RESOURCES

Buyout Team

Assembling a team of professionals who are experienced at implementing management buyouts (MBOs) is critical. The team should include the following:

Investment Banker

The first and most important selection for your buyout team should be an investment banker. Your investment banker should help in assembling the rest of the team. Choose an investment banker who has been involved in dozens of MBOs. It is not critical that the investment banker is associated with a large or well-known firm as much as it is important that he or she has the right background.

You should choose from investment bankers who have invested capital in the equity of MBOs. They should know how to underwrite and value a private company. You can also select investment bankers who have represented the buy-side of MBOs, even though they have not invested capital in the buyouts. Try not to select investment bankers who have only represented the sell-side of MBOs.

Review the background of these bankers carefully. This is your most important decision to ensure the success of your buyout. Do not be shy; get down to the details of prospective bankers' backgrounds. There are thousands of investment bankers who fit the criteria above. Do not settle for second best.

Your investment banker needs to be experienced in the following areas:

• Building comprehensive models of the historical and future projections of companies in the context of a change-of-control transaction.
• Valuing private companies.
• Preparing bids in the form of letters of intent for the purchase of private companies.
• Negotiating the terms of purchase agreements on behalf of buyers of private companies.
• Preparing financing memorandums for raising capital for private companies going through a change-of-control transaction.
• Negotiating supply agreements between sellers and buyers in change-of-control transactions.
• Negotiating the terms of financing with sources of senior debt, subordinated debt and equity.
• Negotiating shareholder agreements among equity investors and management equity participants in a change-of-control transaction.
• Negotiating employment agreements for senior management.
• Orchestrating the close of buyouts on behalf of buyers.

Corporate Attorney

Selecting the right attorney and law firm is your second most important decision. Unlike the selection of an investment banker, it is important that the attorney you select is with a law firm that has the right set of capabilities.

You should select an attorney and law firm that are highly experienced in corporate transactions, preferably representing the buy-side of MBOs. The attorney should be a specialist in corporate transactions. The law firm should have substantial corporate practice, benefits and environmental practices.

The following is a list of the areas in which your attorney and law firm may need to have experience:

• Preparing bids in the form of letters of intent for the purchase of private companies.
• Negotiating the terms of purchase agreements on behalf of buyers of private companies.
• Negotiating supply agreements between sellers and buyers in change-of-control transactions.
• Negotiating the terms of financing with sources of senior debt, subordinated debt and equity.
• Negotiating intercreditor agreements.
• Negotiating environmental indemnities.
• Negotiating shareholder agreements among the equity investors and management equity participants in a change-of-control transaction.
• Preparing incorporation documents for the company.
• Negotiating employment agreements for senior management.
• Orchestrating the close of buyouts on behalf of buyers.

Senior Lender

Selecting the sources of financing for your buyout effort is a critical step. The investment banker you have chosen will be able to advise you on many of the items below, but it is important to understand the issues involved with sourcing the loans that back your bid for the company. There are three primary issues to address when sourcing debt financing:

• The amount that the company may borrow.
• The new capital structure.
• The cost of funds.

In order to address these issues, it is necessary to have a detailed financial model. Your investment banker will guide you through the process of developing the model.

There are two types of senior loans: asset-based loans and cash flow loans. Some institutions only do asset-based loans while others will do both.

Asset-Based Lenders

Asset-based loans are fully collateralized by the value of the company's assets. These loans are based on a formula that applies an advance rate to the assets of the company in order to determine the amount that may be borrowed. While the advance rates will depend on the type, age and quality of the company's assets, typical advance rates are 85% of accounts receivables, 40% of inventory and 50% of net property, plant and equipment.

Advantages of using an asset-based lender:

• Determining the amount to be borrowed is relatively straightforward.
• The advance rate formulas provide a mechanism for the available loan to grow with your business.
• No financial covenants.
• No amortization requirements.

Disadvantages of using an asset-based lender:

• Asset-based loans typically require higher interest rates. This is because the lender must monitor the company's assets, which can be quite expensive.
• Asset-based lenders are usually unwilling to lend as much as cash flow lenders.

Cash Flow Lenders

Cash flow lenders, on the other hand, are most concerned with the company's ability to generate cash flow to pay off the loan. Such lenders will look closely at the company's projected revenues and earnings to determine the amount of debt the company can withstand. Cash flow loans are often referred to as term loans and amortize over three to five years. Creating a financial model will show the company's projected cash flow and, therefore, the amount that may be borrowed and an appropriate amortization schedule.

