In a buyer’s market with low interest rates, now is the perfect time to conduct a management buy-out – if you can get the funding. James Harris reports

In a buyer’s market with low interest rates, now is the perfect time to conduct a management buy-out – if you can get the funding. James Harris reports

A management buy-out (MBO) has never been easy. From the initial approach to the company’s owners to naming a price and dealing with advisers, it is a test of nerve, acumen and powers of persuasion.

It’s no mean feat to have negotiated a buy-out during the past year, when deal volume has plummeted from almost 700 in 2008 to fewer than 300 in the first nine months of 2009, according to the Centre for Management Buy-out Research (CMBOR). Rod Ball, a research fellow at the organisation, says, ‘In terms of the number of deals, we’re going back to mid-1980 levels; in terms of deal value, we’re back in the mid-1990s.’

Debt restructuring has driven many of these deals. Homeware seller Robert Dyas, a familiar name on the high street, was acquired in 2004 by private equity firm Change Capital Partners for £60 million (£30 million of that was debt supplied by Allied Irish Bank and Lloyds).

Debt burden

Graham Coles, financial director of Robert Dyas, says, ‘In 2007, we became aware that our net debt was too high for the EBITDA [earnings before interest, tax, depreciation and amortisation] that we were generating, so we approached the banks to restructure our gearing.’

For year-end 2009, the company’s revenue was up 1 per cent to £107 million, while EBITDA fell 40 per cent to £4.3 million. ‘We had thought that our debt would be paid off by higher profits,’ says Coles. ‘We offer a lot of DIY products, a market that is closely linked to housing, and we didn’t foresee the collapse in property, nor the poor economic climate.’

High debt was choking the company: ‘The level of repayment was challenging; it was hard to incentivise the management with equity when it had no value. Something had to be done.’

After tense negotiations, a special acquisition company was set up by CEO Steven Round and non-executive chairman Ian Gray in April 2009 to acquire Change’s stake for £1 million, which was financed by bank debt.

This transitional structure was designed to give the management and banks a chance to restructure the debt. In September, the debt was halved to £15 million and the rest was converted to equity, leaving the company owned by the banks, with the management team retaining up to 25 per cent.

‘We now have the right amount of debt and we are motivated to maximise the value of the business for our new owners – the banks,’ says Coles.

Back from the brink

Clearly the business was in trouble, but Coles insists that throughout the period the company ‘remained profitable and managed to pay off what was owed when it was due’. He also notes that its ‘market share has risen and profit performance is better than that of most competitors’.

As for the original debt burden, Coles says that this was ‘entirely appropriate for 2004,’ adding that the business was ‘conservatively geared at the time’.

Money worries

Research from CMBOR highlights that nearly a third of buy-outs (29 per cent) completed during the first nine months of 2009 have involved companies heading for receivership.

Ball notes that, after a wave of debt restructuring, many banks are taking over businesses that would have gone under. Instead of holding the debt, they now control the equity. Adds Ball: ‘The question is, who’s going to run these businesses? It’s risky for banks to run them. [Banks] are no good at it, and exit markets have been flat.’

As for trying to fund MBOs as profitable concerns that are not destined for the rocks, Tom Cartwright, a partner at law firm Taylor Wessing, says that ‘banks are still nervous about using high leverage’. He points out that this has caused a funding gap in deals, as the combined debt and equity provided by banks and private equity houses is often sufficient to cover the consideration, but not enough for cash flow. ‘Getting enough working capital to reinvest in a business is a huge problem,’ he says.

This has led to greater interest in specialist lenders, such as providers of mezzanine finance and asset-based lending (ABL). A lot of dealmakers caught in the gap are finding that ‘they might be able to squeeze some debt from a mezzanine house, or obtain additional funding from invoice factoring’, comments Cartwright, although the terms and fees are often more expensive for ABL than for other, more traditional forms of finance.

Long haul

For determined management teams, resilience and patience are required in equal measure. The MBO of Scotland-based IT services company Amor Group provides a fine example of the perilous job of finding finance for such deals in the hinterlands of a recession. Chief executive officer John Innes saw an opportunity to acquire the business when its parent company, Sword Group, decided to focus on software products. Innes approached Sword’s chairman, Jacques Mottard, and they agreed a rough price in January 2008.

