A Guide to Executing a Management Buyout

What is Management Buyout?

A Management buy-out (MBO) is an acquisition of a business by the management team through debt (senior or mezzanine financing provided by banks) and/or equity financing from the business owner or private equity groups. Every MBO has different nuances, but the basic structure follows a pattern. The management team, along with their financial backers, forms a holding company which then goes on to acquire the target business. The management team will need to inject, raise, or borrow sufficient capital to pay the seller, cover initial working capital requirements, and pay transaction fees.

Necessary Elements For Success

A management buyout will most likely succeed if these required elements are present:

• A strong management team that is bankable (i.e. they know the business well and banks/investors would financially back the team in completing the acquisition)
• A CEO or person that can lead the other management team members through the process and the business after acquisition
• A clear strategy for executing the business acquisition and negotiating funding from financial institutions and potential investors.

Advantages and Disadvantages

Some advantages of a management buyout include:

• Loyalty and a sense of belongingness that becomes more evident among the members of the management team since they play a vital role in the entire process of a management buyout.
• Motivation for every employee of the existing company regardless of his/her current position to contribute effectively for overall success.
• Closer relationship between the existing business and the chosen investor or financial institution who had expressed interest to fund their financial needs during an MBO.

On the flipside, an MBO will also have some disadvantages and challenges:

• An MBO will not typically generate the highest purchase price for an existing business owner.
• There are many different parties involved (who also have their own team of advisors,) which generally consist of the management team, financiers, and the owners.
• The complexity of the deal itself which can easily overwhelm existing owners. For instance, legal contracts associated with MBOs are typically more complex than in a normal business sale, as there are at least three parties involved, rather than two.
• The amount of care that must be taken to preserve relationships with customers, suppliers, and creditors. Maintaining these relationships is crucial to ensure the long term viability of the business that is being transferred from one owner to another.

The Management Team

It is highly unlikely that financial backers in an MBO will back a poorly managed team, even in an attractive sector. Thus, it is imperative that the management team is credible for the successful execution of an MBO. The financial backers will be keen to know there is a quality second tier management team in place as well. The backers will also expect the leader of the buy-out team to recommend the composition of the management team and their respective shares. Financial backers want to see commitment through aligned incentives.

Setting Up Your Team

Who is to be included in the management? To successfully execute an MBO, the right CEO plays a key role in leading the team throughout the process. A typical MBO team may consist of 3-4 members of the existing management team. Any gaps in that team may be supplemented by external candidates found with the support of the investors. In most cases, a management team usually consists of the following line-up of professionals for it to be claimed an effective body for a management buyout:

• Chief Executive or Managing Director - this person has a proven track record of managerial skills in handling various departments of a company. In general, the scope of a chief executive officer’s role is to oversee the performance of all employees under his/her wing and ensure that all work alongside the targeted goals of the company. The CEO would be able to easily replace the leadership role of any exiting owners.
• Finance Director - this role is assumed by a certified accountant who has a solid financial background and equipped in providing all the required reporting (financial statements, budget, cash flow analysis, etc.) in a management buyout deal.
• Sales Director - under all circumstances, the person who holds this position must be a top-performing salesman by nature. This person understands where the business is situated and how competition works in the industry.
• Production/Operations Director - the person in-charge of this department has acquired the technical expertise on the areas of production or operation and other procedures including costing needed in running a business efficiently.

Different sectors demand a slightly different mix of skills, but financial backers to the team will expect to see a minimum range of skills with leadership, finance and operations as core. However, in some sectors, IT, personnel and engineering experience may be imperative. Financial institutions will expect the managing director heading the MBO to have a clear vision of the composition of his team.

The MBO Process

There is no cookie-cutter approach to successfully executing an MBO. The process is very fluid, and each key component involved in the transaction may overlap in both timing and completion.

Initial Feasibility Assessment

The feasibility stage is key to the success of the management buy-out as this may shed some light on whether or not an MBO is actually feasible. Equally, it is a time for the management team to articulate their plans, understand the seller’s timetable, and prepare themselves for raising money. For management teams considering the execution of an MBO, it will take a well thought out business plan for it to become sellable among prospective investors, whether it is a private entity or financial institution. The entire management team must contribute and work together in the creation of a plan.

Of course, the guidance of the Finance Director or accountant is crucial in finalizing the content of a business plan. This team member’s contributions are mostly on preparation of financial projections and ability to service debt repayments.

