: A TOOL FOR CORPORATE RESTRUCTURING

Sneha Ghosh1, Kuntal Sil2

1,2 Research Student, Department of Commerce, University of Burdwan, West Bengal ()

ABSTRACT (MBO) refers to the process of management acquiring a majority or significant minority stake in a company. Management buy-outs became an emerging phenomenon in the 1980s and considered one the best exit strategy. However, this cannot be an overnight affair. This requires a series of planning and analysis before actually heading towards the process of management buyout. There may be several reasons but the main reason for opting management buyout is nothing but gaining more financial reward/incentives for future development of the company more directly than they would get as an employee. However, each party involved in this MBO has different conflicting interest. The business owner is seeking the highest price for the company, management is looking to acquire the largest equity stake possible, and if a firm is involved in the transaction they want to maximize their return on invested capital. To overcome such potential challenges and close the transaction successfully, it’s important to structure an MBO in a way that satisfies the collective interests of the parties involved. In the present day context, many companies have used or are also in the process of using this strategy considering it as a great deal. Therefore, the present paper attempts to analyze how Management Buyout act a tool for corporate restructuring and the various issues concerned with it.

Keywords: Management , Collective Interst, Private Equity Firms.

I INTRODUCTION The very definition of management buyout says that it is the purchase of an existing business, usually with a combination of and equity by the current management team. In other words, a management buyout (MBO) refers to the process of management acquiring a majority or significant minority stake in a company. Management buy-outs became the emerging phenomenon in the 1980s and considered one the best exit strategy. However, this cannot be an overnight affair. This requires a series of planning and analysis before actually heading towards the process of management buyout. There may be several reasons but the main reason for opting management buyout is nothing but gaining more financial reward/incentives for future development of the company more directly than they would get as an employee. However, each party involved in this MBO has different conflicting interest. The

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business owner is seeking the highest price for the company, management is looking to acquire the largest equity stake possible, and if a private equity firm is involved in the transaction they want to maximize their return on invested capital. To overcome such potential challenges and close the transaction successfully, it‘s important to structure an MBO in a way that satisfies the collective interests of the parties involved. In the present day context, many companies have used or are also in the process of using this strategy considering it as a great deal. Therefore, the present paper attempts to analyze how Management Buyout act a tool for corporate restructuring and the various issues concerned with it.

II CONCEPT OF BUYOUT ―Buyout is the purchase of a controlling interest in one corporation by another corporation or an investor, in order to take over assets and/or operations. The term buyout is often complemented by words that explain the specific structure and allow differentiating various forms of buyouts (e.g. management buyout, ).‖ ―Private equity is a form of corporate financing where mostly non-public companies are provided with medium- to long-term risk capital by specialized financial intermediaries. Private equity financiers take an active role in the control and advisory of their portfolio companies and provide management support where required. To realize capital gains, investments are undertaken from the very beginning with the intention to resell the equity stake.‖ When differentiating by buyer or role of management, several types of buyouts can be identified. The main characteristic of an MBO is that the existing management, or parts of it, acquires either the entire company or a large part of it, investing a significant share of their net worth. Often, a large company divests one of its subsidiaries by selling it to its management team. Another source of MBOs can be entrepreneurial and family businesses whose owners retire. Thus, three factors are to be considered prior to management buyout i.e, an effective management team, a strong business and a suitable exit opportunity. While effective management team is important due to the following reasons: a) The financial institutions should be well convinced with the management team so that they can handle the buyout and its other aspects independently. b) The equity investors will expect each member of the management team to invest personally. Provided the personal risk is acceptable, the equity investor will welcome a larger investment by the management team. Opportunities for other managers and staff to invest smaller sums can be provided. It is quite commonplace for the leader of the management team to have the opportunity to invest more than other key team members. c) In most cases, the leader of the buy-out team will be the present chief executive. It will be his or her job to ensure that the management team is not overly distracted during the buy-out. It is often appropriate to delegate the day-to-day involvement in the transaction to one or two individuals, and for them to provide regular updates for the team. On the other hand, a strong business is required due to the following reasons:Strong Business