Optimistically, Innes expected the deal to take three months. A gruelling 17 months later, the deal was finally put to bed for £28 million. Says Innes: ‘Either I’m bad at buying companies or there were some serious problems in the economy.’

Fortunately, Innes did get a bank involved quite early on in the process to agree to a £17.5 million senior debt facility. Getting a private equity firm on board proved to be the real struggle. Innes says that during 2008 the management team approached 20 private equity houses, four or five of which were seriously interested. ‘I can tell you, it wasn’t much fun. On one occasion, we went all the way to the sale and purchase agreement, and then the private equity firm fell out at the last minute.’  

The management team eventually identified a firm that agreed to provide £21.5 million through a mix of loan notes and equity, although Innes says that he was keen to make sure that the loan notes comprised the larger element. Innes says that the agreed structure of the deal meant that the management retained a 50 per cent stake in the business. ‘The interest payments to the bank and the private equity house are challenging, but we’re in it for the long haul,’ he says.

There was another reason for introducing a second investor: ‘We were careful to make sure that the bank had a position in the overall investment, but that it wasn’t disproportionate. There was a nervousness about bank behaviour at the time, and we weren’t alone in thinking that the bank influence should be kept to a minimum.’

A more familiar problem during the deal related to the vendor, Sword Group, being a French company that was quoted on Euronext. That created additional legal and commercial complexities, as the company had to ensure that it complied with regulators on both sides of the Channel.

In addition, Sword’s shareholders and investors had to be brought into the deal, not to mention various co-investment partners. ‘It was a mixed constituency, which doesn’t lend itself to a rapid process. At completion, I counted 22 advisers in the room,’ says Innes.

Final analysis

The opportunities for an MBO will increase as large companies seek to dispose of non-core assets. Peter Brooks, managing director of Lloyds Development Capital, the private equity arm of Lloyds Banking Group, says: ‘Scattergun corporate strategies are never as exposed as during a downturn.’

Something similar occurred at UK-based film software company The
Foundry. Two years ago, the company was bought by Digital Domain, a post-production house based in Los Angeles. A year later, the parent company decided that it wanted to focus on its core business, which was making films, as opposed to selling software.

Dr Bill Collis, CEO of The Foundry, saw an opportunity to buy back the company and decided to look for a backer in the autumn of 2008. As with Amor Group, funding did not come easily. Collis says: ‘It wasn’t the best climate to convince people to back a small software company. I had every confidence in the business but I was surprised how hard it was to get people to listen to me.’

Smooth run

The firm finally found a sympathetic venture capital firm, and since then ‘everything has gone smoothly’, says Collis. The company doubled revenue in the 18 months to June to $10 million (£6 million) and the CEO is positive about the future: ‘The film industry has always been resilient in recessions. Although DVD sales have fallen, box office takings have actually risen. The kinds of productions that are doing well now are big-budget and effects-laden films, and that’s where our software lies.’

For all the difficulties of MBOs, there is hope that activity will increase. If nothing else, an MBO is often the easiest way to exit a business, especially in today’s environment. Collis confirms that this was a consideration for Digital Domain: ‘The company wanted to divest, and an MBO was probably the most pain-free way of achieving that.’

Mark Tooth, M&A associate director at accountancy firm Baker Tilly, says: ‘An MBO is the easiest way for business owners to manage succession planning. They can ensure the business is in the right hands and they can exit in a managed way.’

Tooth observes that trade sales are often seen as better for sellers as large corporates can pay more upfront than a debt-dependent MBO team. But he says this is changing as vendors accept that big-ticket sales are not forthcoming. Lower prices and deferred payments based on performance are the order of the day.

After the frothy excess of pre-credit crunch days, Cartwright points out that an emphasis on investing in managers that can deliver in difficult markets, rather than financial engineering, may benefit the private equity industry. ‘Many private equity firms took advantage of the free-flowing debt,’ he argues, ‘but now they have to re-examine themselves and go back to the basics.’