AIB Acquisition Finance's Guide to MBOs and MBIs

Contents 1. Introduction 1.1 MBO - Motivations and First Steps 1 1.2 Terminology - The MBO and Variants 3 1.3 Your First Port of Call 4 2. Conditions for a Successful MBO 2.1 The Company 5 2.2 The Management Team 6 2.3 The Business Plan 8 3. Dealing with the Vendor 3.1 The Approach 9 3.2 Managing the Negotiation Process 9 3.3 Due Diligence 11 4. Structuring the Finance 4.1 Example of an MBO Financing Structure 13 4.2 Senior Debt 13 4.3 Mezzanine Finance 14 4.4 Equity 17 - The Management Team’s Investment 17 - The Institutional Investors 18 5. Conclusion 5.1 MBOs - The End is only the Beginning 22 No two MBOs / MBIs are the same although there are frequently several features in common. This guide is of an informational nature and should not be used as a ‘how to’ manual. Accordingly, those considering or in the course of undertaking an MBO or similar transaction should obtain professional assistance and advice specific to their particular situation. CEO??-????????? www.ceoknowledge.com 1.1 Motivations and First Steps There can be very few managers of initiative and ability who have not at least thought of owning their business. The freedom, the control, the rewards, and even the risks can make the idea of being in charge of your own business an attractive prospect. This can often be achieved through a Management Buyout (MBO) or a Management Buy-In (MBI) and many have been completed in recent years. Substantial numbers of people have moved from salaried management positions to become entrepreneurs in their own right. The following model demonstrates how a successful MBO has the potential to yield a very attractive financial return to the buyout team. Exampleco Ltd. is bought out by its management team. A possible Sources and Uses is set out below: 1 1. Introduction EXAMPLECO LTD. SOURCES €m USES €m Ordinary Equity Price (payable to vendor) 9.0 ‘A’ Shares (Management Team) 0.3 ‘B’ Shares (Institutional Investors) 0.7 Working Capital 0.5 Preference Shares Fees/Costs (re arranging MBO) 0.5 Institutional Investors 3.5 Bank Debt Mezzanine Finance 1.0 Senior Debt -Term Loan 4.0 - O/draft (working cap.) 0.5 Total Sources 10.0 Total Uses 10.0 A new company (Newco) is set up by the management team as the vehicle for buying out Exampleco. The price paid, €9.0m represents a multiple of 9 times Earnings Before Interest and Tax (EBIT). Thus EBIT = €1m. Afterwards, driven by a management team incentivised and commercially sharpened by ownership, the company does well. At the end of, say, five years, Newco has cleared all its bank debt and EBIT now stands at €1.75m. At this point the shareholders sell the company to a third party. Because the CEO??-????????? www.ceoknowledge.com company is now on a better footing and faces a better outlook for strong and reliable cash flow going forward, the vendors manage to command a price equivalent to 9.5 times EBIT. Newco is sold for €16.625m. After costs of €0.5m and redemption of the preference shares, €3.5m, there remains €12.625m for the ordinary shareholders. As the managers hold 30% of the ordinary equity, they receive €3.79m, over twelve times the amount they originally invested. Does it always work out like this? Obviously not. There is a real risk that the company’s value may decline and the MBO managers should be aware that their money can be lost. Generally, however, MBOs tend to work out well for the managers. The possibility of attractive financial returns is by no means the only reason why MBOs are undertaken. Other typical motivations include: • Opportunity to take control of the business, which may arise at the initiative of the management team, or of the parent company • Belief in the potential of the company • Freedom from impediments imposed by parent company • Concern about possible sale of business to third party, or loss of job Positive motivations figure most strongly - people who enter the risky environment of an MBO in search of comfort or security are not very likely to find it. The second item on the above list, belief in the potential of the company, often applies in the context of a company which is under-performing its potential due to lack of support, particularly financial, from the parent. The management team can see the intrinsic potential and perceive that an MBO may be the way to realise it. There are other circumstances which can provide the initial impetus. MBOs commonly arise in family businesses. There may be retirement and succession issues together with the desire to convert all or part of the family shareholding into cash while seeing the business continue in operation, perhaps maintaining the name and providing continued security for the employees. These all combine to make the MBO an attractive exit option for the family shareholders. Of course it does not have to be all or nothing: sometimes the family may wish to recapitalise the company such that it can reduce its shareholding and release cash. 2 CEO??