Aim of the Chapter
Key concepts introduced in the chapter
What is a Management Buy-out?
A management buy out is the acquisition of a business by the management team which runs that business. The management team may or may not be the majority shareholders after the buy out but will have executive control of the business.
A leveraged buy out is rather different. It is normally used to describe the acquisition of a company by a syndicate of investors and managers where borrowing against the future cashflows (including from disposal of assets) of the business is critical to make a deal feasible.
Background
In some ways, it is surprising that the management buy out has been as successful as it has since it is difficult for a management team to raise as much money for the purchase of its business as a trade buyer. The trade buyer can borrow against the assets of his existing business, or raise capital from his shareholders based on his historic performance as well as the potential of the combined group. On this basis, he may well be able to afford whatever price he needs to secure some intangible asset of the target, such as customer list, key staff or even market share.
In contrast, a management team can usually raise limited equity finance from personal assets, family and friends and is reliant on external funds from venture capital and lenders. Both of these sources of finance can only take a view on the historic performance of the company itself, its potential and its assets.
For the venture capital investor, the investment can be justified by the future trading performance of the bought out company, but he is unlikely to be as bullish as a trade buyer who may well feel that he will gain "two plus two equals five" effects of synergy through the combination of the acquired and existing businesses.
The lender is even less likely to depart from a prudent view of the present assets of the business, to secure the borrowing, and its reasonable anticipated cashflow, to service the borrowing.
It is worth looking at the brief recent history of the management buy out which, inter alia, includes the leveraged buy out.
Since the 1970s, large corporations have been much more active in acquiring new businesses and in disposing of parts of their existing business. This process was particularly noticeable in the late 1970s, when these companies started to look critically at the mass of businesses they had built up or acquired over the years. Michael Porter's book "Competitive Strategy" influenced the decision making of many senior managers, who came to see the importance of concentrating on their core business and only acquiring or developing new businesses that directly strengthened
it. Unilever, for instance, disposed of a total of X businesses between 1975 and 1985; these included such varied activities as road haulage and distribution, computer services, etc.
It was important to these large companies to ensure that the disposals went as quickly and as smoothly as possible and, perhaps more importantly, the businesses sold fell into friendly hands. For this reason, the management and workforces were often the preferred purchaser.
Many of these subsidiaries were trading close to, or below, break even and, as a result, were sold at a discount to net assets. Miraculously, management teams which had run a business with modest profitability as a division of a large corporation, were suddenly running impressively profitable growing businesses. Recent research by Peat Marwick McLintock has shown that many firms bought by their management show impressive improvements in profitability in the years immediately after the purchase (see a fuller discussion below).
However, the buy out market place of the early 1990s, both in the UK and USA, is a very different place to its heyday in the early and mid eighties. The signs started to become evident after the stock market crash of October 1987. First, a loss of stock market confidence meant that it became much more difficult for an institution to get the attractive returns from buy outs which were possible before the crash, since flotation had become the usual exit, especially for large buy outs.
Secondly, it became much more difficult to find takers for the intermediate, or "mezzanine" debt, which is the principal characteristic of "leveraged" buy outs. All buy outs are dependent on some borrowing, primarily to allow a financing structure which gives management a worthwhile share of the equity in the bought out company, this is called "leveraging" (this is discussed in detail in the section 4.x on "Structures"). Finally, the massive rise in interest rates worldwide, but particularly in the UK, has made servicing the level of debt necessary in most buy outs prohibitively expensive.
The principal reason why so many institutions, often with limited prior experience of venture capital or unquoted investments, were attracted to backing management buy outs was the apparently limited risk of these investments. After all, thy were backing the same management team with the same products with the same operational resources in the same market places: only ownership had changed. Moreover, the unstoppable rise in the stock market over the decade guaranteed strong growth in the value of the company's equity based on comparatively modest improvements in profitability. The combination of low risk and certain returns was irresistible.
Disillusion, when it came, was all the worse for those who had this one dimensional view of buy outs. The threat of inflation in the UK economy during 1988 led the government to force a series of draconian rises in interest rates. These rises, unforeseen in the modelling behind the large buy outs, meant that the interest cover
and cash flow calculations of the leveraged deal structures were meaningless. Moreover, a number of the largest buy outs, notably MFI and Magnet & Southern, were in retail sectors most vulnerable to the effects of rises in the cost of consumer borrowing. These large deals had involved many of the established buy out houses as well as having drawn in a number of new investors as syndicate partners. Moreover, the lenders, especially of "mezzanine" debt, who had most to lose from the cash flow difficulties of the buy outs, were drastically reviewing their attitudes to these deals. Therefore the conclusions which both equity investors and lenders have drawn from their buy out experience in the last three years of the 1980s have shaped their policy and attitudes for the 1990s.
