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As an investor in both the private and public markets, I have spent a lot of time evaluating management teams. One important factor I always consider is whether the management team is aligned with shareholders; do they have “skin in the game?”
Management teams can tie their livelihood to the performance and value of the company they manage in a number of ways – stock, stock options, performance-based compensation. However, there is no more significant way for a management team to align themselves with the company they manage than in a management buyout (MBO).
By going all in, management can be handsomely rewarded in an MBO. Michael Dell reportedly became $12 billion richer through the management buyout of his company, Dell Technologies, a deal that he executed with Silver Lake Partners in 2013. This sounds like a great outcome, but what is the management buyout process and how does it work?
What is the Management Buyout Process?
In its simplest form, a management buyout (MBO) is a transaction in which the management team pools resources to acquire all or part of the business they manage. MBOs can occur in any industry with any size business. They can be used to monetize an owner’s stake in a business or to break a particular department away from the core business. In some cases, an MBO will take a company from publicly-traded to private.
An MBO is typically a more specific form of a leveraged buyout (LBO) - a transaction in which a company is purchased with a combination of equity and debt, such that the company’s cash flow is the collateral used to secure and repay the borrowed money. Since management teams rarely have the financial resources to buy the target company outright, they generally need to raise debt in order to finance the buyout. I find that the following video distills very succinctly how LBOs (and subsequently, MBOs) work in practice.
The origins of the leveraged buyout can be traced to the 1960s. The acquisition of Orkin Exterminating Company in 1964 was one of the first significant leveraged buyout transactions. The 1980s saw a boom in buyouts, fueled by the emergence of high-yield debt or “junk bonds.” It is estimated that there were over 2,000 leveraged buyout transactions, cumulatively valued in excess of $250 billion, between 1979 and 1989 (Journal of Finance).
What are the Incentives to do an MBO?
There are compelling reasons/motivations for both sides (seller and buyer) to execute an MBO. For an owner that wants to retire and cash out, an MBO gives them peace of mind that they are passing the company along to a group that they know and trust. This can be particularly important for a family business or a company that employs a large number of people in a small town – a company’s legacy really matters in these situations.
The management buyout process also has tactical advantages for the seller. Doing a deal with company management reduces the risk to the owner of confidential information being disclosed during the sale process. Additionally, the closing process can be quicker since the buyer, who has been managing the company, knows the asset well.
MBOs can also be enticing for a corporation as they can use an MBO to “go-private” and execute a long-term turnaround outside of the public eye (as in the case of Dell) or sell/divest a division that is not core to their business or of interest to their shareholders anymore.
An MBO is also compelling for a management group – the buyer. Management wants to earn more direct financial rewards for the hard work they are putting into growing the value of the company. A management team that pursues an MBO is confident they can use their experience and expertise to grow the business and improve its operations. Therefore, they want to invest in themselves by investing in the company they are running.
For confident management teams, an MBO is often the easiest, quickest, and least risky way to take a meaningful ownership stake in a business. In an MBO, the buyers have had an inside look at the asset they are buying; this should reduce the risk of the investment.
Stakeholders beyond the buyer and seller can also benefit from an MBO. Lenders, who often help finance these transactions, customers, suppliers, and employees are all fans of MBOs. Because the existing management team is staying in place, these various constituencies gain comfort that the company’s operations and service will be continuous.
How is an MBO Undertaken?
Executing an MBO is a multi-step process.
First, the management team needs to build experience and credibility with the company’s existing owner or owners (hereinafter “owners”). This is not a short-term action. The management team will achieve this over time by:
- Doing a good job of operating the company, and
- Communicating with the business’ owners in a consistent, straightforward manner.
Aside from their families, this company is likely the owners’ most treasured asset – they will only leave it to a management team that they deem both competent and trustworthy.
Next, the management team will identify an opportunity to purchase the company for which they work and come up with a plan to purchase the asset. The “identification” of the opportunity can be catalyzed by a number of events:
- The current owners of the business may be retiring and not have someone to pass the business onto.
- The management team may simply decide that they want to be owners of a business and decide that they will look for another opportunity if they can’t own the business they are managing.
- The business may be underperforming and the management team (or even former management team) could have a different strategy in mind than that employed by the current owners.