-????????? www.ceoknowledge.com It takes different skills to buy a business than to run it and MBOs are often perceived as involving complexity, cost and risk. There may be uncertainty and a lack of knowledge as to how to proceed, and it would be misleading to minimise the task. It is true that MBOs necessitate bringing together a set of disciplines and expertise not normally available to the management team, and the process can be complex. The good news is that it is quite easy to move beyond that initial point of uncertainty and you will find that the path is well trodden. An exploratory discussion with our experts whose business it is to structure MBOs costs nothing. You will quickly come to see that if you are managing a business which is capable of standing alone, the advice, the backing and the expertise to make it happen for you is available. Nevertheless you need to understand what you are getting into. This guide is intended to explain the issues in a straightforward manner. It sets out to give the manager an appreciation of what is involved in an MBO, and to offer the expertise available from AIB’s Acquisition Finance Unit to carry the project through to a successful conclusion. 1.2 Terminology - The Management Buyout and Variants Most MBOs arise when a firm sells a subsidiary company or division. Where the company is being bought out by its own management team (or part of the team), the transaction is described as an MBO. The MBO will be largely financed by debt because: • Managers do not normally have sufficient personal funds to purchase the company without recourse to debt • To the extent that personal funds are available, managers may wish to restrict the amount committed to the buyout • Managers may wish to limit the amount of external investment from sources such as venture capitalists in order to retain as much control of the company as possible • Debt is cheaper than equity • Institutional investors will want to see leverage in the transaction with a view to optimising their own returns Variants such as the Employee-Led Buyout, the Management Buy-In (MBI) and the Buy In Management Buyout (BIMBO) can confuse the picture by adding to the body of terminology and suggesting that very different types of operation are involved. 3 CEO??-????????? www.ceoknowledge.com By and large the essential transaction type is the same. The variants refer primarily to the parties to the transaction. Thus for example an MBI differs from an MBO in that the purchasing management team is external to the company being bought out. While this gives rise to some special considerations, these largely concern additional risk factors such as the lack of a relationship with the owners and lack of access to internal information. The basic fact that a company is being bought out using leverage (debt) does not change, nor do the basic mechanisms by which the deal will be done. 1.3 Your First Port of Call What stage are you at now? • You are thinking about an MBO but have not raised it with anyone yet. You may be in two minds about making that initial approach to colleagues or owners • You have decided you want to proceed, and are considering how to begin • You have commenced the process and need to discuss structuring the deal At any of these stages it is time to have an exploratory discussion, in complete confidence, with our team of MBO experts. We want to invite you to talk to the Acquisition Finance Unit at AIB. We should be your first port of call for the following reasons: • We can quickly make an initial assessment of the idea and provide feedback on whether it is worth taking to the next stage. Consultation can also be provided on the initial approach, and putting the MBO support team together • Debt is an important element of your MBO’s funding package. Senior debt followed by Mezzanine debt are your least expensive forms of finance. The appropriate mix will depend on risk and cash flow considerations. Only your bank can advise definitively on the levels of debt that can be made available • Your bank is in a position to suggest the financial structure, assist in the location of equity partners, and deliver on the debt elements When does it start costing? A discussion with the Acquisition Finance Unit costs nothing. Before you get into producing business plans or incurring any other costs talk to us. With no obligation, get a feel for the likely total costs of the project. 4 CEO??