Investors' and Lenders' Expectations
Inevitably investors and lenders are now setting much more stringent criteria for the buy outs in view of their experience since 1987. Lenders, in particular, are much more cautious about allowing their loans to be used to gear (or "lever") a deal to the benefit of the equity holders. They are likely to view any debt that is not fully secured and where the interest is not to be serviced from existing or predictable cashflow as mezzanine.
Equity investors, on the other hand, are likely to take a much more cautious view of price.
First, in that they will apply cautious valuations both in agreeing a reasonable purchase price for the company today, making it even more difficult to compete with trade buyers, and in assessing the prospective value of the company in the future. The investor's view of purchase price may well determine whether a buy out is feasible at all, while his view of the future value of the company will, because it affects the return on his investment, determine the percentage of the equity that he seeks in the initial deal structure.
Secondly, the equity investor, because he undertakes the most thorough due diligence, is now likely to take a much more prudent view of the company's profitability and cashflow after the buy out as well as its ability to achieve its forecast sales and margins. This information is likely to be shared with prospective lenders also.
Opportunities for Buyouts
Despite the changes in the buy out market place, vendors still need to sell companies and often in circumstances which favour management rather than a trade buyer.
First, buy outs are the most effective way of dealing with succession in private companies, especially in circumstances where the existing shareholders want to retain part of their equity. This is especially true of family businesses, when a trade sale is unthinkable but where the existing generation of family shareholders want realise the capital value of all or part of their shareholding.
Secondly, larger companies still seek to dispose of subsidiaries. These disposals may be because the parent needs cash, because the parent wants to concentrate management and financial resources on its core business or because an unwanted subsidiary came as part of an acquisition.
Thirdly, company failure can offer an opportunity for a management team to buy its own company. There are some obvious pre conditions to buy outs from receivership, however, which an investor is almost certain to impose. He will be concerned to ensure that the failure did not result from some fundamental weakness in the company's product, market or structure which will be beyond the scope of simple good management to put right. Furthermore, he will want to see that something substantial has changed in the business to ensure that the cause of failure is unlikely to recur.
Disadvantages of Buy-outs
There are a number of problems with trying to mount a buy out. First, the management team are running the risk of alienating the present owner of the business which may mean their being forced out and losing personal assets such as share options or bonuses.
Secondly, the management can find themselves trying to appear in two rather contradictory roles. On the one hand they will want to keep the price of their business down by ensuring that its performance is relatively lacklustre while, to the investor, they will be saying that the performance can be radically improved to generate the upside for which he is looking.
Thirdly, the investor himself may be in danger of being accused of "enticement" if he gets to close to an employed management team who are trying to negotiate backing for a buy out. Yet neither he nor they will want to commit to the project unless they are very close, they have discussed the most confidential aspects of the plan for the business and have proceeded to an offer of investment.
Groundrules for Buy-outs
There are a number of fundamental principles which affect any proposed management buy out:
Vendor's attitude
The vendor must want to sell, either because he has already started the process of finding prospective purchasers, or because the management team believe that they know enough of the vendor's circumstances to be certain that he will be interested in selling if they make the right, realistic, offer to him.
Value of management
The management must be critical to the future success of the business. If thy are not, then a number of problems present themselves. First, it will be difficult for them to persuade a venture capitalist to back the buy out if their
commitment is not critical for the future success of the business. present themselves. Secondly, if a management team's continuing presence and commitment are not critical to the successful sale of the company to a trade buyer, then the management will have no weapon with which to beat an inflated price.
Price
Management, backed by institutional investors, has to buy its company on the basis of future profitability and the return which they can reasonably offer to shareholders. They cannot, unlike a trade buyer, justify a price because of market position, the elimination of competition or to gain entry to a new market. In reality, this means that it is exceptional that a management team will be able to persuade its backers to pay much more than the value of the company's net assets as shown in its balance sheet.
The longer term
Potential backers will want to know where the business will be five years or more after the buy out. They will be particularly concerned about identifying a stage when there is likely to be a profitable exit for their investment, probably through sale or flotation. Alternatively, they will want to ensure that the future performance of the business is likely to remain strongly profitable if they are seeking dividends or other running yield as a significant part of the return on their investment.
The buy out business plan