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a) Most management buy-outs involve high levels of debt, especially during the early years. Accordingly, a positive cash flow is required. A business will be less attractive to financial backers if the cash generated is absorbed by additional working capital, uncontrolled growth or a high level of capital expenditure. b) As most buy-outs depend upon both equity and debt finance, the repayment of both needs to be considered at the outset. The leading debt provider will usually expect both interest and capital to be paid back out of cash flow over a specified period, often 5-7 years. Debt providers will not want to rely on an exit for the repayment of the . Providers of equity capital, however, will require an exit for the bulk of the profit they expect to make from backing the transaction. In most cases, they want to realise their investment within 3-5 years of the buy-out. Investors tend to maximise the annual compound rate of return by an early exit. The probable exit opportunities are: a) a sale of the company to a trade buyer; b) the management team may buy out the shareholding of the , or even a manager wishing to leave or retire, if the business has generated sufficient profit and has adequate cash or borrowing resources. For an attractive exit, it is important that the business: a) has achieved satisfactory sales and profit performance for the preceding 2 or 3 years, compared with other companies in the market sector; b) is capable of sales and profit growth during the medium term; c) is not unduly dependent upon either one or a few customers; and d) has a management team committed to the development of the business.

III WHY IS MBO AN ATTRACTIVE ALTERNATIVE? MBO is considered as an attractive alternative because of the following reasons:  Prior to recession (in the year 2008) there was an unprecedented growth in the financial markets, fuelled by easy access to low cost debt financing. This resulted in private equity firms bidding for target companies at valuation that rivaled strategic buyers, using excessive amount of financial leverage.  At times private owners want to retire and feel it‘s better to hand over the entire business to the management.  When the owner has no one to succeed him\her or successor are incapable of running the enterprise may feel handing over the business to the devoted employees will be a better option.  The owner might feel its better to reward and secure the management and the entire workforce.  When the performance of the company has not been satisfactory over a considerable period of time, the owners might feel that handing over the responsibility to them would however change the scenario.  Sometimes the owners of the company may liquidate certain asset or divest a business unit to generate cash.  Often managers seek MBO as because it will help them to advance in their career and help them to earn capital gain if the buyout process goes out well.

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 The legal formalities will be very less if owners handover the business to its current management than other third party. In other words, provided the MBO team can make a fair offer for the business there is a good reasons for it to be accepted. MBO team is a well placed to compete with the trade buyers and often the vendor will not seek a trade sale provided the MBO offer is reasonable.

IV SUCCESS MANTRA OF MBO For an MBO to be successful the managers have to face lot of difficulty since either they have lack of capital access or they are faced with conflicting interest of the different parties associated with the company. The three L‘s in a MBO deal should be followed so as to make it successful venture which are enumerated below:-  Leadership: the managers of the company must have the leadership skills in order to carry out this venture. A leader is always expected to have great commitment towards his work, clear cut plans and goals which will eventually lead MBO as a successful event. A successful MBO always requires a strong management team and a leader and a well- defined strategy.  Leverage: Before heading towards MBO, the managers must seek the pros and cons of the company so that positive cash generation takes place after MBO while it is not appropriate for the purchase of early stage businesses that are cash flow negative or the need to make large capital infusions to gain scale or cost positions.  Liquidity: Liquidity is one of the important aspects which the manager should take into account before MBO. The most prevalent source of equity capital in today‘s market are private equity investors. These investors need to achieve liquidity in a 3 to 7 year period. They will look to the team and their advisors to define the exit strategy or how they will obtain cash for their investment. This is usually through a subsequent sale of the company to another buyer but can be through a recapitalization. The quality of the exit opportunity will affect the attractiveness of the deal and the ability to attract investor capital. An MBO traditionally delivers value over time to the equity held by the management team and PE House in two ways: • Repayment of debt • Increase in enterprise value