-????????? www.ceoknowledge.com For an MBO to work out successfully for the purchasing team, two essentials are paramount: • The entity being purchased, whether a subsidiary company, or part of a company such as a division or business unit, must be cash generative • The purchasing management team must be strong If either of these fundamentals are not solid, either the MBO will have difficulty completing or will quickly run into problems post-completion. Accordingly it is recommended that careful consideration be given to Sections 2.1 and 2.2 before going further with a planned MBO. 2.1 The Company The company may be operating in any sector and MBOs occur in all types of businesses. The predictability of cash flow is the most important determinant of whether a proposed MBO will receive the necessary financial backing. In today’s environment of rapid change, one can no longer entertain bias in favour of (or against) particular sectors based on characteristics traditionally attributed to them. Thus it would be incorrect to assume that high tech companies operate in too competitive an environment to attract backing for an MBO, or that service companies are too dependent on key people and that the barriers to entry are too low. While such factors may well be significant they will be taken into account as part of an overall assessment, to be made on a case by case basis, designed to ascertain the likely level and dependability of future cash flow. In whatever sector the company operates, it should display the following characteristics: • The company should be well established, have a good trading record with an established product range, a positive trading outlook and a strong position in its market. Ideally there should be identifiable barriers to entry • The company should be operating in a stable sector, not overly susceptible to cyclicality or volatility in the market place • The company should have debt capacity to enable gearing up and should have strong positive cash flows with a high degree of predictability It should be pointed out that having all of the above represents an ideal situation and one which is uncommon in the real world. The reality is usually more complex. Among the features which can give rise to complexity and which will affect the structure of the buyout are: 5 2. Conditions for a Successful MBO CEO??-????????? www.ceoknowledge.com • A buyout of a division of a multi- national with relatively few customers and under-developed management functions • Companies with significant risk concentrations in the areas of suppliers or customers • Service companies with a heavy reliance on a number of key individuals • A substantial degree of earnings volatility • Complex family shareholder issues which have to be dealt with sensitively when structuring the buyout The key to proceeding is a considered and tenable view that the positive fundamentals outweigh the negative. 2.2 The Management Team Most people rise to the challenge. The usual observation is that managers who become owners improve the team’s performance, sharpening its attitudes with regard to tight and professional management. It is necessary to ensure that the enthusiasm and excitement which are part and parcel of an MBO do not overtake hard-nosed realism in the matter of business and cash flow projections. Any error should be on the side of conservatism. The team must protect what it is proposing to buy. It is essential not to allow the business to suffer while the energy that should be going into managing it is instead going into the MBO. The managers must be able to make a financial commitment to the project themselves. However, this does not mean that they should have major financial resources at their disposal - most employee managers do not. The investment made by the management team will typically represent a small proportion of the total funding of the buyout. The credibility of the team leader is of great importance, particularly in smaller projects where one strong central individual must usually be the driving force, providing most of the vision, energy and ability to co-ordinate the project, bring the MBO through to a successful conclusion, and lead the company thereafter. This means a thorough 6 CEO??-????????? www.ceoknowledge.com professional, not an autocrat. Investors are rightly wary of getting involved with the latter. The team needs to have strength in depth and this is particularly important for larger MBOs. A balanced, professional management team possessing all the critical skills to run the business successfully is essential. The ability of each individual to adapt to serious change and a less protective corporate culture must be taken into account. Bear in mind also that institutional backers will seek detailed information/references regarding the team members. They require the comfort of knowing that their investment is in safe hands. 7 UK MBO / MBI MARKET MBO MBI TOTAL Value Average Value Average Value Average Number (Stg £m) (Stg £m) Number (Stg £m) (Stg £m) Number (Stg £m) (Stg £m) 1990 492 2,450 5.0 112 645 5.8 604 3,095 5.1 1991 457 2,184 4.8 124 732 5.9 581 2,916 5.0 1992 456 2,567 5.6 138 736 5.3 594 3,302 5.6 1993 393 2,077 5.3 99 701 7.1 492 2,778 5.6 1994 409 2,610 6.4 150 1,129 7.5 559 3,739 6.7 1995 382 2,982 7.8 216 2,641 12.2 598 5,623 9.4 1996 435 3,699 8.5 207 4,157 20.1 642 7,856 12.2 1997 453 4,487 9.9 246 5,823 23.7 699 10,310 14.7 1998 467 5,036 10.8 217 9,904 45.6 684 14,940 21.8 1999 455 8,057 17.7 189 8,653 45.8 644 16,710 25.9 2000 421 9,460 22.5 167 14,369 86.0 588 23,830 40.5 2001* 192 4,093 21.3 86 8,896 103.4 278 12,989 46.7 Source: CMBOR / Barclays Private Equity / Deloitte & Touche * Year 2001 figures are for first 6 months only CEO??