The attractions to venture capitalists
Although Venture Capitalists will look for above average investment features to be present in all transactions, a typical Management Buy-Out ("MBO") or Management Buy-In ("MBI") gives the added advantage of being able to bring their own financial engineering skills into play.
So far as management teams are concerned, neither MBO's nor MBI's should hold any mystique. They are essentially purchases of businesses by management teams usually using external finance. Reference should therefore be made to our briefings "The Purchase and Sale of Private Businesses" and "Raising Equity Finance for the Private Company".
A classic MBO/MBI target is characterised by a strong asset base and healthy cash generation. These enable a substantial element of the purchase price to be funded by bank debt that can be repaid over the period of investment. Then, even if the business is sold at the original purchase price, investors will still achieve a significant uplift on their original investment.
Beyond that, all Venture Capitalists will rate opportunities in terms of management, markets and products - and in that order! An opportunity based on first-class management is considered a lower risk investment than one based on a better concept but with no-one sufficiently capable of managing it.
This briefing concentrates on business ventures geared more to quality and strength of management than other factors.
It relates to new business ventures, perhaps not in terms of ongoing trading, but certainly in terms of change to management ownership. The underlying business could, instead, be sold to third parties as a trade sale. When negotiating an MBO/MBI opportunity, the management could be in competition with industrial buyers who may possess greater financial muscle or powers of endurance in turnaround or brand establishment/ protection situations.
Typical categories of transaction
The term Management Buy-Out (MBO) is used as a generic expression representing the acquisition of a company from its owners by the existing management team. This is most likely to arise out of a proposed sale or retirement in a private company, the sale of a non-core subsidiary by a publicly quoted company or as a result of insolvency. Finance will normally come from the management team, banks and institutional investors together with, on occasion, the current owners.
Buy-outs are used in public companies and other larger situations often as a defensive move, such as restructuring the activities of a group or even returning it to private ownership. This has spawned the term Leveraged Buy-Out ("LBO"), whereby a large part of the funding is debt financed – primarily by institutions providing mezzanine debt that sits between equity capital and secured debt when the cash flows of a business can support a higher level of borrowing than the asset base alone can secure.
A further Management Buy-Out variation is the Employee Buy-Out ("EBO") whereby managers are joined in full equity participation by a sizeable number of the employees of a business.
Another variation is the Sponsored Spin-Out ("SSO") where a company may recognise that the development of a project may be better suited to a more entrepreneurial environment, but does not wish to forego all of the upside if it is successful. The business can be "spun out" into a new company, owned jointly by the original company, the management team and an institutional backer – often with an option for the original company to buy it back on a price formula.
Yet another phenomenon is Bring the Old Management Back ("BOMB"), where an entrepreneurial business has been sold to a large professionally managed organisation under whose direction it has lost its way – and its profitability. Provided the vendors are not in breach of warranty, there could be an opportunity for them to buy-back the business on favourable terms.
Where an MBO is unsuccessful or impractical, and taking into account the potential legal ramifications of so doing, a management team may consider a Management Walk-Out ("MWO"). This is, in fact, a form of start-up – perhaps a "running start-up" – but the complications and legal implications should not be underestimated.
Where an external management team targets a business as a Management Buy-In ("MBI") it is usually because it believes it can do a better job than the existing management. The opportunity may be a stagnant business, a turnaround situation or an outright rescue and can apply to both private and public companies. All of the funding and leveraging techniques (financial and psychological) that are used in MBO's are equally applicable to MBI's.
About half of all acquisitions by management teams result in the involvement of a combination of existing and outside managers, either by design or at the insistence of financial backers if a strengthening of the team is a condition of their investment. Such a transaction is called a Buy-In/Management Buy-Out; the resulting snappy mnemonic is BIMBO!
Conducting parallel negotiations
The management team are often directors of the company that they wish to acquire. As such, they have a moral and legal tightrope to walk between their duty to "maximise shareholder value" and their natural desire to acquire the business at an attractive price for their own benefit. This dilemma is exacerbated when an acquisition is being considered by other potential buyers. This is even more complex in the case of a publicly quoted company.
Typically, a management team will be simultaneously in negotiations with the owners and its own proposed backers. The vendors will require to be satisfied that the management team is capable of attracting financial support at a realistic price – and the financiers will need to be assured of both the attractiveness of the business and the strength of the management team.
In these circumstances the members of an internal management team MBO can be perceived to have "an inside edge" – as they are presumed to know the business concerned and in most circumstances a trade buyer would not wish to take on board an unwilling management. Therefore, subject to the consent of the existing owners, such a team can normally approach a small number of potential backers at the outset with a business plan - and thereby seek to demonstrate both the opportunities in the business and the team's own abilities.
By contrast, an external management team (MBI) is more likely to be in open competition with trade buyers with significant financial resources. Therefore, prior to commencing the search for an opportunity, such a team would be advised to seek "in principle" backing for "the right opportunity" from an institution with whom it has good chemistry. Owners will be reluctant to reveal meaningful data to anyone without first being reasonably satisfied as to the likely sufficiency of their financial resources – and no institution will make a firm offer to support an MBI team without that data.
A number of institutions have specialist MBI units to assist in assembling and preparing MBI teams that they can then support in appropriate situations either on a stand-alone basis or alongside existing management.
Structure of a deal
The structure of a deal with a vendor in a management acquisition will not be dissimilar to that in a trade sale to an industrial buyer. It will take into account both commercial and taxation factors – including the form of consideration payable (cash, shares, loan stock etc), the form of the acquisition (share capital or net assets plus goodwill) and the conditionality of both the initial and any deferred consideration.
Similarly, funding structures and instruments and the use of tax-effectively structured performance 'ratchets' to incentivise a management team will not be dissimilar in principle to normal venture capital situations.
It is the combination of the two types of transaction, so far as a management team is concerned, that is the differentiating factor.
In particular:
- The relationship with institutional backers is, on the one hand, of an adversarial nature (negotiation of stake in the new business vehicle) and, on the other hand, as an ally in negotiations with the vendor.
- It is normal for a vendor to give warranties, but in an MBO (not an MBI) the management team may also be considered to be knowledgeable on most aspects of the business; in addition, it is normal for an investee company (in this case the management team and its new vehicle) to give warranties to institutional backers.
- The management team must fund not only the acquisition of the business but also the foreseeable requirements for capital expenditure and working capital etc.
Conclusion
Management orientated acquisitions account for more capital invested by the insitutional investment community than start-ups and expansion fundings put together. These are seen as relatively "safe" investments, with acceptable investment returns and offering a lower risk of failure coupled with reasonably quick realisations through trade sales and flotations. Since most of these transactions (not only LBO's) are fairly highly geared, there is a strong bias towards those deals that, after completion, will be cash generators in their own right.
Due to the interaction of such a wide range of factors, there can be no single "rule book" – this briefing therefore seeks only to outline some of the commercial considerations. It is suggested that management teams consult experienced and entrepreneurial advisers with practical experience rather than just theoretical backgrounds to consider the development of appropriate routes forward.