How businesses can decide if an MBO is for them
In most MBOs management will not fund the purchase price from personal resources alone. Picture: iStock.
A management buyout (MBO) is often a very attractive way for an owner to sell a business. Transactions are usually quicker and the handover to an existing management team tends to be very smooth.
On the other hand, management teams rarely have the ability to fund the buyout from their own resources. That usually means funding it through a mix of debt, equity, earn-outs, vendor finance and other means.
What’s the best way to fund a buyout without saddling the business with too much debt or other drains on its resources?
In most MBOs, management will not fund the purchase price from personal resources alone, says Stephen Kane, head of corporate advisory at Goodbody. “We view an MBO as an exercise in optimising both ownership and capital structure. Each funding source plays a different role in balancing risk, return, ownership dilution and future growth capacity.
“Management teams typically fund an MBO through a mix of their own investment, debt, private equity and seller support mechanisms such as deferred consideration/vendor financing and vendors rolling some of their shares. The exact funding mix will depend on the size of the transaction, the valuation, the company’s cash-generating ability, and the seller’s objectives.”
The strongest MBOs combine enough leverage to enhance equity returns, while retaining sufficient headroom to fund growth initiatives, acquisitions and investment post-completion, Kane explains.
Typically, the management team establishes a new company that acquires the existing business, funded by a blend of equity and debt, says Aimee Corcoran, senior manager, PwC Ireland Corporate Finance. “Management needs to make a meaningful contribution to ensure they have skin in the game, but it should remain proportionate to their circumstances.
“The size of the MBO team, their life stage, and overall economics of the transaction all come into play. In my experience a sensible buy-in figure must be arrived at early in the process, as it’s a key part of external lenders initial diligence.”
In determining what is the appropriate quantum of debt for a business to ensure it doesn’t take on too much, debt providers evaluate a company’s capacity using certain financial ratios such as leverage, debt service coverage and debt service capability, says Richard Duffy, director, deal advisory, BDO.
“The leverage metric assesses the quantum of debt a business should secure relative to its Ebitda. Other factors come into play here in determining the appropriate leverage, such as the nature of the business, the sector it operates in, size and scale of the company, [and] security on offer for the loan.”
Vendor finance, deferred consideration and earn-outs can help bridge a funding gap by reducing the amount of capital required upfront, says Ala Browne, sales lead, Bibby Financial Services.
“However, management teams should look at the full funding picture. In many businesses, value already exists within the balance sheet through the debtor book or other assets.
“Combining these options with facilities such as invoice finance or asset-based lending can help create a more balanced funding structure while preserving working capital after completion. Where there is a robust sales ledger, an invoice finance facility can leverage debtor book value to support the transaction, preserve liquidity and provide ongoing funding as the business transitions to new ownership.”
Choosing an inappropriate financial structure is one of the biggest mistakes to make, says Duffy. “At the outset you need to establish your funding requirement and assess what type of funding support you need, which best fits your capital structure. For example, having an inappropriate debt-to-equity mix or having a high interest financing structure which isn’t matched by the cash generation capacity of the business will cause future cash flow crunches and difficulties with funders.
“To avoid this type of pitfall it’s critical you get an experienced adviser on board who can bring objectivity, facilitate a smooth transaction process but above all will have the know-how to get the deal done for the benefit of all involved in a timely fashion.”
Private equity makes sense when the funding gap is too large for debt and management equity, or where growth or acquisitions need follow-on capital, says Corcoran. “Management gives up shareholding and accepts a more formal governance framework such as board seats, financial reporting requirements and agreed controls over major decisions. In return the private equity investor will provide both capital and expert advice to scale the business. Private equity typically will expect an exit within three to five years.”
Investors back management teams first and businesses second, says Kane. “A capable, ambitious and commercially focused team remains the single most important factor in securing funding.
“Equity investors will focus heavily on the quality of earnings, scalability, market position and the potential to deliver a multiple of invested capital through future growth and exit.”
They will want evidence that the management team can successfully lead the business independently after the buyout, Kane explains. “A track record of stable performance and a clear competitive advantage can significantly improve the attractiveness of the opportunity.
“Lenders will focus more heavily on cash-flow visibility, debt service capacity, covenant headroom and the resilience of earnings through periods of weaker trading.”
Alternative lending solutions can offer a range of benefits above and beyond access to finance, including in-depth specialist market knowledge and strong client relationships, says Browne. “There is also typically greater scope to take into account an SME’s existing and future needs when looking to secure finance, as well as factors such as supply pressure payment cycles, currency fluctuations and complex international commercial terms.”
