Leading a Management Buy-Out

A perfect storm is emerging for management buy-outs. Corporates are divesting, private equity firms have ample funds to invest and banks will lend meaningful sums provided the numbers add up. For talented executive teams, the time is right to step up and take control of a business.

Naturally, ambition alone won’t be enough when it comes to a management team successfully purchasing a company. “A failed MBO is very easy to achieve and dangerous to execute,” says Chris Herrmannsen, the Managing Director of recruitment specialist Ochre House, who led a buy-out from Trinity Mirror. “Clearly, if management doesn't succeed in buying it, they are often angry and jilted and feel they can’t stay.”

Plenty can go wrong as management contend with vendors wanting to maximise a price and private equity firms seek to generate a suitable return on investment. Simon Howard, Executive Chairman of Work Group, comments: “In many MBOs, the PE firm actually holds a lot of the cards these days, which makes them wiser and smarter about structuring deals.”

Those individuals who have ‘been there and done it’ often cite the following as essential when embarking on an MBO:

• Choose your own advisors
• Have more than one PE firm interested
• Show you can scale the business (and deliver)
• Get references
• Fully understand the Investor Agreement

Chris Crombie, who led the £100 million MBO of the arts and crafts company HobbyCraft, backed by international PE house Bridgepoint, describes appointing a set of advisors as a “masterstroke”. He explains: “We had somebody to look after our interests who wasn’t going to be increasingly diametrically opposed to what the vendor sought.”

It sounds like an obvious step, but it’s surprising how many management teams make the mistake of not appointing an advisor. Mark Hunter, the CEO of Airclaims Holdings, comments: “We sort of caught on halfway through the process that we really needed to be represented a lot earlier and we needed to have our say.”

The Airclaims buy-out dragged on for 15 months, primarily because the management team became proactive and commercial in stating what they wanted from the deal. “Our advisors were very much on our side from day one and really helped to sway the process in our favour,” continues Mark.

It’s vital for the executives to stand their ground. Chris Crombie recalls: “At certain points, the vendor’s advisor wanted to help us find our own advisor; I felt very strongly that it should be somebody that I found. This was because I wanted the right fit and I didn’t want a patsy.”

Beauty parade

Although billed as a shared partnership of equals, a PE firm becomes, in-effect, the new employer of the management team, which means that the CEO-in-waiting needs to do the rounds and evaluate what the various financial sponsors can offer. Common sense dictates that the more PE houses proclaiming an interest the better, as then it’s easier to negotiate attractive terms and drive up the value of the deal.

Chris Herrmannsen says: “Taking references from previous or current PE portfolio companies is important. You wouldn’t hire somebody unless you had a reference from a person who has direct experience of that individual. When things are going well, PE firms are very supportive and warm and arms’ length. But when getting references, what you need to do is tease out how a firm behaves when things are not going so well.”

Simon observes that it’s vital to understand and negotiate hard with a financial sponsor when agreeing terms. “They always say that such an agreement is filed away and never referred to, however, if it is you’re in trouble because it sets the limitations of management decision making. You need the right sort of investment agreement as the PE firm can call you.”

The worst case scenario leaves executives with nothing. Mark Spinner, Partner and Head of Corporate at law firm Eversheds, confirms that ‘downside protection’ or ‘swamping rights’ are now much sterner than they were two to three years ago: “A financial sponsor will say that if you breach certain agreements and/or financial covenants, then they have the right to either appoint more directors to the board so they have control, or they can take members of the management team off the board.”

Heat of the Battle

Provided management do set their stall out, striking the right balance of being respectful to the vendor without being naïve, the foundations should be there to push the deal through. Mark Hunter says: “Things did become quite strained but the great thing was that by the time we got to the finishing line, I think relationships were pretty much back on track. We ended parting extremely amicably as we understood each other’s viewpoints.”