Preparation of a Confidential Information Memorandum

The Confidential Information Memorandum (CIM) has to accurately and concisely convey facts about the business and its management without the verbosity, sloppiness, and ambiguity which tend to infiltrate many business plans. The CIM should contain sufficient information on the following:

1. Clear description of the business and its product and service offering.
2. Management team profile and capabilities;
3. Substantiation of the earning power of the business, prospects for growth and value proposition
4. In-depth analysis of the business performance including a summary of customer base, competitive landscaping and historical financial results
5. Proposed debt and equity structure post acquisition.
6. Free cash flow projections, ability to service debt and target returns for investors.
7. Suggested sets of actions to achieve targeted goals.

Identifying Financing Sources

The following outlines the potential sources of financing available to close an MBO transaction. It is likely that the management team and seller will approach multiple parties and select the group that best achieves their objectives.

Senior Debt Financing

In most cases, financing for an MBO is obtained from a banking institution. Certain bank have requirements that need to be met, and among those could be requiring the members of the management team to invest a certain amount of their own capital, with the remaining amount will come from the bank or outside investors. Most mid-market banks contain capital markets teams who provide support for MBO transactions. With debt lenders, expect rigorous covenants regarding interest coverage which will be set quarterly going forward with penalties incurred if breached. Lenders will also require security over the tangible assets of the business, so the management team will need to commission an independent appraisal on any capital assets or inventory.

Subordinated Debt and Mezzanine Financing

When a management team is unable to fund the MBO with the available equity and bank debt alone, it may be able to make up the shortfall with subordinated debt or mezzanine finance. These forms of debt are the middle layer of capital that falls between secured senior debt and equity. This type of capital is typically not secured by assets, and is lent primarily based on a company's ability to repay the debt from free cash flow.

Mezzanine or sub debt is more expensive that senior debt, but less expensive than equity. The cost for this type of financing is in the range of 13% to 25%. Senior banks usually view mezzanine financing as equity rather than debt for the purpose of calculating debt covenants. This is because the repayment of mezzanine debt is subordinated to the repayment of senior debt, but ranks above any repayments to equity holders including seller’s notes.

Private Equity Financing

Private equity firms’ primary function is to invest in companies with the goal of selling this equity 3 - 7 years later at a profit. The funding for these investments comes primarily from a group of investors known as limited partners (LPs). Typical LPs include endowments, pension funds, sovereign wealth funds, wealthy individuals, and large corporations. PE firms use the money in their respective funds to make investments (deals) in a broad range of public and private companies.

Many successful MBO deals are completed with a combination of debt (senior and/or mezzanine from financial institutions) and equity financing (from private equity groups). Thus, the business owner, management and their advisors will identify PE firms that may be interested in providing the required equity financing for the proposed MBO. When considering financing options, it is crucial to bear in mind not only the cost of financing but also the restrictions that may be placed as a result of the PE firm’s investment criteria. It is also extremely important for the management team to assess the private equity group as a partner that will help them achieve their desired objectives.

Seller Financing

Seller financing is also a common option available to fill the gap of a capital shortfall that may be experienced in a management buyout. This is not the most favored option for a seller, as they receive less proceeds at closing and are still tied to the risk of ownership in the business. The amount of seller financing can take the form of a subordinate loan, preferred shares or a minimal piece of retained common equity. The financing is usually repaid in full over a period of 3-7 years and bears a reasonable interest rate or rate of return. This type of financing is advantageous to the management team because they have full control of the company and don’t need to involve a third party like a mezzanine or private equity investor. Senior debt financing is still used even in the case where sell financing is used. In the case of mismanagement of the business post-acquisition, the selling shareholder may negotiate the ability to regain control through repurchase of the equity.

Valuation

In an MBO, the issue of purchase price or valuation is one of the most important to get correct. However, the issue of price for the MBO team is centered on affordability. Management teams should have one main advantage over the other buyers: detailed knowledge of the business and an intimate understanding of the growth prospects. Thus, they should leverage this knowledge to gain a deeper understanding of the business’ valuation. Management should be clear on a proposed capital structure and a clear vision of the business’ strategic direction. When applying an appropriate valuation methods, the management team should considered the following important factors when assessing a company’s overall value:

• Fair value of equipment available for security under debt financing arrangements;
• Ability of the company to service debt obtained for acquisition financing and stay within common debt covenant ratios; and
• Growth or cost saving opportunities that may impact future free cash flows of the business.

These factors will assist in reaching a fair valuation for the business but more importantly it will ensure that the capital structure of the acquisition will not put the company in financial distress after the MBO is completed.

