Posted on: January 31st, 2018
A management buyout is a transaction where the management team of a company acquires ownership control of the company by means of equity investment and loans. A management buyout is a highly regarded form of corporate finance as it vests ownership control in the people that are responsible for running the company.
Management buyouts are often pursued by management teams that feel strongly in the future growth of their businesses and wish to control their own fate as owners of the business. They are distinct from private equity sponsored buyouts in that management owns and runs the company, as opposed to an institutional investor.
While regarded as a highly preferred type of deal, their viability requires several conditions which can be difficult to achieve. Management buyouts uniformly require a motivated seller, an incentivized management team and a flexible deal structure.
Moreover, management buyouts require a moderate valuation that allows the management to control the ownership layer of the transaction without having to invest massive amounts of cash equity. Management buyouts are successfully implemented when the management team can contribute meaningful purchase price value to the deal in the form of non-cash investment.
If management buyout success rests on the management team being the highest bidder with the largest equity investment, then it will likely not come to pass.
For a management buyout to occur, the buyer needs to receive purchase consideration from the seller, which the lender can use as quasi equity in the transaction. This consideration can be in a variety of forms including seller notes, earn outs, rollover equity by the seller, or a discounted purchase price.
When this quasi-equity purchase consideration is present in the deal, management buyouts are superior alternatives for sellers looking to exit. Aside from the structural superiority, these types of deals involve less change to the employees, customers and other stakeholders.
Management buyout viability is dependent on:
- Motivation level of seller.
- Flexible deal structure.
- Moderate Valuation level.
- Buyer’s ability to achieve quasi equity in the transaction.
How are Management Buy-out Transactions Valued?
Valuation occurs in much the same way that it unfolds for other buyout transactions, on a multiple of pro forma EBITDA for the company being sold. Usually, the seller of the business has a targeted valuation expectation based on comparable multiples of other companies in the industry.
An investment banker is engaged to provide an estimate of current market value. The ultimate sale value is determined by a market auction through the term sheets submitted by potential purchasers of the business.
The key for a management team in pursuing a MBO is to find a way to control the sales process and ultimately prevent the seller from entering into an agreement with other buyers. Through providing a high quality preemptive bid, management’s goal is to short circuit the auction process.
Management has significant influence on short circuit or influence the process in a way that enriches their position as a preferred buyer. Management deals with the day to day issues of the business and is responsible for driving strategic long term growth.
The growth assumptions employed by the investment banker’s appraisal are provided by and controlled by management. Management is in a conflicted role as both an informational resource to the sales process and a potential buyer themselves.
They must be careful to not compromise themselves. Yet they have considerable latitude as the keepers of the value drivers for the business, who are ultimately responsible for conveying the greatness of the business to potential buyers.
Information asymmetry between the insider management and outsider purchasers universally results in management being able to provide a stronger bid for the company. Because they know the company better, they know what value drivers are available and can execute with a higher level of certainty than other buyers.
Management team’s advantages in buying the business:
- More knowledge.
- More execution certainty.
- Close relationship with seller.
- Ability to scale it more reliably.
They can capitalize on latent growth opportunities with new products. They can rationalize overhead cost structures that may have languished under current ownership.
They can justify investment in new business development more easily than any other buyer.
While they have more optionality and vision as to how to enhance the business, they must capitalize on other factors with the seller in arriving at a purchase price that will allow them to purchase control.
Management teams are usually not the highest bidders and to successfully secure the right to purchase the business, the team must trade on non-monetary intangible aspects.
These include appeals to the seller’s legacy, commitment to management team, concern about the future of the business and concern about the future welfare employees. There is usually an emotional component to the decision of an owner to sell to his management team.
Many sellers by the time they exit have accumulated significant wealth and are interested in seeing their lifetime of work in the hands of people they can trust. Management teams are the most trustworthy purchasers when it comes to continuing the business in the spirit of the founder.
What are Common Structural Approaches of Management Buyouts
There are a variety of structural approaches available to execute a management buyout. They all center around the creation of a quasi-equity layer in the capital structure, wherein management can optimize their investment in the deal and receive disproportionate levels of ownership in return.
Quasi equity means a non-cash component of the transaction structure unique to the purchaser. It is a component that would not be present, unless a specific buyer is involved in the deal. It functions as a fulcrum of transaction viability and allows management teams with minimal cash to purchase companies with large prices, utilizing non-dilutive debt capital.
It can be one of four things;
- Below Market Purchase Price – if the company is worth 6 times EBITDA and management can extract a significantly lower price, (i.e. 4 times EBITDA), they can capitalize on this purchase price equity in attracting a lender, with minimal cash investment. The price discount functions as quasi equity in the deal.
- Management Rollover Equity – if management as a group owns 15% of the shares, they can get a loan for the rest of the purchase price if the financing quantum meets structural guidelines for the lenders.
