MBO’s: Balancing the Risk
9th November 2016 by David Scrivener
Management Buyouts, or MBO’s, are becoming an increasingly popular deal mechanism to achieve a controlled shareholder exit. Typically in an MBO, the senior management of a company purchase the entire shareholding of that company from the existing owners, thereby becoming the new owners. This provides the previous owners of the company with an efficient exit mechanism from the business and releases liquidity in exchange for selling their shares to the new owners, aka the senior management team. MBO’s may be wholly initiated by the senior management team or may be backed by a sponsor, such as a private equity fund.
Whilst an MBO provides an efficient means of exit for the existing owners, there are inherent risks associated with any MBO. We discuss two such associated risks below – the debt conundrum and pay-out risk.
The debt conundrum
Most MBO’s are partially financed by debt. Whilst debt is a popular financing mechanism given its tax deductible nature and since it is normally cheaper than equity, too much debt can be risky for the company’s financial health. The arrow below highlights the leverage risk of taking on too much debt (from left to right in increasing order of debt funding).
On the left end of the scale is an MBO which is 100% equity funded. There is no leverage risk in this scenario (i.e. the risk of the company becoming insolvent due to its inability to meet debt service payments); however, the return that the shareholders will receive on the capital they have invested will be fairly low. On the right end of the scale, the MBO will be funded almost entirely by debt and a slither of equity from management. Whilst the returns for shareholders would be very high in this scenario, the leverage risk would be equally high too. Debt can be either secured (eg. secured against property, current assets) or unsecured (mezzanine debt, vendor loan notes etc). A higher amount of unsecured debt in the company is synonymous with higher leverage risk. Unsecured debt is not guaranteed by any physical assets in the company, and it usually carries a higher rate of interest. A larger proportion of higher interest bearing debt increases the risk that the company may be unable to meet its debt servicing obligations in the future.
The fact that debt is cheaper than equity significantly increases the returns to shareholders on their invested capital. However, this is somewhat off-set by the leverage risk of taking on debt. Between the two extremities discussed above, lies the ‘middle ground’ that aims to balance out the leverage risk and maximise return to shareholders. The optimum level of leverage in a company is a subjective issue that
depends on the projected level of profitability, management’s ability in delivering forecast performance and the resilience of the market that the company operates in. The MBO team would need to consider each of these factors before they can decide on the optimum leverage structure to be used in financing the MBO.
The pay-out conundrum
The exiting shareholders and the MBO team have conflicting views of level of cash paid out to the vendors on deal completion. The arrow below highlights the pay-out conundrum.
On the left end of the scale is the scenario where all of the consideration due to the exiting owners is deferred or contingent on future performance of the business. This is ideal for the MBO team as they don’t have to pay any cash upfront to the departing shareholders and it also transfers the entire risk of achieving future performance on to the departing shareholders. As is evident, this would be the worst case scenario for the vendors who prefer as much cash upfront as is possible. The scenario on the far right of the arrow is therefore ideal for the vendors, where all the cash is paid upfront.
In reality, most MBO’s would be structured somewhere in between the two extremes highlighted above. It is highly improbable that any vendor would accept all of the uncertainty of future performance and no upfront payment. At the same time, it is equally unlikely that the MBO team would accept all the downside risk of future business performance and pay-out the vendors in full on deal completion. This conflict between the vendors and the MBO team has led to a popular deal mechanism typical of MBO’s, known as’ ‘debt and deferred MBOs’. Debt and deferred MBOs are structured such that a large part of the consideration due to the vendors is deferred over a fixed time period in the future. The upfront payment to the vendor is usually financed through a mix of debt finance and equity put in by the MBO team. This is an effective mechanism that ‘locks in’ the vendor into the business for a certain period of time and ensures that the vendor is motivated to work with the MBO team towards delivering the target business performance over a specified period.
In summary, the debt conundrum and the pay-out conundrum pose the greatest challenges to most MBO’s. Perhaps the most successful MBO is one where both these risks are managed and all parties complete the deal with smiling faces. The interaction of the debt conundrum and the pay-out conundrum is graphically illustrated in the chart below.
If you have any questions in relation to MBO’s, do not hesitate to get in touch with me for a confidential conversation.
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