Negotiation

Generally, the management’s financial advisors will assist with all negotiations with the various parties involved in the buyout on behalf of the MBO team. During the negotiation process, the management team will need to come to agreement with the following involved parties:

• The Seller - issues such as valuation and financing structures (i.e. seller’s financing) will be the most contentious issues;
• The Financiers - this will include both the banks or outside investors such as a private equity group. The financing/equity terms, equity percentages retained and inventive plans will be the main points of negotiation with these groups; and
• Each Management Team Member - items regarding items such as shareholder agreements, compensation, and roles and responsibilities post acquisition need to be contemplated.

During the negotiation, the vendor may have certain expectations with regards to valuation, staff plans, strategy for the business, ability to fund the offer and conditions attaching to the offer. MBO teams must carefully balance these expectations of the seller while also holding firm to deal terms that they believe are required to operate the business efficiently post acquisition.

If the vendor’s aspiration on pricing is not met, then options worth considering include:

• Deferred consideration such as seller financing or an earnout; or
• Buying less than 100% of the equity.

Other arrangements to consider during the negotiation process include:

• Cut-off Arrangements - This is an area often left to the last minute and because of time pressures ambiguity can creep in. The MBO team must be clear on the cut-off point for the balance sheet on which the deal is based. Is there to be a net asset adjustment? How is the balance sheet to be audited at completion by the acquirer? Would a cut-off point one month prior to completion make sense to allow both parties to sign off all adjustments by completion? How will existing debts be paid off? How will bank balances at completion be handled? These issues are all key to the MBO team’s working capital requirements immediately post the deal.
• Anti-embarrassment Clauses - Vendors may seek claw back arrangements regarding the target business (or specific assets) being sold on to third parties by the acquirer, realizing super profits. These claw back arrangements will cover periods 12-24 months post the sale.
• Due Diligence Still Outstanding - The vendor is obviously worried at these late stages of negotiation that the acquirer cannot deliver a deal. This may be for many reasons but the main one will be due diligence problems. Therefore the MBO team can take this opportunity to reassure the vendor that due diligence will cause them no problems; they understand the business in detail because they run it. However, despite this intimate knowledge it is still important to articulate the areas requiring further investigation by the financial backers. It is worth making clear to the vendor any areas where the vendor could give the financial backers comfort on the future operations of the target.
• Lock Out Agreements- It is worth confirming with the vendor that the process of completing the MBO will be accompanied by an exclusivity arrangement or lock-out arrangement. This is an agreement between buyer and seller that the vendor will deal only with one buyer for an agreed period. From the MBO’s perspective an ideal period is 3 months but of course agreeing to a shorter period does send attractive signals to the vendor that you are ready to close a deal quickly.

Due Diligence

The due diligence process for MBOs is notably less tedious as the buyers are already well acquainted with the business at hand. MBO teams should be aware that the seller and funders will have their respective legal representation and due diligence teams. During the MBO process, detailed due diligence will still be required by the preferred lead funder and/or private equity group. It is likely that these parties will only be granted permission by the seller to examine in detail the books of company once the major point of a deal are negotiated.

Under the due diligence procedure, an extensive evaluation of the business itself including the capital structure, review of the materials created for contracts and agreements as well as other areas dealing directly to the internal accounting responsibilities, assets of the business, any prevailing litigation, any regulatory aspects and insurances. The process is much akin to a background check of the overall stability of the company and whether it is a good form of investment or greater risk is at stake. Diligence topics fall into four broad categories: legal, accounting, valuation and commercial.

• Legal diligence focuses on confirming that the target is not subject to any material unreported legal liabilities. Legal diligence is highly detailed and specialized, usually executed by 3rd party lawyers.
• Accounting diligence focuses on confirming that the target’s reported financials accurately represent the fundamentals of the business. This work is important because valuation depends on reported financials which are susceptible to mistakes as well as intentional manipulation. Accounting diligence is highly detailed and specialized, usually executed by 3rd party accountants.
• Valuation diligence centers on determining the current fair market price for the asset and the multiple it could be sold for at exit. This analysis serves to assure the firm that it’s paying a fair current price and helps to forecast its profits at exit. Valuation diligence is usually conducted by the PE firm’s deal team, occasionally with some input from its investment bankers.
• Commercial diligence centers on projecting the target’s operational and financial performance. Commercial diligence includes investigation of market growth, historical performance, the target’s competitive position, the target’s business model, key performance drivers, supply chain analysis, customer analysis, etc. Commercial diligence is usually executed by a combination of the PE firm’s deal team alongside 3rd party advisors such as management consultants.

Even at later stages in the process, it is possible for the preferred funder or private equity group to pull out because of facts uncovered in their investigations into the business. It is therefore imperative for MBO teams to ensure that funders remain well informed.