I once worked with a group of managers that attempted to buyout a publicly-traded, specialty retail company at which they used to work – they felt they had a better strategy than that being pursued by the existing management team. This fueled their desire to start the process, as it allowed them to focus clearly when communicating their vision to the relevant stakeholders
Below is a diagram outlining all the steps of the MBO process; I will walk through it in the next section.
Pre-Offer: Initial Steps Taken
Regardless of what sparks the opportunity or desire to own the business, the management team needs to start planning – what will they pay for the asset and how will they run it post-purchase? This planning stage involves a number of tasks, including building a financial model, figuring out valuation terms, laying out their strategy for running the business, and identifying the team members’ individual responsibilities within that strategy. In terms of valuation, management can perform all the textbook corporate finance analyses they want, but they need to be prepared for the owners to have an ambitious view of their company’s valuation – they always do.
During this planning stage, the management group should leverage their experience with the company to memorialize the key risks/questions they have regarding their investment in the purchase of the business.
Having completed their initial work, the management team then approaches the owners with an offer to purchase the company. This step is more art than science and can be done in different ways depending on the relationship between the management team and the owners. In some cases, the management team may have an informal conversation with the owners in which they express their interest and provide high-level thoughts on their valuation terms. In other cases, the management team may send a formal letter, including their specific terms for the transaction, to the owners. Regardless of the method employed, the goal of the management team (prospective buyer) at this stage is to adequately express their interest in a transaction, gain insight into the owners’ (prospective seller) interest in a transaction and sell the owners on why the current management team is the best buyer for the asset.
Sometimes, this step happens in reverse. The owners will approach the management team about buying the company. The owners will have a value for the company in mind. The management group will then have to decide if this is a value they can stomach – can they pay this amount to purchase the company and still make an acceptable return on their investment?
Post-Offer: Funding and Execution
The next step is for the management team to raise the money to purchase the business. The management team typically doesn’t have enough money to completely fund the purchase themselves. Consequently, the management team will seek financial partners, which can include financial sponsors/private equity firms, banks, and/or mezzanine lenders. This stage of the process will require the management team to sell both the asset and themselves to potential financing partners during investor/lender presentations and one-on-one meetings.
The final step before closing the deal is due diligence. The management team and its financing partners “kick the tires” and try to learn everything they can about the business. The key questions/risks list that management made during the planning stage should guide their work at this stage – management should seek to answer and mitigate all the questions and risks. Additionally, management and its partners should ensure there are no previously unknown risks or liabilities that add risk to the transaction (potential loss of major customer, outstanding litigation, liens on assets, etc.) Often, buyers will outsource due diligence tasks to various experts. Actions taken during this stage may include a quality of earnings analysis, a market size analysis, and a review of legal and regulatory issues/obligations. During this stage, the buyers and their legal team will concurrently negotiate the purchase agreement and other legal documents necessary to close the purchase.
In an MBO, the diligence process should be abbreviated (vs. a deal in which the asset is being purchased by an outside party) given the buyer’s intimate knowledge of the asset. Still, it is important for the management team and their partners to perform customary diligence.
Planning is Key
A successful MBO process is all about planning – planning of strategy for the business, planning of responsibilities across functional areas and planning of the objectives and time horizon for the deal/investment. Before the deal has closed, the management team should have all of their planning complete and should be running the business as they will after purchasing the company.
Robert Napoli, formerly with First West Capital and now with Promerita Capital, states:
“The key to a successful MBO for the management team is to as fully as possible transition the management of the business before the buyout occurs. This means having all critical functions managed by the buyers, including sales, operations, research and development, customer service and accounting. This reduces the risk of any ‘skeletons in the closet’, and demonstrates to funders that the management team can successfully run the business, opening up more funding sources, including lower cost debt options.”
How are MBOs Funded?
In most cases, the management group will need help footing the bill for the company they are purchasing. In these cases, the transaction is often structured as an LBO. In this arrangement, the management team funds a portion of the equity (similar to a down payment on a home) with their own capital in order to ensure they are actively incentivized to grow the earnings/profit of the business. This investment shows the other financing providers that the management team is committed to the transaction and business. Depending on the size of the deal, the down payment or equity check could be pretty high. As a result, the management group often partners with a private equity group that provides additional equity capital.
