Management buyout

A management buyout (MBO) is a form of acquisition where a company's existing managers acquire a large part or all of the company from either the parent company or from the private owners. Management and leveraged buy-outs became phenomena of the 1980s. MBOs originated in US and traversed the Atlantic, spreading first to the U.K. and then throughout Europe. The venture capital industry has played a crucial role in the development of buy-outs in Europe, especially in smaller deals in the U.K., the Netherlands, and France.

Overview

Management buyouts are similar in all major legal aspects to any other acquisition of a company. The particular nature of the MBO lies in the position of the buyers as managers of the company and the practical consequences that follow from that. In particular, the due diligence process is likely to be limited as the buyers already have full knowledge of the company available to them. The seller is also unlikely to give any but the most basic warranties to the management, on the basis that the management know more about the company than the sellers do and therefore the sellers should not have to warrant the state of the company.

Some concerns about management buyouts are that the asymmetric information possessed by management may offer them unfair advantage relative to current owners. The impending possibility of an MBO may lead to principal–agent problems, moral hazard, and perhaps even the subtle downward manipulation of the stock price prior to sale via adverse information disclosure, including accelerated and aggressive loss recognition, public launching of questionable projects, and adverse earning surprises. Naturally, such corporate governance concerns also exist whenever current senior management is able to benefit personally from the sale of their company or its assets. This would include, for example, large parting bonuses for CEOs after a takeover or management buyout.

Since corporate valuation is often subject to considerable uncertainty and ambiguity, and since it can be heavily influenced by asymmetric or inside information, some question the validity of MBOs and consider them to potentially represent a form of insider trading.

The mere possibility of an MBO or a substantial parting bonus on sale may create perverse incentives that can reduce the efficiency of a wide range of firms—even if they remain as public companies. This represents a substantial potential negative externality. The managers of the target company may at times also set up a holding company for the purpose of purchasing the shares of the target company.

Purpose

Management buy outs are conducted by management teams as they want to get the financial reward for the future development of the company more directly than they would do as employees only. A management buyout can also be attractive for the seller as he can be assured that the future stand-alone company will have a dedicated management team thus providing a substantial downside risk against failure and hence negative press. Additionally, in the case the management buyout is supported by a private equity fund (see below), the private equity will, given that there is a dedicated management team in place, likely pay an attractive price for the asset.

Financing

Debt financing

The management of a company will not usually have the money available to buy the company outright themselves. They would first seek to borrow from a bank, provided the bank was willing to accept the risk. Management buyouts are frequently seen as too risky for a bank to finance the purchase through a loan. Management teams are typically asked to invest an amount of capital that is significant to them personally, depending on the funding source/banks determination of the personal wealth of the management team. The bank then loans the company the remaining portion of the amount paid to the owner. Companies that proactively shop aggressive funding sources should qualify for total debt financing of at least four times (4X) cash flow.

Private equity financing

If a bank is unwilling to lend, the management will commonly look to private equity investors to fund the majority of buyout. A high proportion of management buyouts are financed in this way. The private equity investors will invest money in return for a proportion of the shares in the company, though they may also grant a loan to the management. The exact financial structuring will depend on the backer's desire to balance the risk with its return, with debt being less risky but less profitable than capital investment.

Although the management may not have resources to buy the company, private equity houses will require that the managers each make as large an investment as they can afford in order to ensure that the management are locked in by an overwhelming vested interest in the success of the company. It is common for the management to re-mortgage their houses in order to acquire a small percentage of the company.

Private equity backers are likely to have somewhat different goals to the management. They generally aim to maximise their return and make an exit after 3–5 years while minimising risk to themselves, whereas the management rarely look beyond their careers at the company and will take a long-term view.

While certain aims do coincide—in particular the primary aim of profitability—certain tensions can arise. The backers will invariably impose the same warranties on the management in relation to the company that the sellers will have refused to give the management. This "warranty gap" means that the management will bear all the risk of any defects in the company that affects its value.

As a condition of their investment, the backers will also impose numerous terms on the management concerning the way that the company is run. The purpose is to ensure that the management run the company in a way that will maximise the returns during the term of the backers' investment, whereas the management might have hoped to build the company for long-term gains. Though the two aims are not always incompatible, the management may feel restricted.

The European buyout market was worth €43.9bn in 2008, a 60% fall on the €108.2bn of deals in 2007. The last time the buyout market was at this level was in 2001 when it reached just €34bn.

Seller financing

In certain circumstances, it may be possible for the management and the original owner of the company to agree a deal whereby the seller finances the buyout. The price paid at the time of sale will be nominal, with the real price being paid over the following years out of the profits of the company. The timescale for the payment is typically 3–7 years.

This represents a disadvantage for the selling party, which must wait to receive its money after it has lost control of the company. It is also dependent, if an earn-out is used, on the returned profits being increased significantly following the acquisition, in order for the deal to represent a gain to the seller in comparison to the situation pre-sale. This will usually only happen in very particular circumstances. The optimum structure would be to convert the earn-out to contracted deferred consideration which has compelling benefits for the seller as it legally fixes the total future amount paid to them. It's paid like a quarterly annuity, and then the seller needs to secure the annuity by taking out a deferred consideration surety guarantee from an independent surety institution. The direct beneficiary of the surety is the seller and should the sold firm become insolvent, following its sale, with any outstanding deferred payments due the seller, then the surety will pay the money to the vendor on the purchaser's behalf.

The vendor agrees to vendor financing for tax reasons, as the consideration will be classified as capital gain rather than as income. It may also receive some other benefit such as a higher overall purchase price than would be obtained by a normal purchase.

The advantage for the management is that they do not need to become involved with private equity or a bank and will be left in control of the company once the consideration has been paid.

Examples

A classic example of an MBO involved Springfield Remanufacturing Corporation, a former plant in Springfield, Missouri owned by Navistar (at that time, International Harvester) which was in danger of being closed or sold to outside parties until its managers purchased the company.

In the UK, New Look was the subject of a management buyout in 2004 by Tom Singh, the founder of the company who had floated it in 1998. He was backed by private equity houses Apax and Permira, who now own 60% of the company. An earlier example of this in the UK was the management buyout of Virgin Interactive from Viacom which was led by Mark Dyne.

The Virgin Group has undergone several management buyouts in recent years. On September 17, 2007, Richard Branson announced that the UK arm of Virgin Megastores was to be sold off as part of a management buyout, and from November 2007, will be known by a new name, Zavvi. On September 24, 2008, another part of the Virgin group, Virgin Comics underwent a management buyout and changed its name to Liquid Comics. In the UK, Virgin Radio also underwent a similar process and became Absolute Radio.

In Australia, another group of music and entertainment stores were subject to a management buy-out in September 2009, when Sanity's owner and founder, Brett Blundy, sold BB Retail Capital's Entertainment Division (including Sanity, and the Australian franchises of Virgin Entertainment and HMV) to the company's Head of Entertainment, Ray Itaoui. This was for an undisclosed sum, leaving Sanity Entertainment to become a private company in its own right.

See also

• Takeover
• Management buy-in
• Leveraged buyout - includes secondary buyout
• Envy ratio

External links

• Definition of management buyout
• Definition of buy-in management buyout
• Creative Management Buyout Strategies Article"