The truth about MBOs

Mike Wright and Rod Ball from the Centre for Management Buyout (MBO) Research, Imperial College Business School, examine the opportunities offered by MBOs.

Management buyouts (MBOs) have grown in importance as innovative ways to restructure and reinvigorate corporations. They involve the acquisition of an existing company or division to create a new independent company owned by management and private equity firms.

Where do MBOs come from?

Corporations undergo frequent restructurings and may sell-off under-performing divisions which don’t fit with the overall corporate direction. However, divisional management may identify opportunities for improved performance and decide they would like to buyout the business. Family business owners, for example, can face a succession problem but be keen to keep the business independent. Only a few buyouts actually involve listed corporations that see little advantage to remaining on the stock market – either because they find it difficult to raise funds or need to restructure away from the pressures of quarterly earnings reporting. MBOs can also be a way to rescue viable parts of troubled corporations.

How are MBOs financed?

Buyouts are financed using cash from management and private equity firms, and debt secured against the firm’s assets. Medium-sized deals involving transactions from £10 million upwards form the vast bulk of the buyout market. They are likely to be funded with an equal amount of debt and equity. The business will need to be able to service the interest on the debt, so cash flow should be as stable and predictable as possible.

What about price?

Corporations selling businesses need to demonstrate to shareholders that they have got the best price. Larger businesses are likely to be sold through a controlled auction in which management teams will need to bid against outsiders. Private equity firms have often been able to outbid corporate bidders because they identify areas for efficiency and growth improvements. They use different financing instruments to mitigate the need to service the finance to fund the purchase from current cash flow by postponing capital repayments until the firm is sold. Even so, there is a need to avoid over-bidding and ending up with a financing structure which does not leave enough headroom to allow for fluctuations in earnings.

What are investors looking for?

To strike the best deal with investors, a credible plan should be formed for improving performance beyond what was being achieved before the buyout. Areas for efficiency improvements must be identified along with, increasingly, potential new products and markets. Management also need to develop a team that investors will be convinced can run the firm as an independent entity, committed to generating the returns private equity firms will be seeking over a three-to-five-year period.