Busting finance jargon with Roger Esler #4
IBOs, MBOs, LBOs, SBOs, TBOs, MBIs and BIMBOs
The decision for business owners to pursue a private equity (or financial buyer) exit route versus a trade sale process is a fundamental one. In Busting Jargon #3, the challenges and risks of mixing two processes together, when each can achieve a very different outcome for shareholders and management, were discussed.
The private equity market is highly evolved, diverse and well-funded and is populated by professional investors seeking buy-outs and transactions of various shapes, sizes and forms. Good businesses with good management are pushing on open doors. Those in financial distress or in need of restructuring can potentially find a specialist “white knight” with the requisite skills and risk appetite to save them.
So why pursue a private equity route rather than a trade sale?
Firstly, shareholders’ loyalty to, and belief in, the management team is an important factor, perhaps influenced by the owners’ desire to remain involved (and even partially invested) over a period, or by the appeal of leaving the legacy of an autonomous, UK business. Trust between shareholders and the management team is critical if both price and ongoing incentivisation for the management team are to be perceived as fair and balanced.
Secondly, the business needs to be in a sector and have the scale, characteristics and demonstrable growth potential that will both attract private equity investors and give the owners the confidence that this route can deliver overall terms that match, or better, a trade buyer. This is true of many sectors, notably in technology and specialist business services. Additionally, taking overall terms in the round (ie cash up front plus any rollover), a business with potential that can be unlocked by additional investment capital, management change, acquisition or simply building more scale over time, can potentially get a better outcome for shareholders from a private equity investor taking the long view, than from a trade buyer with a shorter term integration agenda.
Thirdly, the commercial risk of sharing voluminous confidential information with competitors in a trade sale process is off-putting for many business owners and leaks can be unsettling for employees and customers. Whilst this can be managed through focus on key strategic buyers, phased information release and so on, the reality is that the best valuations generally come with full disclosure. Private equity investors do not present the same risk. Plus, they move more quickly.
Importantly, shareholders need to evaluate at the outset what deal they wish to achieve and be independently assured that there is the growth plan and management team to deliver a private equity deal. It is in the Feasibility and Planning phase of the project that this is assessed with the input of Corporate Finance advisers, deriving not only a price expectation on the business but also the target structure for the deal: investment requirements, which shareholders are exiting, which are rolling over, which managers need incentivised, debt capacity, appropriateness of an equity ratchet, the ultimate exit timeframe and, therefore, required cheque size and likely terms from a private equity investor.
What then is the most appropriate approach to the process?
Institutional Buy-Outs or “IBOs” describe financial buyers acquiring significant majority positions perhaps from another investor, a corporate divestor or a business with layers of non-shareholder management and minimal dependence on the vendors. In truth, private equity investors do not buy businesses, they back management teams, whether in situ or following planned changes post deal. A key consideration with such a vendor-driven approach, or institutional auction, is not to alienate or marginalise the management team that is best place to sell the strategic vision. At best they might get lousy deal terms and at worst the sale might be perceived by management as a hostile takeover, unnerve investors and derail the process, leaving the owners with a fractured relationship. Ensuring the appropriate involvement of the management team in the process, and that they have access to proper, independent advice, can deliver a superior outcome for all.
Management Buy-Outs or “MBOs” tend to be management led (or strongly influenced), the price expectation of the vendors being agreed up front and the management team developing the strategic plan and seeking the necessary funding and the right investment partner through a competitive process. This would include determining the optimal level of debt in the structure since many such deals suit this less costly capital alongside equity and can be described as Leveraged Buy-Outs or “LBOs”.
Both vendors and management being independently advised and in a relationship of trust can make this traditional MBO approach very effective, with investors getting the quality time with management they need and, whilst generally taking a majority position, the management team’s economic terms should better over the long term than for an IBO. The vendors being given transparency into the process and the terms being tabled can enhance this trust.
In practice, some or all of the existing shareholders might wish to continue to be involved managerially and economically, perhaps as part of a deal that has succession and handover characteristics. Together with any requirement for growth capital, private equity transactions can have several moving parts for the different factions of old and new senior management and a significant rollover of value into the deal can mean a minority interest for the private equity investor rather than a controlling one, albeit laced with some substantial, but justifiable, minority protections.
Where a business is absent an ongoing senior management team, either because shareholder-directors wish to retire or because the business is a subsidiary or division and managed at group level, a Management Buy-In or “MBI” is a theoretical solution. However, such transactions carry much higher risk than a MBO for obvious reasons – a management team new to the business will take time to understand it and will not know where the skeletons are, which makes such deals harder to fund and valuations lower. In addition, private equity investors do not keep ready-made MBI teams on their books for every occasion.
In practice, therefore, it is MBI candidates themselves that often nose out the deals from their industry connections and market knowledge and then go looking for funding, sometimes even working in the business for a period with the understanding that they will get a run at a deal. This is powerful collateral for some investors and, together with the possibility of buying a business off-market and the MBI team having some “hurt money” to put up, does generate successful deals, albeit generally not as part of conventional competitive sale processes.
A lower risk variant of a MBI is a Buy-In Management Buy-Out or “BIMBO”. An existing management team is complemented, or gaps left by exiting director-shareholders filled, by new senior arrivals. This approach can also revitalise a business’ strategic plan by bringing new ideas and expertise in products, markets, technology, acquisitions and so on. Clearly everyone needs to get on and be aligned on the strategic plan and that can take time to explore. So ultimately the transaction process is similar to a MBO and cannot be easily vendor-driven.
The diversity of the private equity industry is such that a business can go through a series of private equity investors over many years, as one fund crystallises its return and another larger fund backs the larger business, addressing management succession and a refreshed strategic plan at each transaction event. Secondary and even Tertiary Buy-Outs, or “SBOs” and “TBOs”, are fairly common and whilst some address an increase in scale, others address a changing investment profile. For example, where a maturing business is potentially more suited to an institutional debt fund in a yield-driven structure rather than to a growth investor. Of course, not all private equity investments are successful, and some get rescued by specialist turnaround investors.
Whilst target investment returns for private equity funds do not vary greatly, deal structures do, as every situation and every set of shareholder objectives are different. Private equity structures are highly versatile at moulding around these dynamics. However, solving the equation and getting to the right answer for both vendors and the management team requires very careful consideration of the optimal and deliverable outcome, as well as the right process to deliver that.