Considerations for Management Teams in Private Equity Buyouts
There are a ton of different ways you can make considerations for your management team when it comes to private equity buyouts. Watch out for conflicts of interest and provide the right incentives for success.
When one thinks of private equity buyouts, the first topic that comes to mind is rarely the consideration for the management team. However, the human element should not be underestimated when contemplating buyouts.
The management team is:
- A crucial success factor in buyouts.
- Required in order to reach performance targets.
- The source of future competitive advantage.
The discussion that follows looks into several topics related to the incumbent management team that require some thought when engaging in private equity buyouts.
Management Time Commitment
The sale process is stressful and can take a long time to complete. Acquisitions from inception to completion can regularly take between four to six months. During this time, management has the additional task of getting the purchase across the goal line. However, they still have to do their day jobs of running the business.
Unfortunately, having to deal with the various acquisition-related tasks, their daily roles, and keeping staff motivated makes for a significantly long week. Running an efficient acquisition process is extremely important since a poorly run one will eventually affect the performance of the underlying business.
With the increased stakes, it is crucial that the seller seeks out ways to minimize impacts to the management team and, ultimately, the business. The seller should consider concluding any significant business initiatives before starting the sale process. Attempting to complete a complex business initiative while executing daily roles and supporting the sale of the business will cause something to slip. Any of these can lead to issues that can hurt the company and the acquisition.
Since a buyer will conduct a significant due diligence investigation, the data room must be appropriately set up and populated from the outset. Failure to have a complete data room ready when bidders conduct due diligence will slow up or potentially kill a buyout transaction. A correctly populated data room means you won't have management and staff distracted from their daily jobs to fulfill never-ending ad-hoc requests.
Furthermore, it assists in efficiently coordinating the Q&A process. Here, an experienced M&A professional can provide a detailed list of documents that potential buyers typically expect to see in an acquisition-focused data room.
Management Conflicts of Interest
Mitigating the agency dilemma on the part of management becomes extremely important. Management's information asymmetry can have serious if not fatal ramifications to a deal. Ultimately, the seller must find ways to align management's interests with their own and incentivize management to make decisions in the business's best interests rather than pursuing their self-interest.
Many factors drive management's attitude to the sale of the business. These factors can include:
- Personal attitudes regarding the type of the buyer (e.g., private equity, strategic buyer, competitor, etc.)
- The buyer's plans for the business.
- The employment terms.
- Their day-to-day autonomy after exit.
These factors can push the scales in favor of one potential buyer over another, regardless of the offer price, or even lead to the deal's collapse.
A particular case that can lead to a significant conflict of interest is the management buyout (MBO). As part of management's fiduciary duty, management must seek out the seller's best interest. However, in an MBO transaction, management sits on both sides of the transaction.
While management has a fiduciary duty to attain the best price for the seller, management, as the buyer, is incentivized to keep the price paid as low as possible. This conflict of interest creates a potential for management to "manage earnings" or not pursue specific business opportunities to keep prices low. Furthermore, management can use their superior knowledge of the company to seek bargain prices for a transaction.
The warranties in the purchase and sale agreement provide another illustration of the conflict. As managers, they must assist the seller in preparing disclosures that limit the warranties, while as buyers, they may benefit from those warranties.
When management buyouts are an option, the parties are well-advised to institute protocols addressing the above issues and facilitating a controlled and fair process.
Incentivizing key management personnel to continue with the company is an integral part of any buyout transaction. When buying a company, part of the purchase includes proprietary knowledge, strategic client relationships, and business expertise. Management incentives help keep these important assets with the firm post-close. Incentives should be designed to maintain a strong link between the management and the company and keep management fully engaged in driving company performance.
A feature of private equity investments is the opportunity for management to share in the risk and reward of the business as equity owners. Private equity firms reserve a significant minority stake in the portfolio company to incentivize management and align managers' interests with the private equity owner. In some cases, roll-over equity is also offered. Roll-over equity involves "rolling over" any held equity in the company before the private equity firm's acquisition into the new transaction.
Equity can also be used as compensation for future company performance. Management incentive pools consist of a percentage of equity set aside for management in options or appreciation rights. Management earns this based on company performance and hitting specific metrics determined at the beginning of the transaction. Vesting might be required, and the bonus is paid out to the management team as a whole. Although many factors determine the percentage earned, the typical compensation varies from 5% to 20% for middle-market companies.
Although considerations for the management team are not what comes to mind when one hears private equity buyouts, they are vital and can make or break a buyout transaction. Conflicts of interest, management incentives, and time commitments must be managed and handled appropriately. The management team holds the keys to intellectual property, business relationships, and ongoing company performance. Ensuring they are happy and that their interests align with the seller is critical in achieving favorable buyout outcomes.