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Wednesday, 24th April 2024 |
| Financing management buy-outs |
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| Management buy-outs (MBOs) are an attractive way of taking over a business, as a large proportion of the capital can be financed via debt. |
The total finance required for a buyout will be made up of the purchase price of the shares; the refinancing of existing bank debt; any funding requirement for investments or acquisitions, and the transaction costs.
An MBO is likely to include:
• Ordinary shares, subscribed for by the management and investors
• Preference shares or loan stock (these give the entitlement to fixed dividends but generally have very limited voting rights), subscribed for by the investors
• Senior or bank debt, usually provided by specialised acquisition finance units of investment banks.
• Revolving credit or working capital facility, supplied by banks
• Larger MBOs can include various other types of financial instrument like mezzanine and high-yield bonds. Mezzanine finance takes the form of a loan with warrants attached that allow the holder to subscribe for ordinary shares on exit (an ‘equity kicker’). High-yield bonds are usually longterm non-redeemable loans paying high rates of interest
The structure of the deal: For the sole purpose of buying the company and financing the purchase, management and the investors create a new company (Newco). In the most common structure, Newco acquires 100% of the shares in the company and thus becomes the holding company. Newco then raises different types of financing from different sources. The principal shareholders of Newco are the management and investor(s). Subsequent acquisitions will also be funded through Newco with debt and / or equity.
A possible financing structure: This example assumes a total funding requirement of 300. A third (100) is financed by equity and the remainder by debt (200). Management puts up 3 and the investor 97 of the equity.
Sources of finance: 3 Ordinary shares management (10 per cent); 27 Ordinary shares investors (90 per cent); 70 Preference shares investor; 200 Loans; 300 Total funding requirement
As you can see, management invests 3 per cent of total equity for a 10 per cent shareholding. Now, let’s move quickly forward and look at a possible future outcome. Imagine the company is sold for 1.5 times the original price (450) with 75 per cent (150) of the loans repaid from trading profits.
In this scenario the returns on exit look like this: 450 Sale proceeds; 50 Repayment of loans; 100 Repayment of preference shares (including rolled-up dividend); 270 Receipts on ordinary shares investor (90 per cent of 300); 30 Receipts on ordinary shares management (10 per cent of 300)
Management receives 10 times their original investment. The reason that management can make many times their original investment is that the increase in the company’s value accrues only to the ordinary shares. This is why it is often said that management invests in the ‘sweet’ part of equity capital. MBOs can be ingeniously engineered, financially speaking, and the leverage effect may boost shareholders returns. However, an MBO is never purely a financial play because the most important prerequisite and driver of shareholder value is a growth in company value. Without growth the model does not work. Management is expected to grow the business, invest for the future, make acquisitions and increase profits if it is to succeed in adding value over the long term.
Setting the price
Valuing a company is not an exact science. There are different valuation methods that may be employed: such as ‘discounted cash flow’, a valuation based on projections of future cash flows and their risk. There is also ‘price earnings ratios’ which is based on comparable quoted companies or those paid in comparable transactions. As a rule, though, investors like to use performance and cash flow-related valuation ratios like EBITDA to calculate purchase price (including current debt), where EBITDA stands for earnings before interest, tax, depreciation and amortisation (of goodwill).
The right price is essentially a matter of judgment and negotiation. It must be acceptable to the vendor and it must be such that the buyout financing model will work. With regard to the latter, too much debt may burden the company and too much equity may put shareholder returns under pressure. This simply means there is an upper limit on the price that can or should be paid for the business.
Investing your own money
Management is expected to invest personal funds into the buyout but its contribution to the purchase price is only expected to be moderate. It is not so much about management financing the entire transaction but more about showing their commitment and confidence in the future of the company. |
Source: CFM Capital.
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| Article appeared in the March 2006 issue.
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