RESOURCES

Basics

Management buyouts (MBOs) have been successful at thousands of small and large companies over the past 35 years. Such transactions represent a sizable percentage of all corporate transactions that have occurred during that time. Increasingly, managers have come to expect participation in the ownership of the companies in which they work. Often, managers become owners in the context of a corporate transaction. These transactions compete with the more common strategic acquisitions by corporations that are implementing either vertical or horizontal integration strategies. MBOs have a number of advantages over strategic acquisitions.

This section describes how management buyouts of corporations, subsidiaries, divisions and product lines are typically structured. It describes many aspects of an MBO and compares such transactions with strategic acquisitions. It demonstrates why managers may be the most viable buyers and why the resulting company may be the healthiest company relative to alternative transaction structures. It also demonstrates the impact an MBO can have on the value of a company and thus on the return, after dilution, to equity investors in an MBO.

Sellers have learned that they can often maximize their return if they sell to management. Members of management have learned that through such buyouts, they too can share in the ownership of their company.

The Rise of MBOs

Every year, thousands of subsidiaries, divisions, product lines and entire corporations are sold. These sales are typically arranged through privately negotiated transactions or private auctions conducted by investment banks. The entities being sold range from healthy to distressed. Buyers are typically companies in the same line of business, companies with complementary product lines, companies that are either suppliers to or buyers of the product or service offered by the company for sale or private capital firms teamed up with management of the company being sold. Selling a company to all its employees through an employee stock ownership plan (ESOP) transaction has also been a growing trend.

The Securities Data Corp. estimates that from 1990 through 1998, thousands of MBOs were implemented in companies with over $10 million in sales.

MBOs of Corporate Divestitures

Why are buyouts of corporations, subsidiaries and divisions common today? There have always been many corporate transactions as companies have been bought and sold and have divested operating units for strategic reasons. The number of these corporate transactions skyrocketed in the 1980s, declined in the early 1990s and has now risen again. There are many reasons for the large number of these transactions:

• First, large corporations are focusing their resources on their main lines of business and divesting other operations to stay viable in the highly competitive world economy.
• Second, management is widely believed to work more efficiently when it owns a piece of the action and some of its capital is at risk in the business. There is more incentive for each manager to "go the extra mile," and there is less need for the costly supervisory and monitoring systems that typify large, absentee-owned corporations and conglomerates.
• Third, management not only works harder when they are owners, but they expect the entire organization to work harder and smarter to enhance the value of their ownership. Managers are in a better position then absentee owners to demand and develop better performance from the organization.
• Fourth, as investors have become more sophisticated, they would rather make their own decisions concerning diversification (by investing in companies with different lines of businesses) instead of investing in a single corporation whose management makes such decisions by diversifying the company's assets through conglomeration.
• Fifth, only the largest corporations in the United States could qualify for the investment-grade debt that formerly was needed to fund the purchase of a large company. In the past, few others could ever hope to borrow such funds. However, in a trend initially engineered by Drexel, Burnham and Lambert but now offered by many firms after the demise of Drexel, debt is widely available to less-than-blue-chip companies. This makes it possible to finance MBOs through the public markets or through private placements to insurance companies, pension funds, subordinated debt funds or other long-term investors. Many MBOs of companies financed in this way have produced enormous financial rewards for their investors.
• Finally, significant cultural changes in America support the kind of corporate risk-taking and entrepreneurship that MBOs require.

Each of these trends has contributed to the growth in MBOs of public and private corporations and their subsidiaries, divisions or product lines. Many transactions, of course, are still completed by strategic buyers. To fully understand the value that management can bring to a leveraged buyout one must first understand how a typical MBO is structured.

Typical MBOs

During the 1980s, it became more common for members of management, assisted by an investment group, to purchase their company, subsidiary, division or product line. These transactions are commonly known as leveraged buyouts, or LBOs, because the buyout group finances the transaction with funds borrowed against the assets and projected cash flows of the entity being acquired. These transactions usually rely heavily on senior debt and subordinated debt.

However, LBOs received negative press for their use in hostile takeovers. As a result, leverage buyout firms began to refer to themselves as private equity firms and to leveraged buyouts as management buyouts.

Capital Structure

The subordinated debt in MBOs is provided by insurance companies, pension funds, subordinated debt or mezzanine funds, other institutional investors and often the seller of the company. Equity is provided by management and an investor group, such as private equity funds, that specializes in LBOs.

LBOs are financed chiefly with borrowed capital, not only because such funds are readily available, but also because equity reaps higher returns (subject to greater risk) when transactions are financed predominately with debt. Senior lenders are not prepared to lend 100% against the collateral value of assets. Subordinated lenders, however, will take a second lien on assets and be paid from the cash flows of the company left over after servicing senior debt in exchange for a premium rate of return. Subordinated debt allows a company to be more highly leveraged and reduces the need for equity, thereby replacing extremely expensive equity with less costly debt.