In theory, strong gamesmanship should be appreciated and respected (once the deal is done, at least). Chris Crombie states: “The relationship between myself and the vendor was maintained all the way through. We actually went up to London on the train together for the completion. That was important to me as I had worked for the chairman for 14 years.”

Again, advisors on both sides had a role to play here in taking the heat out of high-pressured negotiations. “It was made clear that the price was important,” recalls Chris, who left HobbyCraft at the beginning of the year. “We were on our mettle right from the outset; this was not going to be an altruistic handing over of the baton.”

He compliments the chairman for making the rather innovative decision to introduce a non-executive director to assist with negotiations. “The vendor appointed an independent NED primarily to look after his interests. However, it proved to be incredibly useful as, in practice, he was like an impartial advisor, which I’m not sure you can always say about corporate finance advisors. The management team met this person before he was appointed so, although he was acting in the vendor’s interest, he was an amazingly powerful catalyst for pushing the deal through.”

First Contact

Once that initial approach is made to the owner, there’s no going back. Simon states: “The reality is that, from the time you have that conversation, assuming it’s initiated by you, it becomes a bit of a one way ticket. You need to have done a good deal of homework before that point – unless you have an incredibly understanding owner.”

If the bid is made in haste, the deal can fail before it’s even started. “The move from being a manager to becoming a buyer can happen too soon and lead to ill feeling; you have to be careful how you, as a management team, dare to go past the point of no return with the vendor,” say Chris Herrmannsen.

The general view seems to be that conditions are currently ripe for making the move from employee to owner. Although data from the Centre for Management Buyout Research (CMBOR) shows that European deals fell by two-fifths in the first quarter of 2011 to €11.7 billion, the UK continues to demonstrate impressive levels of activity. UK deal flow in the first quarter dominates the buy-out market in terms of value (€3.9 billion), with 44 deals accounting for 36 per cent of all European deal flow in that period.

Aleen Gulvanessian, Senior Corporate Partner for Eversheds, argues that a significant reason for this is the “large number of funds looking to deploy capital as there is an equity overhang from money raised in 2007”. For the PE firms, it’s genuinely a case of use it or lose it and that puts highly skilled management teams in a healthy bargaining position. “If I was an incumbent manager in a good business right now…, I’d certainly be trying to execute a buy-out,” she states.

Day In, Day Out

Ambition alone may not be enough to secure a great deal, but it’ll be a factor as negotiations inevitably go through rocky patches, maybe due to the last minute attentions of a trade buyer or yet another round of due diligence as doubts resurface over the business plan. An MBO will put enormous stress and pressure on executives as they carry on their day jobs and engage in talks that could have life changing outcomes.

Mark Hunter says: “It is extremely hard to do and it’s incredibly challenging for the key members of the team who are effectively doing two things at once – running operations and buying the business. Do not underestimate the personal strain it puts you under, but when you come through the other side it’s fantastically rewarding.”

Chris Herrmannsen states that the calculated returns have to be delivered on as there’s no use in promising the world to an investor if it’s inspired by pie-in-the-sky optimism: “If you don’t have a really detailed understanding of how to grow your business substantially, don’t do it. Under the rules of private equity, there are no prizes for standing still.”

There will never be a perfect MBO. That said, there are definitely principles to follow which can lessen the chances of a deal falling through or, perhaps worse, leading a buy-out and then becoming a hostage to investors because the terms and conditions weren’t fully grasped. For Chris Crombie, the focus throughout was on finding a backer that believed in the executive team and their vision and possessed the financial firepower to take the business forward, allied with genuine sector expertise.

“From the outset, we were clear about what management wanted,” he says. “We were proactive when we went to the PE firms and put together a comprehensive legal document. We then had the PE firms mark that up and comment accordingly and, by the time we reached the final rounds, it was difficult for any party to renege on what was being offered to management or on any of the other terms.”

The management team must be fixed on the endgame and make it abundantly clear that the value of the business lies ostensibly in their hands.

Please get in touch if you have any comments about the issues raised here.