Cash flow lenders consider earnings before interest, taxes, depreciation and amortization (EBITDA) as a proxy for the company's cash flow. The lender will usually lend up to a certain multiple of EBITDA. This multiple will vary greatly between industries and is very dependent on the company's health and competitive position. For purposes of performing a preliminary analysis, three times EBITDA is a median EBITDA multiple for a senior lender.

Like any investor, the senior lender will consider your company's place in the competitive landscape of its industry, the strength of the management team and any perceived threats to the company's revenue streams and profit margins.

Advantages of using a cash flow lender:

• Buyout efforts are often able to source more funds through a cash flow lender than an asset-based lender.
• Interest rates are usually lower.

Disadvantages of using a cash flow lender:

• The lender will inevitably have a conservative view of the projected cash flows.
• The lender will require financial covenants to control the company's level of debt and interest requirements relative to its cash flows.

Understanding the different types of lenders and having a solid financial model will help you to understand the amount and the types of loans that are available to you in your buyout effort. All lenders were not created equally, and the best way to choose one is to send an information memorandum and financial model to a number of lenders and request term sheets. Your investment banker will know of interested lenders, and he or she will handle the process of receiving and analyzing term sheets.

While the amount of the loan and interest rate are obvious concerns, some other key issues to look for in the term sheet include:

• The term length and maturity.
• The amortization schedule.
• Prepayment penalties.
• Financial covenants.

All lenders will require the company to stay within certain financial parameters and covenants. Breaking a covenant may put the company in default of its loan. Covenants will not be determined until you have a purchase agreement to buy the company and the lender has committed to providing you with the funds. However, it is important to keep in mind that the lender will use these covenants to exert some control over the business operations in order to protect his or her loan.

Most often, MBOs involve both asset-based and cash flow loans. The company will usually use an asset-based revolving credit facility to fund its working capital requirements and provide for short-term cash needs. Additionally, one or two term loans will be lent against the projected cash flows. If your deal requires such a structure, it is advantageous to find a senior lender who will make both types of loans. This will make the transaction process smoother and quicker by reducing due diligence expenses, reducing intercreditor issues and allowing you to deal with only one senior lender.

Subordinated Lender

One of your goals during the buyout effort will be to fund the purchase price with as much debt because debt capital is much cheaper than equity capital. During the process of structuring your bid for the company, you will access as much senior debt as possible. The next source of debt available to you is subordinated debt. These funds are loaned based on the amount and predictability of cash flow exceeding that required to service senior debt. Typically, 15% to 30% of the financing of an MBO is in the form of subordinated financing.

Price

Because subordinated lenders have a secondary claim on the assets and carry much more risk than the senior lender, they charge a higher interest rate. Interest costs can be anywhere from 2 to 8 percentage points higher than senior debt.

In addition to the interest rate, the subordinated lender often requires an equity kicker in order to receive a return that is commensurate with the risk that it has taken. To receive the desired return, the subordinated note will often require a piece of the company's equity in the form of warrants. The amount of warrants required may range from 1% to more than 50% of the company's equity. The subordinated lender typically seeks an 18% to 27% compound annual return over five years resulting from both the interest payments and the equity kicker. The required return varies based on the risk associated with the transaction, the company and its market and industry.

Like senior cash flow lenders, subordinated lenders will insist on financial covenants. However, because they assume more risk, these covenants will be more lenient than the senior covenants.

Subordinated lenders include a variety of institutions. These include banks, mezzanine (another term for subordinated debt) funds, pensions, insurance companies and wealthy individuals. The process of raising subordinated funds is quite similar to raising senior loans. Potential lenders will require an information memorandum and financial model in order to do preliminary analysis and gauge their interest in the deal. They will want to meet the management team and perform the same sort of due diligence as other investors. Your investment banker should handle the process of contacting subordinated lenders and receiving and evaluating term sheets from them.

Equity Sponsor

Equity sponsors are seen as the primary financial backers of a buyout transaction in spite of the fact that they often invest the least amount of capital. The sponsor will invest the remainder of the required capital after the debt financing has been raised. This often amounts to 10% to 30% of the capital structure.

Equity investors usually 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 leveraged buyout fund, a corporate investor or a group composed of institutional equity investors. 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.

Because the sponsor has no claim to the assets and is assuming the most risk, he will analyze potential transactions quite differently from lenders. While an equity investor will perform the same type of financial due diligence as the lenders, equity investors are more concerned with the company's upside potential than with analyzing the likelihood that the investment will be repaid.

Equity sponsors are usually private partnerships that have raised a fund of capital from institutional investors. These investors are often insurance companies, universities or pensions. Funds are often raised with a targeted five-year lifetime and an internal rate of return of 30% or more. Because of the targeted lifetime, sponsors often try to liquidate their investment in three to five years.