Debt is less costly than equity financing for two reasons: First, equity is at greater risk because it is subordinated to debt, trade creditors and others as to rights to cash flow, including cash flow generated in liquidation. Equity investors can therefore expect substantially higher returns on their investments than do lenders. Second, interest on debt is a deductible expense, whereas dividends on equity are paid with after-tax dollars. Consequently, it is more costly for a corporation to provide a certain return to equity than it is to provide the same level of return to debt.

How do these varying costs of capital impact the seller? A seller can frequently receive the highest price from a buyer who relies heavily on debt financing. Today, a corporate as well as an LBO buyer typically values a company based on the cash flowing to a capital structure composed predominately of debt. This kind of capital structure maximizes the potential return to equity, although it reduces the flexibility and increases the operating risks of the company.

Corporate Divestitures

The now popular belief that companies are more competitive and profitable as independent units rather than as parts of conglomerates precipitated a wave of corporate divestitures in the 1980s. The 1960s and 1970s were periods when companies grew through mergers and acquisitions. The 1980s and 1990s were a time of breaking up or spinning off corporate assets. A standard LBO usually makes the new company an independent entity.

Strategic Buyers

Corporations are still the most frequent buyers of other corporations. They are called strategic buyers. A corporate bidder with easy access to credit may have a powerful advantage over an MBO. To enhance the value of the entire corporation and the value of the company being purchased, a prospective corporate buyer may want to integrate the new company into the rest of its operations. A corporation that believes it can attain economies of scale, greater market share, expanded product lines, additional operating capacity or any other enhancements to its existing business because of the acquisition may bid far above the levels associated with the potential cash flows and earnings of the new company on a standalone basis. If the corporation has sufficient access to capital and believes it can achieve important synergies between its current business and that of the new company, then it will normally be able to outbid an MBO.

MBOs Advantages

Existing senior managers that team up with a private equity firm have a number of advantages over other bidders when competing for the purchase of a company. At times, these advantages give management the edge in the bidding process:

• The existing management of the company usually understands the company better than any other prospective bidder.
• Management may know of hidden values in the company that will be hard for others to discover or realize.
• Management also requires less time to evaluate the company and generally knows in advance that the company will soon be for sale.
• Management often has well-thought-out plans for operating the company independently, including strategies to spur growth or reduce costs.
• An independent company requires less corporate reporting and can eliminate overhead costs associated with its parent.
• Management usually has close, personal ties with the company's financing sources.
• A management-supported bid is often viewed sympathetically by the board of directors, which must ultimately decide to whom to sell.

An MBO can be initiated by the owner, the management or a third party.

Owner Initiated

A corporation's owners or board of directors may realize that selling the company or divesting a division may be most effectively accomplished through an MBO. The board of directors may assist a management employee buyout effort in either a privately negotiated sale or a private auction of the company.

Private Sale

In a private sale, the board can control virtually all aspects of the transaction. The board can negotiate with management regarding the terms and conditions of the sale. Additionally, the board can direct the company to raise the necessary financing to implement an MBO. This can be done entirely at the expense of the seller.

The board's control of a private sale is, however, limited by its financing sources and by the need to protect the interest of minority shareholders.

Private Auction

The board can also conduct the sale through an auction yet still support an MBO as one of the bidders. The company can assist the MBO by using corporate funds to help fund the management's retention of expert advisors. It can also give management complete access to company books, records and advisors. This offers the seller an additional bidder with certain competitive advantages and may result in the seller getting a higher price for the company than it might otherwise have obtained. Where the company is in distress, this often assures the seller of having at least one nonliquidation bidder for the company.

Management-Initiated Buyout

A management-initiated buyout is typically initiated by senior management and can be supported by the board and owners of the company, even to the extent of providing corporate funds to conduct such an effort.

Third-Party-Initiated Buyout

Any prospective bidder for a company can integrate the management into the overall ownership structure of the transaction. Such an effort can reap the various advantages associated with MBOs noted above and therefore enhance its competitiveness. However, strategic buyers are generally not willing to provide management with ownership and so generally would not be willing to participate in an MBO.

MBO Financing Structure

Virtually all MBOs are financed with a combination of senior debt, subordinated debt and equity. The amount of equity required in a transaction is determined in part by the amount of debt that can be borrowed. The following describes the various components of financing in a typical MBO.

1. Senior Debt

Typically, 50% to 70% of an MBO's financing takes the form of senior financing. A senior loan is collateralized by a first lien on the current and long-term assets of the company. Senior financing is generally made available from banks, although privately placed notes to institutional investors are also possible, or a public issue of bonds is on occasion the source of senior debt.

