Demystifying the risks and rewards Management Buyouts

  • Date:01 Feb 2005
  • Type:CompanyDirectorMagazine
Directors are increasingly faced with the opportunity and risks of participating within, or approving, MBOs. Jeremy A. Samuel and Nicholas Humphrey provide a general overview of management buyouts particularly from a director’s perspective

Demystifying the risks and rewards

Directors are increasingly faced with the opportunity and risks of participating within, or approving, MBOs. Jeremy A. Samuel and Nicholas Humphrey provide a general overview of management buyouts particularly from a director's perspective

A management buyout is a transaction where the existing management buy the business from the current owners, usually supported by private equity investors and often debt financiers using a mixture of senior debt and sometimes junior or mezzanine debt.

A management buy-in involves a new management team. A leveraged buyout generally refers to any MBO more heavily weighted towards debt finance than equity.

Management and the investors will form a new company to acquire the assets from the vendors. The bulk of funding will be provided by the financiers and investors, with management investing a relatively small but "meaningful" stake.

In the United Kingdom up to 50 buyouts occur each month. While Australian buyouts are scarcer, they are gaining increasing acceptance in the market as a viable option for vendors.

Sources of MBO opportunities

Some of the more common MBO opportunities are:

  • Non-core assets: a larger business group decides that a part of the business has become "non-core";
  • Unwanted acquisitions: where a purchaser acquires a "bundle" of businesses but may not wish to operate all of them;
  • Succession issues: the founder or owner of the company wishes to retire;
  • Divergent interests: the existing shareholders have divergent aspirations for the company and one or more wish to exit;
  • ACCC: in some cases the ACCC may force a bidder to divest of part of a recently acquired group for competition reasons;
  • Public to private: where it no longer makes sense for the company to be listed;
  • Insolvency: the receiver or administrator of a company in liquidation wishes to sell the business or part of it as a going concern;
  • Secondary MBO: where a MBO has already occurred, some of the financiers and management team may wish to realise some or all of their capital gain, and to give other managers or employees a greater stake in the business.

Why do vendors consider selling business units to MBO teams

The vendor, usually through the board, must determine the best way to sell the business. They may decide to run a sales process with several trade buyers and provide management with an opportunity to bid against trade buyers. While this competitive tension can maximise the likely price, it also risks "tainting" the business by risking sensitive information falling into competitors' hands thus reducing the likelihood of a successful, full value sale.

Few logical competitors/trade buyers often heighten these concerns. Management uncomfortable with the potential acquirer can also jeopardise an open sales process. Therefore, vendors often enable the management team to have a first look at the business and if the MBO team can meet the vendor's price expectations, enter into exclusive arrangements to complete due diligence and documentation.

The exclusive MBO process enables the vendor to sell the business to those that understand the intrinsic value better than most outside parties, while minimising the risk of damaging confidential leaks. If MBO discussions falter, then the vendor may revert to an open sales process. This is usually preferable to starting an unsuccessful sales process and then reverting to an MBO. Otherwise, the MBO team is clearly the only remaining buyer and this negotiating power may lead to a sub-optimal outcome for the vendor.

Other reasons for selling to an MBO team include:

  • An MBO is also sometimes seen as a final chance to reward loyal senior management, particularly in privately held businesses.
  • An MBO is also a faster and easier may of exiting. As the management already know the business, the sale process can be streamlined in a number of aspects (including reduced due diligence and warranty negotiations).
  • MBOs are also often more acceptable to other stakeholders including the broader workforce, unions, customers and suppliers.

Overview of process

The key stages of a buyout are generally:

  • Agree members of management team (and financial advisers if required);
  • Seek approval from vendor's board;
  • Select potential private equity investor/s;
  • Appoint legal advisers;
  • Execute terms sheet with vendors and conduct due diligence;
  • Obtain debt funding; and
  • Prepare and negotiate legal documentation.
The entire process typically takes 2-3 months but can take longer in more complex transactions (or when the sale is put to competitive tender).

Choosing a private equity firm

It is important that both the vendor and management have confidence in the private equity firm to deliver on any indicative offer. Criteria for choosing the appropriate firm include:

  • Credibility, integrity and ability to maintain confidentiality;
  • Track record of private equity principals;
  • Ability to structure and fund the MBO;
  • Transparent investment and approval process;
  • Understanding of investment mandate including deal size and industry; and
  • Complementary fit with management.

What do private equity firms look for

Private equity firms' investment criteria for MBOs vary. Most private equity firms look primarily for an honest management team that has a proven ability to run the business and aligned interests with investors.

Other factors vary with the opportunity but usually include strong cash flows, growth potential, reasonable entry price and potential exit prospects in 3-5 years. Good quality firms have seamless relationships with their investment committees.

They can clearly articulate their investment mandate to the vendor's board and management team early in the process.

What are the legal risks

When the management team of a business consider making a bid for the ownership of that business, a conflict of interest arises between management and the current owner. Directors must monitor and help manage this carefully.

Confidentiality

Much of the financial and marketing information necessary to show business viability to a potential investor is confidential, and belongs to the company. Before management disclose any information, it is critical that they obtain:

  • confidentiality undertakings from all potential investors, potential creditors and legal and financial advisers; and
  • consent from the vendor company for the release of confidential information. The vendor will often put specific conditions around the nature and extent of disclosure.

Breach of duties

Until the MBO transaction is finalised, management has a duty to act in the best interests of the vendor's shareholders. These duties may arise in their capacity as directors, company officers, employees or agents of the vendor or through any specific service agreements. This means that during the MBO negotiations, management effectively act both as agents of the vendor, and as potential buyers. This creates potential conflicts of interest.

Managing conflicts

To ensure that conflicts do not derail the MBO process it is prudent to set out some formal protocols for the process. These may include:

  • the vendor may establish a separate decision-making committee for the sale independent of members of the MBO team;
  • management should allow a specialist adviser or a representative of the equity financier to lead negotiations;
  • as soon as possible, management should obtain from the vendor: (a) consent in writing to management involvement in the MBO process and (b) acknowledgement that management may devote a significant amount of time to the MBO process without breaching their service agreements.

* Jeremy A. Samuel is a director with ANZ Private Equity. Nicholas Humphrey is a partner with Deacons specialising in private equity. This article is an introduction to a fairly complex and dynamic area of law, tax and finance and is not intended to be a substitute for independent advice. It represents the authors' personal views and not the views of Deacons or ANZ Private Equity

Disclaimer

The purpose of this database is to provide a full-text record of all articles that have appeared in the CDJ since February 1997. It is aimed to assist in the research and reference process. The database has a full-text index and will enable articles to be easily retrieved.It should be noted that information contained in this database is in pre-publication format only - IT IS NOT THE FINAL PRINTED VERSION OF THE CDJ - therefore there might be slight discrepancies between the contents of this database and the printed CDJ.