The equity capital providers, which is the group that will own the business, will then raise debt in order to fund the remainder of the deal. This debt could come from a bank, a CLO, or a mezzanine capital fund. By raising debt financing, the equity holders (management group and its partners) reduce the amount they have to pay in order to purchase the company. Financing the deal with debt also increase the potential returns – IRR or “internal rate of return” is the return metric in MBOs – for the equity holders in the deal.
The diagram below shows visually how the funding of an MBO all fits together structurally.
Examples of Successful MBO Processes
In order to make the theory sound more tangible, I will now walk through an example of a real-life MBO and how all the pieces of the puzzle all came together.
1. Atchafalaya Measurement, Inc.
The management buyout of Atchafalaya Measurement, Inc. (AMI) is a great example of how to finance a management buyout when the management group has limited resources.
AMI is a Louisiana-based oil and gas services company. The founders/owners were ready to retire and wanted to leave the company in the hands of two of the company’s young, talented managers – the founders/owners wanted to reward these managers for their hard work and did not want to sell the company to a competitor. The managers were interested in purchasing the company but they could not fund the $15 million purchase price. They found it would be difficult to secure a loan for the total amount of the transaction value and they also weren’t interested in personally guaranteeing a loan. To solve this problem, the management team partnered with a private equity group.
The private equity group provided 100% of the equity for the deal and offered management a 20% equity opportunity with the ability to earn significantly more equity as the business grows. The private equity group also helped arrange the debt financing for the deal – having a financial sponsor partner often gives the lender more confidence in a management buyout structure. As a result, post-closing, AMI’s capital structure consisted of debt and equity (the owners); the private equity firm owned 80% of the company and the management group owned the remaining 20% of the company.
2. Incentivizing Management
When I worked in private equity, we facilitated management buyouts. Our firm often purchased a company from its founders – we were typically the first institutional capital in the company. We would provide the majority of the equity capital and arrange debt financing.
We always made sure that the management team had a decent share of the equity (the company), up to 25%-30%. In some cases, the management team had ownership in the company before our deal and they would roll that ownership stake into the new deal. Other times, the management team would tap into their personal net worth in order to fund a portion of the purchase price and earn equity. In cases where the managers had limited resources, we would grant stock options so that they built equity over time and with good performance. While these options would dilute the ownership of existing shareholders (such as ourselves, the private equity owner) as these options were exercised, we were fine with this dynamic as these options were a powerful motivation tool for the management team.
Factors that Contribute to Failed MBOs
So far, an MBO sounds like a pretty great arrangement. A team of seemingly capable managers buys a business they know well. The management team executes their well thought out strategy, thereby increasing the earnings power and value of the company. As a result, the management group and their financing partners reap the rewards of owning this more valuable asset. At the same time, the business’ other stakeholders (employees, vendors, etc.) can be part of a stable going concern.-
Don’t be fooled, though. An MBO can go wrong. The common mistakes/pitfalls with an MBO include:
- Lack of defined leadership – The management group (buyer) needs to have an operator identified to lead the business. The investor group cannot have a “management by committee” approach. While agreeing on who this CEO should be is not an easy task, it is something that must be done before the investor group purchases the asset.
- Different Expectations among Partners - The management team and their partners (the other investors) are not on the same page with regards to the time horizon of the investment or the strategy for the business. Duration mismatch is a common issue when a management group partners with a private equity group – the management team might make decisions with a 20-year hold period in mind while the private equity group has a five-year hold period.
- Financing the deal with too much debt – This is a risk in any buyout, not just with management buyout funding. Debt helps juice returns in a buyout, but it also reduces the margin for error in a buyout. The recent Toys “R” US bankruptcy is a great example.
- Lack of ownership experience – A management buyout deal is often the management team’s first experience in owning an asset. There is a difference between managing an asset and owning an asset.
- An MBO may not be the best deal for the Seller - By nature, the sale of a company to its management team tends to have a streamlined process. Consequently, this process could restrict other potential buyers from taking a look at the asset. Additionally, the management team, who is looking to purchase the company, may be incentivized to impair the near-term results of the company (prior to executing their deal) in order to drive down the purchase price (sounds vicious but it happens).
How Do You Protect an MBO from Going Wrong?
