Aim of the Chapter
Key concepts introduced in the chapter
Definition
A management buy in is the acquisition of a business by a management team which does not run that business. It is often an alternative to management buy out considered by a team unable to buy its own business.
Background
The last chapter, on management buy outs, showed that the opportunities for competent management teams to buy their own businesses are declining. Unless a management team is prepared to match, or even exceed, the terms of the best other offer, they are increasingly unlikely to succeed in buying out their business. The more successful they have been in managing the business, the higher will be the price that they will have to pay to secure it. The obvious alternative for the able management team, frustrated in buying their own business, is to try to buy another business: to mount a management buy in.
In a competition to raise the highest price to secure a business, the management of that business are likely to be at a disadvantage to a prospective trade purchaser. The management will probably have to use borrowing, as well as selling equity, to raise the total purchase price. The lenders of this money will want to satisfy themselves that the business has the assets to secure the borrowing or, at least, the cashflow to service the debt and give a reasonably predictable repayment schedule. In contrast, a trade purchaser may be able to fund the acquisition through cash that is already in his business or by raising equity finance. Even if he has to borrow to fund all or part of the purchase price, he can use the assets of his own business, or its cashflow and profitability, as well as those of the target to give comfort to potential lenders.
Ironically, therefore, a management team with an excellent track record in managing its own business is more likely to be frustrated in trying to buy out its own business than a business with a more indifferent performance. Yet the better team is the one that an investor would want to back. There are enough risks in making an equity investment without the self inflicted wound of backing indifferent management. What, therefore, can the excellent management team do to end up running and owning its business?
It was probably 3i who coined the phrase "management buy in" in 1986 or so. It had become increasingly apparent that there were considerably more competent management teams who wanted to buy out their businesses than there were opportunities to do so. These teams had had their interest aroused by the increasing publicity that buy outs were attracting, especially those businesses where the buy out had been a success and the participants had later sold the business, or had floated it, to see a major capital gain.
3i was also experiencing increasing competition to back management buy outs as well as feeling the effects of the increased price expectations of vendors. Moreover, with its long established network of regional offices and having had a subsidiary which specialised in helping family businesses minimise the effects of estate duties, the company had a large number of investments in family businesses with managerial succession problems on the retirement of family managers. Some of these businesses were attractive to trade buyers, some were best liquidated but what of those which had a trading future as independent companies yet had no obvious succession to senior management?
The marriage of frustrated management buy out teams and family owned businesses with shareholders seeking to sell was an obvious step for 3i. However, experience showed that there are also a number of practical obstacles which stand in the way of completing management buy ins, despite the obvious attractions.
Investors' and Lenders' Expectations
3i is the obvious starting point for anyone considering a buy in. First, because they have been the buy in pioneers and have most experience in backing this type of deal. Secondly, they have the advantage of a network of 29 regional offices (at mid 1989) with extensive contacts in local industry and business. This advantage means that they are well placed to help a buy in team find a suitable target interested in selling. Moreover, since 1988 they have had a specialist buy in unit which has sought out potential buy in teams and suitable targets and hold both on a database looking for possible matches.
Other venture capital institutions have been active in the field. County NatWest Ventures (CNWV) has backed a number of buy ins since 1985 and offers a similar service to 3i.
Opportunities for MBIs
The management buy in offers many of the advantages of the buy out. It gives the purchasers (management team and equity investors) the opportunity to acquire a business with existing products or services, with customers and with operational or production resources.
Some of this will be represented by the tangible assets of the business, particularly production plant and machinery. The tangible assets will be represented on the target's balance sheet along with those intangible assets which can be capitalised (some R&D, patent and other intellectual property and, most imponderably, goodwill). The valuation attributed to these assets will nearly always be verified by the purchaser prior to completion of the sale; therefore it is unlikely that they will be grossly unrealistic.
However, the aquirors will also be assessing the business'
intangible assets which may well be the key assets which they are seeking to acquire. They will probably be managers of a competitor and will have a good idea of the attractiveness of some of the target's intangible assets. These could include the present product portfolio, the customer base (easier to assess in some industries than others), the key employees and the good name of the business or its branded products.
Disadvantages of MBIs
A management team buying its own business is likely to have a detailed knowledge of the company's trading and financial position, its managerial strengths and weaknesses and the risks of an exceptional liability from litigation or a claim. None of this information is necessarily available to a buy in team. Accounts can be extremely misleading, especially if the business has been trading unprofitably or near break even.
Moreover, that information about a target which may be publicly available, typically product information, may be misleading or incomplete, especially if it is the development of new products that is vital to the business' success. There is all the difference in the world between the value of a new product that is a plywood mock up and some half finished drawings and the value of one that is in user trials with selected customers.
Some of these disadvantages are less significant if the buy in team is backed by an institution which is currently a shareholder in the target. A venture capital investor is likely to know the business considerably better than any other shareholder (see discussion in Chapter X Maintaining the Relationship) having undertaken a detailed commercial and financial investigation prior to investment, and having received regular management accounts since. However, there is a potential conflict of interest since the institution will be required to act in concert with both the other purchasers and the existing shareholders. It can only work if the buy in is an obviously better route for the vendors than any other option and maximising price is not an overriding priority (deferred consideration may be a useful mechanism).
Groundrules for MBIs
There are a number of fundamental principles which affect any proposed management buy out:
Knowledge of the target
It is essential that the buy in management have taken the best available steps to ensure that they really do know what is going on in the target, especially if the price is at all full and there will be substantial loans to service once the deal has been done.
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. 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 MBI Business Plan
