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Management buy-outs make bold offerings Back  
Dave Savage asks what motivates a management team to launch a buy-out of the business for which they work.
Quite likely, it is a combination of self-esteem, a sense of achievement or a belief that the company for which they work is undervalued. But whatever the reasons, there is no doubt that management buy-outs (MBOs) are becoming more and more common in Ireland.

In the past year, we have witnessed the sale of Jefferson Smurfit to a private equity-backed management group for more than E3 billion. Green Property was taken private by its chief executive in a E1 billion-plus deal backed by Bank of Scotland (Ireland) while in the public company sector alone, there are currently reported management negotiations pending for Riverdeep, Alphyra and Conduit. According to a recent survey of the financial sector by the Sunday Business Post there are 17 Irish PLC’s identified as possible targets to be taken private during 2003.
Management buy-outs may occur where a company wants to divest itself of what it sees as a non-core activity.

Possibly the best examples of these in recent years were the MBO of Cantrell & Cochrane from Allied Domecq and the sale of BWG Group by Pernod Ricard to a management group backed by Bank of Scotland (Ireland) as part of a syndicate of bankers.

Buy-out options can also occur where the owners of a family-run firm wish to retire but then find out that there are no members of the next generation willing or able to take on the running of the company.

In all cases of potential MBOs, however, the prospect of success will inevitably come down to the vendor being willing to sell for a reasonable price. In some cases, the vendor may have an emotional or sentimental attachment to the business that has been built up and this may colour the assessment of the company’s worth.

Apart from a company’s wish to divest non-core businesses and a management group’s desire to take control of an asset they believe is undervalued, the recent surge in MBO activity has been aided by a number of market-related factors. These include:

• the decline, in the past couple of years, of domestic and international equity markets (in the Irish market the ISEQ is currently down 25 per cent on the year to date)
• the historically low levels of interest rates.

The initial stage in evaluating an MBO proposal would usually involve the management of the company conducting a detailed appraisal of the company to decide whether the MBO can be funded. The typical characteristics of a feasible MBO proposal are that the target company has strong cash flow, a low level of debt, good quality assets and a willing seller. The business should have strong growth potential and a strong management team, as once the deal is done the MBO instantly becomes a MOB (management-owned business).

However strong the management’s desire to own their own business is, the price they pay for the business must represent good value. There are many ways of determining ‘good’ value including asset value, multiples of profits or turnover and also the cash flow generated by the business.

But management groups contemplating an MBO should be wary of values set by other bidders and particularly any element of goodwill or ‘hope value’. Business plans must be realistic and at the same time must stretch the company’s resources. It is far better to have over-achieved a performance target when visiting the bankers at the end of the first year than have fallen short of an over-ambitious performance target.

Management groups should also consider bringing in a trade partner as an equity investor. Not only can such a trade partner provide a greater level of equity - and a corresponding lower level of debt - but it can also provide production and marketing expertise as well as an enhanced distribution network for the MBO company’s goods or services.

For the banks and investors financing a management buy-out, an essential element is a detailed due diligence which will include some or all of the following elements: an assessment of the company’s commercial and financial performance, accounting controls, property and valuation, taxation, legal and environmental issues.

In most MBOs, funding for the transaction will come through a combination of equity from a venture capital house and/or private equity investors as well as some equity from the members of the management group themselves. In smaller transactions, the equity financing might come from a single provider or the management group, while in larger transactions a syndicate of venture capital houses or private equity firms might combine to provide the equity finance.

Mezzanine finance is becoming increasingly popular in financing MBOs as it bridges the gap between senior debt and equity and forms an integral part of the MBO financing package. Frequently businesses have sufficient cash flow to service a level of debt in excess of the senior secured debt. This is where mezzanine finance fits in as it is secured behind the senior debt or in some cases it is unsecured. Because mezzanine finance is higher risk the returns required are also higher and include a reasonable margin, interest roll ups, redemption premiums and in some cases share warrants.

In many cases, the terms of the transaction will allow the management group to increase their equity holding over a period of years subject to performance targets being made. The financing package should ideally also make allowance for incentives such as share options to as many key personnel as possible. Consideration could also be given at this stage to a number of ways in which all employees could own shares in the new business.

Most MBO deals will also include some element of subordinated debt such as redeemable or preference shares or vendor loan notes (deferred consideration). The choice between the different subordinated instruments will depend on the size of the deal with all of them probably being used for very large transactions. In smaller transactions, mezzanine debt is the most common.

The final element in the MBO finance package is bank debt, or senior debt, which can be broken down into various tranches - property loans, invoice discounting, asset finance and working capital. The senior debt will either come from a single bank or from a syndicate of banks headed by a lead bank, which sets out the parameters of the deal and acts for the other banks in the syndicate.

While financial advice in essential for a management group contemplating an MBO, legal advice is also a must. The management group will have to ensure that all Companies Act requirements are met while employee rights such as protection of employment also need to be addressed. Other issues that need to be investigated include contingent liabilities, potential litigation and issues relating to the company’s pension scheme.

Those contemplating an MBO should also be aware of the costs and input associated with retaining professional advisers - corporate financiers, accountants, lawyers, stockbrokers etc., who all need to be paid. Managers will also need to be aware that at the time they are investing their time in the long hours putting together a takeover package, they also have to continue to manage the company.

Venture capital houses and private investors who finance an MBO generally have a three to five-year timescale to realise their investment. The exit mechanisms will depend on a number of factors and in larger cases it will be the state of equity markets. But those involved in an MBO - both management and investors - should not depend on a stock market flotation as an exit mechanism as was illustrated earlier this year when Cantrell & Cochrane abandoned its planned flotation.

The other exit mechanism includes the management group itself buying out the equity investors and taking 100 per cent control of the company or else a trade sale of the MBO company to another company.
Owning one’s own business can be an extraordinarily rewarding experience - both in financial and emotional terms. But the process demands hard work and long hours. It requires the management group to be comfortable with each other and to be sure that there are no weak links in the group.

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