Management buy-outs (MBOs) involve the management team of a company combining resources to acquire all or part of the company they manage, taking control and ownership of a company to drive it forward. MBOs usually require external funding from banks or private equity investors, who contribute to the company group and are entitled to a share of the profits if the company is profitable.
Here we’ll be covering the fundamentals of MBOs in the UK, including:
What is a management buy-out (MBO)?
A management buy-out (MBO) is the acquisition of a business by its core management, usually with the financial support of a lender or private equity fund. MBOs vary in size but all MBOs involve the management team taking an equity (ie, shares) stake in the business.
Depending on the vendors, a MBO can vary from a 100% acquisition of the business to a controlling stake in the company. In effect, MBOs turn the management of a company into its shareholders.
Common practice is for the management team to fund the buy-out with a portion of their own capital to ensure they are incentivised to grow the company.
Why do MBOs happen?
Shareholder motivations to sell a company via a MBO vary, but tend to come down to realising value in the company. A shareholder may be about to retire and want to divest of his or her shares, or a large company may be moving in a new direction and want to stop trading in a particular area.
They may also happen after a takeover, where a company no longer wishes to retain all of the products or services provided by the company it has bought.
MBOs can be an attractive route to selling a business as they are typically quicker than selling to a third party. The management already knows the ins and outs of the business, and requires less time to conduct due diligence.
For management it presents a relatively low risk path to owning a business. The management already has an understanding of the workings of the company, its market exposure and what the company needs to be successful.
Advantages of MBOs
For a company undergoing a change of ownership, a MBO offers advantages to all parties. In particular, it allows for a smooth transition of ownership with little impact on the continuity of business.
The management knows the company and there is a reduced risk of failure or unanticipated problems. Other employees and clients are also less likely to be concerned by a MBO than a takeover, as the status quo is likely to be maintained.
MBOs require less due diligence and the internal changes and transfer of responsibilities remain confidential between the vendors and the management. This means that trade secrets are more likely to remain confidential.
Management may also not wish to continue with the business if the company was sold to a third party and a MBO might prove to be the only mutually acceptable route to a sale.
Disadvantages of MBOs
Management typically lacks the financial power to be able to buy a business outright. This means a seller might not be able to attract the same level of value as selling to a third party. If management do decide to buy then they may require additional financial help from a bank or from private equity funds. This extra funding introduces additional debt and spreads equity thinner amongst investors.
Debt repayments can eat into profits and may reduce the money available to pay dividends. Many investors will also want to exercise some level of control over the company and this may mean that management has less control over the company in the future.
For a MBO to be successful, a company will need to have strong fundamentals. The business will need to be able to generate adequate profit to sustain itself as it develops and provide an adequate return to stakeholders, as well as supporting ongoing capital expenditures.
The management buy-out process
Once the structure of the MBO is settled, the institutional lenders and private equity sponsors will want to begin their due diligence enquiries. The object of this process is to ensure that the business is financially sound and likely to repay their investment.
Key due diligence elements include:
- Accountants’ report
- Commercial due diligence
- Legal due diligence
- Market report
The accountants’ report generally includes a review of the historic performance of the company, its assets, tax position and assumptions underlying financial projections. Commercial due diligence will focus on the company’s products, customers and markets in which it operates. The commercial due diligence may be supplemented by a market report looking at the sector more generally. Legal due diligence will look at the implications of litigation, title to assets and intellectual property.
A key consideration for investors will be whether the business is capable of supporting the buy-out financing from the cash it generates. For example, it will need to be able to pay the interest on funds raised to support the buy-out.
How is an MBO structured?
Most MBOs are financed through a combination of debt and equity, although other hybrid sources such as mezzanine and vendor deferred loans may also be used.
Typically, a new corporate group is formed as part of the management buyout process. The group will comprise of a holding company and a wholly owned subsidiary. The holding company acts as the investment vehicle for the private equity fund and the managers.
By contrast, the subsidiary acts as the investment vehicle for debt finance provided by banks and other lenders. The subsidiary company also acts as the purchasing company. A double group structure may be used if the lenders wish to achieve a structural subordination.
How is an MBO funded?
MBOs are normally funded through a combination of management and external finance. Typically this is a combination of debt and equity. Senior debt is the cheapest form of capital and includes loans, overdrafts and lease funding. Senior lenders receive an agreed interest rate and are entitled to take control over certain assets if the company does not repay their loans.
Mezzanine debt is often used to bridge the gap between senior debt, available equity and the purchase price. Mezzanine debt ranks behind senior debt and normally offers a higher rate of return.
In some circumstances, vendor financing may also be used. Vendor finance involves delaying paying the seller(s) part of the consideration of the company. For example, the vendor may take shares alongside the management post-MBO. The shares entitle the vendor to future dividends in the business, if the business is profitable.
Common MBO issues
MBOs are complex and involve a substantial amount of work. All parties should be sure that they have thoroughly considered all their options. Common issues include not considering all options before pursuing a buy-out and not considering the other parties’ points of view.
An impending MBO can also lead to principal-agent problems and moral hazards. For example, management may be tempted to manipulate earnings lower to get a cheaper price or may present the owner with a buy-out or walk scenario. Management may also have an asymmetric information advantage over owners which needs to be considered in the representations and warranties given.
Management should take care to understand the personal commitments and securities the lenders will require to fund the buy-out, and take care to effectively communicate the situation to staff to avoid rumours.
What are the differences between an MBO and LBO?
A MBO is a type of leveraged buyout (LBO). Leveraged buyout finance refers to the provision of bank loans and/or the issue of high yield bonds to fund the acquisition of a company (or parts of a company). Most managers of companies do not have the financial resources to buy a company outright and must obtain additional funding. This additional debt is what raises the debt to equity ratio and makes the acquisition a leveraged buyout.
