Converting

With the superfluity of money available in private equity and bank debt to fund management buyouts (MBOs), it may appear that they are an easy way to make a fortune. But there have, in fact, been notable examples of both successes and failures.

In the past two issues, we have looked at why businesses get sold and the optimal timing for a sale. In this last column, we will examine the process, or the “how”.

In an MBO, a business is acquired from shareholders by its management, often backed by an equity co-investor, which pays a large proportion of the price by raising debt against the value of the business.

Over the course of the investment, the management increases the profit and reduces the debt, so that when it comes to selling the business – usually after a period of three to five years – its equity value will have grown substantially. This is then split between all equity investors.

Strong management
The high incidence of MBO failures, however, indicates that they are not as simple as they first appear. There are a number of factors that can make or break them.

- The management team: this is the most important factor in any MBO. It must have the right combination of abilities and motivation. Of course, varying business conditions will affect the venture, but without good management, there is no basic foundation for the business.

- Management skills: the management team must be adequately skilled to run the business for profit and growth.

- Aims: management must have come on board for the right reasons. Having clear objectives and proactively advancing buyout is a good sign. The team needs to build a strong plan and avoid excessive optimism.

- Motivation: management must be incentivised. If it owns too small a part of the business, or if the prospects for success are remote, its commitment will suffer accordingly. Most investors will insist that management invests a significant amount in the venture (often one year’s salary).

- Debt burden: if the business has taken on high levels of debt, the monthly interest payments can be onerous and present a risk to solvency. Repayments of interest and capital must be negotiated with some flexibility if cyclicality of cash flow is going to be an issue.

- Due diligence: this is often not an issue in these cases, because the management knows the most about the business being sold. However, if a new team has been introduced or if they have had little experience of running the group, due diligence must be conducted.

- Private equity: banks are often more willing to lend to a venture if a professional investor has some involvement. Private equity investors will also subject any investment to a high degree of due diligence. Therefore, they don’t fail as often as management-only-backed buyouts. Private equity is sometimes essential to provide the top layer of finance, but it is not a necessity and will result in a dilution of equity and control.

Masked failures
In summary, while it is true that there are high-profile examples of failed MBOs, there are not necessarily more failed MBOs than other types of failed business. It is just that other failing firms are often part of larger groups, so their failures are masked by bail-outs from head office. However, a highly leveraged MBO is normally put into receivership if it fails to make repayments; a strong argument that MBOs can be better for shareholder value and economic efficiency.

The high incidence of failed MBOs in the printing industry is, unfortunately, reflective of the high number of struggling businesses in the sector in general and the fragmentation of the industry – since most failed MBOs are under £10m in value.

There is no need for pessimism, though. Some of the most successful listed companies in packaging, including RPC Group and Field Group (Chesapeake Corporation), were once MBOs. Furthermore, businesses such as Clondalkin have gone from strength to strength since their buyouts.

Nicholas Mockett is a partner at Europa Partners. Contact him at nmockett@europapartners.com


30-second briefing on... how to launch a successful MBO
- Having the right management team, with a strong mix of skills and experience, is essential to the success of an MBO

- Do not be tempted to pay over the odds for a business, as this can potentially scupper the chances of its success from the start. This is because it will overload the business with debt and thereby reduce the chances of successfully selling it on for a profit

- Determine what the long-term prospects of the business are. If they are poor, the MBO period will always be a struggle, regardless of how effective the management team is. Good long-term prospects also improve the chance of a successful exit from the business and will substantially boost its price value

- Management must be honest when creating a business plan. Unrealistic forecasting will create over-optimism and can exacerbate the burden that debt repayments can have on the business

- If the company is part of a bigger group, going solo may have an adverse effect on the day-to-day running of the firm. The effect that the departure of the current owners will have must be realistically assessed

- The type of funding needed to launch a management buyout must be appropriate for the business. Just because banks offer enormous debt packages, does not mean that they are suitable for every business. While private equity is sometimes essential, it will dilute equity and control

- While many MBOs do eventually fail, many also survive and thrive in the packaging industry. Clondalkin is a good example