

Several factors underpin the MBO’s mainstream status.

Experience indicates an owner will achieve a competitive price via an MBO while avoiding the selling and pricing challenges that might emerge if management continuity cannot be assured.

Simultaneously, the growth of private equity investment as an engine of the leveraged buy-out has increased the popularity of MBO solutions. Furthermore, the banks have become very comfortable with these structures. The trend is also supported by the emergence of mezzanine-finance providers.

Within the private company environment these developments have led to a situation where the seller is happy with his price, the financiers are happy with structures and returns, but the executives who are acquiring the business may be confused about the exact workings of an MBO.

The MBO can generate significant wealth for managers, turning key employees into owners and transforming their lives. The MBO is a subsidised route to ownership, but there is no free lunch.

The first thing a prospective manager/buyer must do is understand the roles and motivation of all players and how these relationships work.

There are four key players:

1. The manager is usually the chief executive or the managing director. He may operate alone or might involve other executives in a consortium to secure the support of key contributors to the business. The defining characteristic of the managers is that they know their industry and company intimately and are confident they can manage the business, generating considerable value along the way. They need some capital of their own as their financial partners will insist that the interests of all parties are ‘aligned’. This means risk is shared to some degree and everyone is incentivised to succeed.
2. A corporate finance specialist is called in by the manager/s to act as an advisor and negotiator.
3. A bank is involved at an early stage to advance debt (both senior and “mezzanine”) on the deal.
4. The private equity investor (aka venture capitalist) who might be a wealthy individual or a private equity fund and is called in to provide the balance of the funding and plays a high-level strategic role within the business.

Capital from the manager/s, the private equity investor and bank provide the money to buy the business.

The bank takes no equity. Its debt will be serviced and settled during the term of the transaction, but the private equity investor and the manager will work together as partners to realise optimum value on their equity.

The manager normally provides a relatively small amount of capital; the private equity partner considerably more. Yet in equity terms the manager can expect a sizeable portion of the shareholding (possibly as high as 70%).

Yet the manager might have contributed only a tenth of the capital needed to buy the company from the original owner. This implicit ‘subsidy’ from the private equity investor to the manager does not come for free.

The manager’s financial partner is taking considerable risk on the equity. It therefore expects its capital to earn a return and that the debt be progressively settled. It also expects to achieve significantly enhanced value on exit at the end of the transaction – usually five years.

Payback to the private equity partner therefore takes three forms: interest on ”mezzanine” debt at a premium to prime (to the extent such debt is provided by the private equity partner), a dividend stream and optimum value on its portion of the equity.

If these dynamics are thoroughly understood by the manager, the basis is usually in place for a successful business relationship.

Homann is director of corporate and structured finance service provider Spirit Capital. This is the first in a series of articles on management buyouts.

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