Revolving Line of Credit

One component of senior debt is almost always a revolving line of credit. It is loaned to an MBO based on a certain percentage of the appraised orderly liquidation value of the eligible accounts receivables and inventory. Such loans are further limited by the predictability of cash flow to service senior debt. A revolving line of credit typically has a term of one year with renewal provisions. The interest rate ranges from the prime rate to three over prime. (Figure 1)

Senior Term Debt

Another component of senior debt is a senior-term loan. This is a loan based on a certain percentage of the appraised fair market value of the land and buildings and the orderly liquidation value of the machinery and equipment. Such loans are further limited by the predictability of cash flow to service senior debt. The term for senior term debt is typically five to eight years. The interest rate ranges from the prime rate to three over prime. (Figure 2)

2. Subordinated Debt

Typically, 15% to 30% of the financing of an MBO is in the form of subordinated financing. These funds are subordinated to senior debt and generally have only second claim to the collateral of the company. Subordinated financing is generally made available directly from subordinated debt private and public funds and, in large transactions, directly from insurance companies.

Alternatively, it is raised through public offerings of high-yield ("junk") bonds to insurance companies, pension funds and other institutional investors. In many MBOs, subordinated debt is given back to the seller, comprising a portion of the purchase price.

The term of such financing is typically six to 10 years, and principal payments are commonly deferred until after the senior debt is retired.

These funds are loaned based on the amount and predictability of cash flow exceeding that required to service senior debt. Interest costs can be anywhere from 2 to 8 percentage points more than senior debt. Because subordinated debt usually has little collateral protection, it almost always is granted an equity kicker with the intention of providing the lender with an 18% to 27% compound annual total return over five years resulting from both the interest charges and equity kicker. The required return varies based on the risk associated with the transaction, the company, its market and its industry. (Figure 3)

3. Equity

Typically, 10% to 20% of the financing of an MBO is in the form of equity financing. These funds make up the difference in the financing requirement and the financing available in the form of debt. (Figure 4)

Those who invest in the equity of a company typically reap seven rights of ownership:

• Voting rights
• Dividend rights
• Trading rights
• Appreciation rights
• Liquidation rights
• Hypothecation rights (the right to pledge the stock for borrowing purposes)
• Information rights

However, dividend and liquidation rights of equity investors are typically subordinated in an MBO to the interests of the secured lenders of the company. Liquidation rights are further subordinated to the unsecured creditors of the company.

Management usually invests in the equity of an MBO company together with a private equity, a corporate investor or a group composed of institutional equity investors. The seller and subordinated lenders sometimes receive equity in the new company. An institutional investor investing in the equity of an MBO typically seeks a 30% to 40% compounded annual total return over five years, depending on the perceived risk. These returns are only projections; the investor has no contractual rights to such returns like a lender has concerning interest charges.

Structure of a Typical LBO

The outline below models a typical LBO:

A.	Uses of Financing
	1. Purchase Price		$30 Million
	2. Transaction Expenses and Cash Reserves		$ 2 Million
		Total:	$32 Million
B.	Sources of Financing
	1. Senior Debt
	a. Revolving Line of Credit		$ 9 Million
	Interest Rate	8.5%
	b. Term Debt		$ 8 Million
	Interest Rate	8.25%
	Term	5 Years
	2. Subordinated Term Debt		$ 9 Million
	a. Interest Rate	9.75%-10.8%
	Term	9 Years (Retired in years 4-9)
	b. Ownership	11.0%
	3. Cash Equity Investment		$ 6 Million
	a. Interest Rate	NA
	b. Ownership	89.0%
		Total:	$32 Million
C.	Starting Operating Income
	(Earnings Before Interest and Taxes [EBIT])		$ 5 Million
	a. Growth Rate:	0.0%
D.	Tax Rate
	(Federal and State Combined)	39.9%

The net worth of the company will rise over a five-year period as retained earnings accumulate and debt is retired. Enterprise value in this example is assumed to be six times operating income, plus cash, less outstanding debt. The internal rate of return for the cash equity investment in the non-LBO scenario over a five-year period will be 42%, based on the growth in enterprise value. The MBO will require eight years to retire all its debt.

Stock Ownership Structure

The investor in an MBO must share equity with the subordinated lender who, in this example, requires 11% of the equity. Ownership must also be shared with management.

Conclusion

The many advantages of an MBO in the sale of corporations or divestitures of subsidiaries, divisions or product lines are likely to continue to make this approach attractive in years to come. A sale to a management team combined with a private equity investor can prevent a company from being on the market for an extended period of time, which can cause a decline in the company's value, a loss of morale among employees and uncertainty and concern among employees of the parent firm, who may wonder if they are next in line.

The advantages of a management buyout, however, may not be enough to outweigh other considerations strategic buyers may bring to a transaction. If a strategic buyer can gain a market edge or economies of scale by purchasing a company, it may be willing to pay more than an MBO can pay for the same business based solely on earnings potential. Other strategic buyers may be willing to pay more because they can realize special tax or other financial advantages that are not available to an MBO.

In many cases, though, a management buyout is not used simply because those involved with the sale do not know how it can be used beneficially. For the owners and management, this lack of familiarity with buyouts can come at the cost of a solution favorable to everyone. MBOs create an opportunity of a lifetime for those lucky enough to have the chance of participating in the ownership of their company. It is often the case that managers have done more than any group to have created the value a company has in the market place. It is only appropriate and natural that managers should gain a foothold through MBOs in the wealth-creation capability of America's businesses.