Alternative Insight – January 2015

10 point health check for MBOs

This Insight focuses on key challenges that face management teams considering their first MBO and private equity buyers assessing a management team, and provides 10 suggestions to help the process run smoothly.

In the last 12 months the return to a seller’s market has put pressure on private equity buyers to accelerate transaction and has put management teams seeking their first MBO in a strong position to negotiate favourable terms.

However, once an MBO is under way, deal momentum rarely allows time for a management team to step back and consider the transaction’s impact on their careers, personal finances and, of course, their business. Similarly, the PE house backing the team should take time to assess if the managers are ready to assume the risks and liabilities and face the challenges that accompany an MBO.

Below are 10 key issues for both managers and buyers to be aware of in the preparatory stages of an MBO:

1. Personal finances

  • Buyers – understand the management team’s appetite to put their personal wealth at This is often delayed. leading to pressurised conversations late in the day
  • Managers – be realistic about what you can afford to invest (including borrowings) – a buyer will want to ensure you have sufficient ‘skin in the game· to incentivise you to maximise value, but don’t forget this is still risk capital
  • Both – consider (with input from legal and financial advisers) the tax position of the managers, and whether tax reliefs – such as entrepreneur’s relief – would be available to boost net returns

2. Management warranties

  • Be conscious that in UK deals managers are invariably asked to give warranties (contractual assurances, for which managers are personally liable, usually up to a multiple of salary). Buyers should flag their expectations at an early stage, and managers should consider what they would be comfortable warranting, and their maximum exposure
  • Warranties typically cover due diligence reports and/or the agreed business plan (over 75% of deals), and sometimes managers· awareness of any breach of warranties in the sale and purchase agreement (less common, but still seen in approximately 25% of UK deals)

3. Managers will become owners, not controllers

  •  An MBO will turn managers into but they will still have many ‘bosses’ to answer to
  • For example, the shareholders agreement will compel managers to seek the buyer’s permission to take certain material steps (typically including changes to business plan, material borrowings, acquisitions and disposals, senior staff changes)
  • Bank covenants will require careful monitoring and financial discipline – the impact of this is often underestimated by CFOs

 4. It’s all about the “Exit”

  • The management team should be aware (and be made aware) that liquidity on their investment may be some time away – are they prepared and motivated for the long haul?
  • Managers should demonstrate (both before the MBO, and afterwards) that the team also has its eyes on the buyer’s ultimate goal of ‘Exit’, and that they are key to its success – both operationally and as salesmen’ of the business to the next buyer
  • If any of the above doesn’t initially ring a buyer should consider how best to incentivise or re-focus the team

5. Profits may drop

  •  Management will be distracted away from the business while an MBO process is under way (six months minimum). and profitability may suffer during the process and in the immediate aftermath
  • The managers and buyer should ensure that the transaction runs to a strict so that all energies are refocused on the business as soon as possible

6. Call on the A-team

  •  Without exception, a PE buyer expects an orderly board structure, with day-to-day responsibilities clearly delineated between a Chief Executive Officer, Chief Financial Officer Chief Operations Officer and Head of Sales (or equivalent)
  • If this isn’t the case – and in particular if there is no ‘leader· of the management team to act as its representative and driving force during the MBO process – the buyer will be justifiably concerned about deal deliverability, team cohesion and effectiveness

7. Pre-deal spring clean

  • Managers should assume that any shortcomings in the business· finances. legal/accounting records and trading relationships will be exposed during due diligence
  • Management teams should be expected – and encouraged – to identify and resolve issues pre-MBO. failing which doubt may be cast on the team’s command of the business and whether disclosure has been full and open

8. Plan growth together

  • If the management team hasn’t devised a clear strategy for growth on its preferred terms, the buyer’s plan will dominate
  • The management team should use financial advisers to ensure that projections and assumptions are well thought-through and professionally presented, and to navigate the tension between showing the business in a favourable light (i.e. likely to yield high returns) and being credible
  • Equally, a buyer should ask for the management team’s growth both to sense-check its own and to encourage “buy in” to the eventual strategy. The buyer should remain open-minded if the managers· strategy differs from its own

 9. Know who you’re dealing with

  •  A management team should research potential PE buyers: how they what other businesses they have interests in. and what future they may envisage for the business
  • Similarly, a buyer will seek third party references and soundings on the management team – so the managers would be wise to compile a list of fair and

1o. 100-day plan

  • A buyer is likely to have a list of post-MBO priorities to put the business on the ‘right’ track – managers should work on it with them and offer to input ideas
  • However managers should also have a plan to ensure that the change in ownership causes minimal disruption to the business – in particular. effective communication with employees and trading partners is key

 

Alternative Insight is produced by MJ Hudson’s private funds lawyers. We provide expert legal advice to fund managers, other financial sponsors, investors and advisers on the formation, structuring, investment into and regulation of private funds, managed accounts and similar vehicles. Our practice covers the full spectrum of alternative assets, including private equity, venture capital, hedge funds, private debt, real estate and infrastructure. Clients praise our entrepreneurial approach, commercial outlook and dedication to helping them achieve their objectives, regardless of the obstacles.