The good news is that a lot of these pitfalls can be avoided with a well-designed management buyout process. I have found the best way to create and maintain a process for transactions, especially management buyouts, is with the help of an independent advisor.
The management team still has a day job, running the company, so it’s unreasonable for them to successfully execute a deal without some help. A good advisor will tell the management team what they should expect at each stage, perform valuation analysis, manage the diligence tasks and most importantly facilitate conversations within the management team and between the management team, seller, and financing partners. No deal is the same but an independent advisor can leverage their experience from previous transactions to help solve any issues or obstacles that develop. One common trait between deals is that issues always pop up!
Any successful MBO process should consider the following tips:
- Transparency – All parties should be very clear with their expectations regarding the key deal terms and the strategy for the business post-closing of the deal. One of the first things an advisor will do is meet with all members of the buyer/management team to go over the process, the strategy for both acquiring the company and then post-purchase.
- Sustainability - Make sure the business that is being purchased can comfortably support the debt that is being placed on it. Run sensitivity analyses. Think of a bad operating scenario and see if the business can still service its debt in that scenario. Make sure the advisor is experienced in financing modeling; that way, they can work with management to construct financial scenarios and perform the necessary analyses based on these scenarios.
- Skills blend - Be sure the management group that is purchasing the company has the right combination of skills. You don’t want four CFOs running the Company. This issue will be addressed in the advisor’s initial meeting with the team and will be a constant discussion throughout the process. Diligence may reveal that the company needs to add capabilities to its management team. The advisor will help the management team discover and understand these needs.
- Share the wealth – the management group should consider sharing equity with employees at the company. This could be done through the outright issuance of shares or a combination of performance-based and time-based vesting options. A shared incentive structure will be a powerful driver of successful outcomes for the business. An advisor can share insights based on successful incentive structures they have seen in prior deals.
- Keep it low-key – The management group shouldn’t tell everyone what they are up to, they don’t want to let word get out. This could distract the company’s key stakeholders and/or trigger an auction process that could cause the management team to lose the asset. Advisors are used to working in discrete situations. They can help management with being very careful and efficient in their sharing of information.
Alternatives to Management Buyouts
For sellers, there are alternative liquidation/exit options for their business, beyond an MBO. Below, I have summarized these methods and their respective pros and cons.
|Sale to a Third Party||Clean and simple exit for the owners. An auction will likely maximize the value the seller can receive for the business.||It can take time to find a third party buyer for a business. The seller will likely not be familiar with the buyer and consequently will have less certainty that the legacy of the company will be maintained.|
|IPO||Allows owners/sellers to monetize a portion of their stake and still maintain ownership in the public company stock.||Going public is an expensive, laborious process. The seller has no control over who will own the company in the public market.|
|Recapitalization||Owners/sellers can monetize a portion of the business by selling a minority stake. Also provides time for a new minority investor to learn about the company.||Owners probably can't completely retire and have to stay involved with the business for longer.|
|Start a new Company||The management team can follow their exact desired strategy and won't have to change legacy features they might not agree with at an existing company.||Starting and scaling a new business is very difficult and risky; it would probably be more difficult to receive funding to start a new, unproven business than it would be to receive funding to purchase an existing, proven business.|
|Find another Company to Buy||By expanding the search beyond the company where they currently work, the management team increases its chances of finding a willing seller; may be easier to transition from managers to owners at a new company than at the existing company where all the employees may still think of them as managers and not owners.||The management team will not have an intimate knowledge of the company/asset which could hinder returns.|
In Summary: Wait for the Perfect Conditions!
There is no simple formula that suggests the best method by which to transfer ownership of a company. Provided the right conditions are in place and a sound process is followed, an MBO can be an attractive option for both the sellers/current owners and the management team.
- A quality management team that has a strategy for the business post-purchase.
- A company/business with strong cash flow generation.
- Market/due diligence ready company.
- A private equity group/financial sponsor that is willing to partner with the management group.
Understanding the Basics
What are LBO and MBO?
A leveraged buyout (LBO) is when a company is purchased using a combination of debt and equity, wherein the cash flow of the business is the collateral used to secure and repay the loan. A management buyout (MBO) is a form of LBO, when the existing management of a business purchase it from its current owners.