- Back ended Transaction Structure – if the seller will accept a large portion of the price in a subordinated seller note, then the buyer can use this as quasi equity in the transaction and seek a loan for the remainder of the cash purchase price.
- Seller Rollover Equity – if the seller is amenable to keeping a residual ownership percentage in the deal, this can be used as quasi equity in the deal. Much like a seller note, the buyer can seek a loan for the remainder of the cash purchase price.
Regardless of the approach, the management team still needs to bring a level of cash funding to the table to close the deal. Lenders are wary of cashless MBO’s as they represent deals where the buyer has no skin in the game.
While quasi equity is the vehicle to optimize the management investment, and deliver them majority control, it is challenging to close a deal with 100% quasi equity and zero cash equity.
In addition to these structural approaches, it is common for management teams to try and capitalize on any options they own in the company or sweat equity they have invested in building the company.
Middle market lenders are receptive to seeing options and sweat equity as valuable contributions of management team to a deal.
Due to their desire to enter into a true lending relationships with the management team, lenders flex their lending parameters to accommodate quality management teams that are attempting to transition from employees to owners.
What Types of Lenders will fund my Management Buyout
There are two types of lenders available to finance your deal – asset-based lenders and cash flow lenders. Asset based lenders can provide a small amount of financing for the purchase price but can provide larger availability through lines of credit to support working capital growth.
Usually asset-based lenders are unable to fund the entire amount of cash needed to pay the seller. Cash flow lenders can either be a unitranche or mezzanine lender.
In the case of a unitranche lender, they can provide a senior and subordinated layer integrated into one structure, making it easy to close.
A mezzanine lender is usually beneath a senior lender in the structure though they can provide all of the financing and play a one stop role on their own. Both Unitranche and mezzanine lenders operate under EBITDA multiple parameters, when sizing and approving the loan.
They must see future cash flow as stable and growing as they defer all principal payments until the end of their term, which is usually five years.
Both unitranche lenders and mezzanine lenders are comfortable funding the entirety of the purchase price if there is a quasi-equity layer and some management cash invested in the deal.
Additionally, some banks, particularly aggressive Commercial & Industrial focused regional banks, will fund a management buyout. Banks are less likely to fund 100% of the capital need like a mezzanine or unitranche lender would.
Often management teams default into thinking that an institutional equity investor is required to have enough funding for the deal.
This is simply not the case as it depends on the purchase price being paid, the amount of quasi equity in the deal and the amount of management cash investment.
If management can negotiate a favorable price with a structure rich in quasi equity, there is likely not a need for an equity investor at the table.
Different Lenders Available for Management Buyout Funding
- Asset based lenders.
- Cash flow-based lenders.
- Mezzanine & Unitranche lenders.
Usually in management buyouts, there are hefty seller notes, representing value to be paid to the seller later. The seller is considered a lender to the deal because they hold a note with the company as the maker and obligor.
There are intercreditor issues to be dealt with in this situation between the mezzanine lenders and the seller note holders. These issues include cross default provisions, interest blockage periods and standstill rights.
Most sellers wish to have fast repayment while most lenders require that seller note principal repayment occur outside of the maturity of their note term. This is a classic point of negotiation, particularly in a MBO were the seller note can comprise up to 30% of the price of the company.
Usually, lenders will relax their requirement and allow for interest payments, but restrict principal payments at least for the first two years.
What are some of things to watch out for when doing a MBO
Management buyouts are great tools for seamless transition of corporate ownership. Yet, it is easier for some management teams to manage than it is for them to lead as owners.
Most managers buying their companies are mid-career executives and may have been employees for most of their careers. Being an owner means making tough decisions that are sometimes unpopular with employees, but are in the best interest of ownership.
Doing this successfully requires a strong awareness of post-closing governance structures including board of directors’ dynamics and how the board will now deal with major corporate decisions.
Too often, management teams think that once they own the business, the board process will be smooth and easy. The reality is that the board role is now more important than ever to ensure that the execution of the growth vision of new ownership.
Board roles should be clearly defined and board committees such as compensation and accounting should be clearly delineated. This should be agreed upon before the closing so there is an orderly process in place.
Additionally, management must identify all changes they plan before they close and set out to execute them immediately post-closing. Closing a MBO is not easy and often getting the deal closed takes precedence over post-closing organizational changes.
Ownership should develop a 100-day plan and come up with a tactical transition team to ensure the delivery of the proposed changes. Lender management is also an important area to watch out for especially post-closing.
Chances are you have developed goodwill with your lender in working together to close the deal. Be sure to maintain the lines of communication post-closing and ensure they feel part of the team.
You will inevitably need their help with a covenant issue or for more capital, so the closer they feel to the company, the better.