Management Buyout (MBO)
What is a Management Buyout (MBO)?
Management Buyout is a transaction where the management team is involved in the acquisition in part or all of the business they manage. Financing sources of an MBO transaction may be obtained from a combination of personal funds, bank loan, equity finance, seller finance, and mezzanine finance. Reasons to consider an MBO
Typical exit strategies for a privately owned company may include:
MBO’s are typically financed through a combination of debt and equity, and or a hybrid form involving mezzanine instruments. Senior Debt
Senior debt is the highest-ranking liability of a company’s balance sheet and is also the cheapest source of capital. Debt may include loan or credit notes from banks, who take business assets as collateral. While the interest rate is lower it comes with rigorous covenants regarding interest coverage amongst other things. Mezzanine Finance
Bridging the gap between debt and equity, mezzanine debt is subordinate in priority of repayment and security to senior debt, but ranks in priority to equity. Mezzanine debt may take the form of junior debt, subordinated debt, convertible debt, private “mezzanine” securities, or second lien debt. Mezzanine providers typically look at an IRR between 11% and 25% subject to the pricing of the risk. At the top end of the price range it begins to overlap with expected equity returns which we estimate at a +25% IRR target for today’s equity investors. Management teams choose mezzanine finance to enjoy a control ownership position, flexible repayment terms and higher return on equity (ROE) that results from using appropriate leverage. Mezzanine investors often work together with the shareholder/management team by bringing the structuring and finance expertise to help the company grow as well as engineering the repayment terms to match the business’ cashflows. Advantages of using mezzanine debt are providing the necessary capital to own the business, minimizing the weighted average cost of capital (WACC) through lower cost and tax shield deductibility on interest payments, and to reduce the need for equity capital and thereby avoid unwanted equity partners. Most importantly mezzanine debt is an effective tool to mitigate partnership risk which we have found is an often misunderstood and overlooked issue for MBO parties. Equity
Equity is the most expensive source of capital, and it represents ownership of the business. Private equity firms are a common provider of capital for buyouts. However, you should know that they seek to invest in companies with the goal of selling their equity in 3 – 7 years, and they usually demand significant investment returns (25%+). If the business is a success the equity holders often earn five to ten times invested capital. While an MBO is a big decision, the rewards can mitigate the risks particularly when the existing owner is already semi-retired or absentee. How is an MBO structured financially?
An example of MBO funding structure:
The Owner of ABC Company is looking to retire and the management team is interested in buying the company for $5MM, which includes the purchase price, transaction costs, and working capital/CAPEX requirements. However, the management team is only able to put up to 10% ($0.5MM) of their own money on the table. The rest of the capital ($4.5M) can be funded through:
Management Buyout is a transaction where the management team is involved in the acquisition in part or all of the business they manage. Financing sources of an MBO transaction may be obtained from a combination of personal funds, bank loan, equity finance, seller finance, and mezzanine finance. Reasons to consider an MBO
Typical exit strategies for a privately owned company may include:
- Merger and acquisition/Industry consolidation
- Initial public offering (IPO)
- Employee stock ownership plan (ESOP)
- Sell to a friendly individual
- Private equity
- Management buyout
- Liquidation
Sources: Exit strategies. Anatomy of a management buyout, Deloitte
Private business owners may pursue exit strategies due to retirement, competitive pressure, death or illness, and with no succession plan in place. A management buyout may be the best option for a smooth transaction since the management team is already familiar with the business, which lowers transaction risks, and they can use their expertise to continue to grow the business. Furthermore, other employees, business partners and clients are reassured as they are familiar with the existing management team. How to finance an MBO?MBO’s are typically financed through a combination of debt and equity, and or a hybrid form involving mezzanine instruments. Senior Debt
Senior debt is the highest-ranking liability of a company’s balance sheet and is also the cheapest source of capital. Debt may include loan or credit notes from banks, who take business assets as collateral. While the interest rate is lower it comes with rigorous covenants regarding interest coverage amongst other things. Mezzanine Finance
Bridging the gap between debt and equity, mezzanine debt is subordinate in priority of repayment and security to senior debt, but ranks in priority to equity. Mezzanine debt may take the form of junior debt, subordinated debt, convertible debt, private “mezzanine” securities, or second lien debt. Mezzanine providers typically look at an IRR between 11% and 25% subject to the pricing of the risk. At the top end of the price range it begins to overlap with expected equity returns which we estimate at a +25% IRR target for today’s equity investors. Management teams choose mezzanine finance to enjoy a control ownership position, flexible repayment terms and higher return on equity (ROE) that results from using appropriate leverage. Mezzanine investors often work together with the shareholder/management team by bringing the structuring and finance expertise to help the company grow as well as engineering the repayment terms to match the business’ cashflows. Advantages of using mezzanine debt are providing the necessary capital to own the business, minimizing the weighted average cost of capital (WACC) through lower cost and tax shield deductibility on interest payments, and to reduce the need for equity capital and thereby avoid unwanted equity partners. Most importantly mezzanine debt is an effective tool to mitigate partnership risk which we have found is an often misunderstood and overlooked issue for MBO parties. Equity
Equity is the most expensive source of capital, and it represents ownership of the business. Private equity firms are a common provider of capital for buyouts. However, you should know that they seek to invest in companies with the goal of selling their equity in 3 – 7 years, and they usually demand significant investment returns (25%+). If the business is a success the equity holders often earn five to ten times invested capital. While an MBO is a big decision, the rewards can mitigate the risks particularly when the existing owner is already semi-retired or absentee. How is an MBO structured financially?
An example of MBO funding structure:
The Owner of ABC Company is looking to retire and the management team is interested in buying the company for $5MM, which includes the purchase price, transaction costs, and working capital/CAPEX requirements. However, the management team is only able to put up to 10% ($0.5MM) of their own money on the table. The rest of the capital ($4.5M) can be funded through:
- 50% ($2.5MM) from bank/debt provider
- 25% ($1.25MM) from mezzanine provider
- 15% ($0.75MM) from other new equity investors or preferably the former owner