-????????? www.ceoknowledge.com 2.3 The Business Plan The business plan is the most important document the MBO team will produce because without a well thought through plan, underpinned by supportable assumptions, the MBO will not make it through the finance raising stage. The business plan may be put together with or without the benefit of professional assistance. The two most important points to bear in mind in preparing the business plan are: • The plan is your blueprint for the objectives, strategies and tactics for the future. It has an important role in defining and clarifying your way forward • The plan is your key marketing document. It will be critically read and tested by prospective backers. Do not lose credibility by offering anything less than a realistic, professional and comprehensive production The plan should possess certain characteristics, and it should provide certain information. The characteristics include clarity, relevance, structure, and concise but comprehensive treatment of all relevant issues, both positive and negative. The appropriate contents vary from case to case but should normally include: General Information • The company’s background, history and trading record and current organisation • Detailed information on the company’s management team • Product/Service descriptions, development plans and marketing strategies • Market, market position and competitor analyses • Detailed strategic rationale for the proposed MBO Financial Information • Comprehensive historical accounts. Normally three to five years audited accounts will be sought by backers • Current budget, management accounts and medium/long term (3 to 5 years) financial projections (P&L, balance sheets, cash flows) • Present financing arrangements of the company 8 CEO??-????????? www.ceoknowledge.com 3.1 The Approach When an MBO has been successfully completed, the vendor will often remain a useful customer, contact, or indeed investor. So take care with this crucial relationship. The initial approach to the vendor may be the most delicate move that the MBO team will have to make - the situation varies. In the case of a company which is non-core and knows that it is for sale or soon will be, the situation is straightforward. In other situations, particularly where family firms are concerned, the approach may need to be very sensitively handled. It is important to maintain good relationships whether the MBO proceeds or not. The MBO team may wish to consult with an adviser or institutional backer as to the best method of handling the approach and indeed may ask the adviser/backer to make the approach on its behalf. This can be an astute move because these parties have a lot of experience of handling such situations. Bear in mind that the requirement to maintain confidentiality about the company’s business will normally be part of the manager’s employment contract together with a requirement to apply full-time effort to the management of the company. Judgements must be made in each situation as to the most appropriate way of progressing the discussion. There are some good reasons for making the initial approach to the vendor very early in the process: • There is no point in incurring costs and putting in a lot of planning effort if the owner is not disposed, even in principle, to sell • If the owner is well disposed to the MBO bid, there may be a willingness to allow the MBO team to get its offer together before negotiating with other prospective purchasers. This will usually be built into the Heads of Agreement described below • Backers will require a depth of internal information about the company which cannot be delivered without the owner’s consent • An early idea of the owner’s price expectations may be obtained 3.2 Managing the Negotiation Process Once the initial approach has been positively received, the MBO team can enter negotiations. Depending on relationships, the negotiations may be fronted by the MBO leader, by an adviser, or investing institution. The main advantage of the MBO leader is his close understanding of both the company and the vendor (although this may not be the case in an MBI situation unless incumbent management are also involved in the team). 9 3. Dealing with the Vendor CEO??-????????? www.ceoknowledge.com The main advantage of the latter two is that their more impersonal ‘outside expert‘ role makes it easier for them to raise difficult issues, and drive hard bargains without upsetting the relationships. Both the purchaser and vendor will wish to establish the other party‘s commitment and this is normally achi