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V PROCESS INVOLVED IN MBO The typical MBO comprises of few steps which may vary from organization to organization depending upon the deal.  Initial discussions between owners and management: The business owner may approach management, or vice versa, to determine their level of interest in acquiring (or selling) the company. The initial discussions ultimately determine if the process will continue. This stage is critical to successfully starting the MBO process and allows each party to present and align their interests.  Initial valuation: The initial valuation exercise helps to ensure that both parties are reasonably aligned in respect to expectations. An independent valuation expert normally is engage to assist in the determination.  Preparing confidential information: When financial investors (debt or equity) are required, management will need to prepare a confidential information memorandum (CIM) to entice those groups. The CIM should contain enough information about the company (i.e., customer base, market position, financial results) to allow prospective investors to assess their level of interest.  Identifying financial investors: In order to successfully negotiate and structure the financing needed to support an MBO, there needs to be an understanding of what financial investors consider when making an investment and how they behave. Most private equity firms set out their investment criteria on their website, which helps in identifying the firms that might have an interest.  Preliminary due diligence: Financial investors interested in continuing with the MBO after they review the CIM will conduct further due diligence. In this stage, the business owner and management should strive to learn about the financial investors to help in selecting the right financial partners and negotiating the financing terms.

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 Negotiating terms of the deal: The value of the MBO is subject to the dynamics of further negotiations with lenders and private equity firms. Some of the most important deal structuring considerations are: if the owner is selling the entire company or retaining a residual interest; the nature and extent of security that management can offer for any debt financing; whether the deal will incorporate an earn out arrangement; and the role the business owner will play (if any) after the MBO is complete.  Execute the term sheet: Financial investors that are interested following their initial due diligence will submit a term sheet, which sets out the terms for financing the transaction. The financial investors offering the term sheet that best meets the needs of the business owner and management are provided a period of time to complete their due diligence and to negotiate the definitive agreements.  Closing: The closing of the transaction involves the financial investor‘s final due diligence, negotiating the lending agreement, the purchase and the sale agreement, the shareholders agreement, and finally the close.

VI THE ROLE OF FINANCIAL ADVISOR IN MBO A financial advisor has to be appointed as soon a possibility of MBO arises. The key contributions of the financial advisor should include:  advising on the format and content of the business plan;  To access whether MBO is feasible or not. If not the possible efforts should be made to pave ways to MBO.  choosing 3 or 4 prospective equity investors most likely to be keen to invest in the type of business and size of deal;  negotiating the best possible equity deal for management from the preferred equity investor;  working with the equity investor to negotiate the lowest possible purchase price and most advantageous deal structure from the owners; and  introducing the management team to appropriate legal firms with proven experience of management buy-outs.

VII THE ROLE OF LEGAL ADVISOR IN MBO While the various parties have a common interest in pursuing the legal agreement to buy the company, the management team needs its own lawyers to handle their agreement with the equity investor. It is vital that the management team appoints competent lawyers with an established management buy-out track record. Both the vendor and the financial institutions may use ‗heavy-weight‘ law firms and the management should invest time in ‗beauty-parading‘ prospective law firms to ensure relevant expertise and competitive fees. The Articles of Association of Newco, essentially the bye-laws for operating the company, and the Shareholders‘ or Subscription Agreement between the management team and the equity investor need to be negotiated. The

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agreement initially drafted by the lawyers acting for the equity investor may impose many restrictions on the managerial freedom of the management team to operate the business. The arrangements for members of the management team who leave the business prior to the exit are likely to need considerable negotiation. Investors will want the shares to be sold at the lowest possible price to incentivise replacement managers. The departing manager, however, will want to receive full value. The attitude of investing institutions to these issues varies. Some will seek to make a distinction between ‗good‘ and ‗bad‘ departures and be prepared to increase the value attributable to a manager‘s shares over time. Others will seek a simpler basis, agreeing a valuation formula to be applied regardless of the circumstances surrounding the departure. Service between Newco and the management team just be negotiated before legal completion. The starting salaries and duration of the service contracts must be acceptable to the management. If interest on mortgages or to purchase an equity stake is to be repaid monthly then the salaries should be increased to avoid a drop in the standard of living. It must be realised that subsequent salary increases for the management team will not only need the approval of the equity investor, but are likely to be strictly regulated. Generally speaking, the lawyers to Newco will handle the acquisition agreement between the vendors and Newco and the loan agreement between Newco and the lenders.

