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Taking the Reins - The risks and rewards of a management buyout

For most managers, conducting a management buyout (MBO) can be a life changing experience. An MBO offers the management team (either as a whole or a few individuals) an opportunity to purchase the business from its current shareholders, usually with the backing of a private equity fund. The transaction allows the individuals involved to enjoy a significant stake in their own business and be given the opportunity to “run the show”.

12 July 2009

Numerous high profile stories have drawn attention to the potential rewards of a successful MBO. Among such stories is that of Olex Cables which was purchased from its previous owners Pacific Dunlop Limited in 1999 by its management team. Seven years later, the business was sold in a private trade sale realising an internal rate of return of 20% or 3.5 times the initial investment.

Recognising an MBO Opportunity

Notwithstanding the potential monetary gains highlighted in the media, there are many other circumstances in which an MBO may be appealing.

The opportunity to take the reins may be particularly attractive to managers of businesses in which the current owners have lost interest and the business is in a state of stasis, as is often be the case for the directors of a subsidiary business. Where the operations of the business do not fall within the core focus of the parent company subsidiary directors may feel disillusioned as funds are directed to other areas within the group and their business is left to take a back seat. By conducting an MBO, the directors are able to separate the business from the core operations and steer it towards growth.

Executives of small publicly listed companies may also wish to undertake an MBO. By taking the business private, the executives may have the opportunity to focus on its fundamentals without the added pressure of shareholder scrutiny and disclosure requirements.

For many private companies, on the other hand, an MBO can prove to be an ideal tool for business succession. The transaction can provide a vehicle for the current owner to hand down the business to a deserving management team.

Furthermore, an MBO can be an effective exit strategy. While a competitive trade sale can increase tension and maximise the sale price it can also taint the business as information is required to be disclosed to interested parties; often the business’ direct competitors. An MBO, therefore, may be used to protect the reputation of a business.

While there are potential benefits of an MBO it is important to note that the process can be very time consuming and stressful. A typical MBO will take between three and six months to complete but can take much longer. A model MBO timeline is shown below, assuming completion within three months.

During this time, the management team is likely to be distracted from the day to day running of the business. Additionally, MBO managers are required to “put some skin in the game” by making a significant investment of their own personal wealth which is unlikely to be realised for at least three to five years, thus requiring a strong commitment.

Recognising and addressing areas of conflict

As soon as the management team has made the decision to embark on an MBO it is vitally important that the current owners are approached in relation to the transaction; failure to do so may result in a conflict of interest. Embarking on an MBO or disclosing information to a private equity firm may jeopardise the directors’ duty of care to the company’s shareholders or result in a breach of the managers’ employment contract.

Additionally, a separate committee (excluding those directors embarking on the MBO) should be set up to make all decisions in relation to the transaction.

Funding

The majority of MBO’s are backed by private equity firms and are gaining frequency within Australia. According to Thomson Reuters and the Australian Private Equity and Venture Capital Associated Limited (AVCAL) the value of capital raised and committed to MBO’s within Australia has grown rapidly over recent years as shown in the chart below:

Source: Thomson Reuters and the Australian Private Equity and Venture Capital Associated Limited (AVCAL) Yearbook 2008

While there has been a drop in the value of capital committed to MBO’s between 2007 and 2008, it should be noted that there has been a fall in private equity funding across all investment stages during this period which may in part be attributed to the recent global economic climate.

Private equity firms are generally very stringent about the investments that they make and a solid business plan with achievable forecasts is a necessity when approaching any firm. Similarly, it is essential for the management team to be particular in its choice of private equity firm; both parties should share the same goals and objectives. This is especially important in relation to the eventual exit strategy which may include a private trade sale, a secondary buy out or a stock exchange listing. Timing is also important, generally speaking a private equity firm will wish to realise its investment in three to five years.

Embarking on an MBO with a private equity firm is the start of a new partnership. As renowned corporate finance writer J.Kelly once said:

There are only four ways for a venture capitalist to exit a deal: IPO, M&A, redemption or bankruptcy. You can divorce your wife but you can’t divorce us.

Learn from Experience

For many managers, embarking on an MBO will be the first experience that they have with private equity firms and it is important to be prepared for the extra scrutiny that the business will come under. Moreover, the management team will transition from being the potential vendor of the business to the potential purchaser which can result in a number of conflicts both legally and personally.

As few managers will go through more than one MBO in their lifetime it is useful to speak to other individuals who have completed a similar transaction and appoint experienced independent advisors as early as possible. The role of the advisors will be manifold, from conducting a feasibility study and helping to prepare the business plan to securing funding from private equity firms assisting in final negotiations.

By Manda Trautwein and Bryony Vandepeear.

Manda Trautwein is Director of Corporate Advisory Services at William Buck, a renowned Chartered Accounting and Business Advisory firm. For more information, please call Manda Trautwein or Jonathan Hickey at (02) 8263 4000 or visit www.williambuck.com.au .

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