Closing

The closing process involves further due diligence, negotiations, drawing up the purchase and sale agreement and the related shareholders’ agreement. The business owner and management team should ensure no further surprises arise during this period. Common hurdles which may still need to be cleared at the closing stage include:

• Lawyers and accountants may need to finish their diligence;
• Final financing documents must be executed with the banks;
• The target company’s management contracts must sometimes still be negotiated and executed;
• Unexpected regulatory issues;
• Shareholder disagreements between management team members and/or external financiers.

Common Obstacles in an MBO Transaction

Conflict of interest

An issue for any management buy-out, is the conflict of interest that inevitably arises if a management team wishes to bid for the business that is currently being marketed to independent third parties. In the management buyout, management sits on two sides of the transaction with differing goals - the buyer and seller. It is a well-settled principle of corporate law that management owes a fiduciary duty to the corporate shareholder. This duty requires that managers work for the good of the corporate enterprise. As part of its fiduciary obligation, the management must refrain from self-dealing and, by hypothesis, ignore its own self-interest when that interest diverges from the interest of the shareholder.

Additionally, management also possesses superior knowledge of the company being sold relative to shareholders. In this case, it is imperative that all parties are granted equal access to the information required to prevent any unfair advantage gained by one side of the transaction. The key risk for shareholders in this case is that they will be undercompensated as a result of management’s advantage. This issue is usually dealt with through the provision of a data room containing all requisite information, meant to create a level playing field.

Concurrently running an competitive auction process with an MBO

Sometimes a vendor will try to sell the business to other parties while also trying to conduct an MBO. Needless to say, this can get messy. Accordingly, in some public sector buy-outs the official policy is that on declaring an interest, the leader of the management team should be temporarily put on 'gardening leave’. As long as the existing management behaves sensibly, such a policy is rarely implemented in practice as the value of the business being sold will quickly decline if deprived of its key management. Furthermore, it will be in the management team’s interest to maintain a good relationship with the vendor as this will be critical to the future success of the buy-out. Ground rules, however, must be established concerning the conduct of the management team during the bidding process. For example, a representative of the vendor may attend if strategic buyers seek meetings with management.

Information Confidentiality

Given the competitive environment of the auction process, the MBO team must be careful when dealing with seller information requests. This works both ways. Firstly, MBO teams must realize that all answers to questions set by the seller will be passed onto the other bidders to assist their bids. Equally, answers given by the seller to the MBO team will be issued to all bidders. These tactics are employed by a well-advised seller to ensure a level playing field. The MBO team must therefore be careful when dealing with the seller regarding information releases and, additionally, care must be taken regarding information release to staff. The management’s business plan should be the property of the management team and their advisors and should reflect the specific view of the future of the business through the eyes of the existing management team. Management must attempt to gather information which supports their view of future profits, e.g. conversations with senior officers of the seller regarding future work of relevant evidence from the seller which affects any aspect of the business going forward or detailed knowledge of the business which they have built into future profits.

Juggling Multiple Financing Options

The auction process puts pressure on management teams to pick a lead funder who will be their financial partner in executing the deal. It is therefore preferable for the MBO team to have selected their lead financial partner before submitting their first bid. However, due to time pressures, or perhaps due to the unattractive terms being offered, it may be desirable to delay choosing one preferred backer at the first round of bidding. As long as several reputable names are supportive of the bid at the price indicated then the seller will not be concerned about the financial credibility of the management’s bid. However it is not practical to run an MBO bid with many private equity backing the team. Of course, the preferred private group you choose may decide to syndicate the deal post completion. Therefore, eventually, and probably prior to the first round of bidding, the management will choose a preferred funder to supply the equity required for the transaction.

Not Having an Advisor

The management buy-out process needs to be carefully managed. Thus, appointing a lead advisor makes sense for almost any size of transaction. The Principal advisor should be an M&A specialist responsible for guiding the management buy-out team through every stage, including the appointment of specialist help such as lawyers and personal advisors. In summary, the advisor duties will encompass an in depth strategic review of the business as well as its financial performance. The advisor will then groom the MBO team, pointing out deficiencies and skills gaps that need to be filled; edit the business plan to ensure a robust believable document is produced; raise the money; recommend the best capital structure and assist in negotiations with the seller and the funders to ensure that management have the best deal possible. This decision will be supported by projections of the business’ financials which produces a valuation range to guide the management’s final decision.

If the MBO team is completing their first MBO or even their first major corporate finance transaction, choosing a reputable name to advise is a vital part of the process. Choosing the right director or partner within the advisory company with the appropriate transaction experience is also crucial to executing the MBO successfully. MBO advisors are generally awarded a cost indemnity to cover their costs along with a win bonus payable at completion (typically 1-2% depending on transaction size).