VIII TIME SCALE

Source: guide to MBO pdf.

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Most buy-outs take up to 6 months. When buying from a receiver, speed is essential and the equity investor will respond accordingly. Private equity houses occasionally publish case histories showing a management buy-out legally completing within 3 months. Throughout this period, the management team must continue to manage the business, or suffer the consequences immediately after the management buy-out is completed. The financial advisers must take the brunt of the workload connected with the management buy-out.

IX TAX CONSIDERATIONS

The tax aspects of an MBO are an important structural and commercial feature of most transactions. The following key areas usually need to be investigated, alongside others which are situation specific.  Seller‘s position 1. A seller will want to minimise the capital gains tax payable on the disposal of shares. 2. Deferred consideration and contingent consideration such as earn outs need to be carefully structured as potentiallythese could attract higher rates of tax  MBO Team 1. The MBO team will have tax issues relating to the shares or ―‖ that they acquire in the Newco. 2. It isimportant not to trigger any income tax liabilities as a result of acquiring the shares which occurs when they are seento be acquired at less than their market value. 3. Equity ratchets sometimes offered to MBO teams to incentivise performance also need to be structured carefully soas not to create income tax liabilities. If the manager borrows to make an investment into the company, tax reliefshould be available on the interest, provided that the loan is structured correctly.  PE/VC Funders 1. Funders may have particular tax driven requirements for the transaction which may, for example, drive the debt:equity mix. However, at times it is seen that management team makes several mistakes after MBO that are illustrated below:  Lack of proper leadership qualities and understanding the duties: the management team must understand that even if the same amount of money is employed by the team member there lies a clear demarcation between employee and shareholdings. Since, in a company first the team will be regarded as an employee then as a shareholder. Presence of strong leader is a must in the organization who will clearly divide the work among every subordinate. Once the Management Buyout has been completed and being a shareholder doesn‘t change this. Being a shareholder means the managers directly benefit from the success of the business.  Wrong choice of financing-mix: There are various sources of financing that may be available to complete the deal – , term lenders, subordinated debt providers, private equity, vendor financing – all of which have different costs and attributes. Banks are the cheapest form of financing but they have strict rules that

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managers need to live with while private equity is very expensive but also very patient. However, it seen the management often fails to choose the right financing-mix which leads to a bad consequences.  Lack of understanding the financial partners: Each of the sources of financing has their unique characteristics and it‘s better to understand them very carefully. Banks are not the equity partners and, if private equity investors are brought in, soon it may be discovered that private equity partners are very different from the banker. There is a need to treat all the financial partners with openness, honesty and full disclosure. But one of the keys to successfully growing your business is to understand what each of the financial partner‘s nook and corner.  Not spending enough time on the Shareholders Agreement: A well drafted Shareholders Agreement has to address all those difficult ―what if‖ questions such as what happens if someone gets sick, dies, is fired (with or without cause) and what are the issues going forward that require a majority consent from the shareholders. How a shareholder exits the business and how, and at what value will it be sold shares is a key topic that needs to be spelled out in the Shareholders Agreement. These matters are to be carefully taken into account before heading towards MBO.  Not being candid and honest about key issues: The best candidate for a Management Buyout is a business (or business unit) that can assume debt and is stagnating because management is being prevented from unlocking upside revenue opportunities by the current owners.  Inability to synergies: Management does not have the ability to realize synergies unlike strategic buyers. This can reduce the purchase price.

X FINANCING MBO For the sole purpose of buying the company and financing the purchase, management and the funders create a new company (―Newco‖). In the most common structure, Newco acquires 100% of the shares in the target company and thus becomes the . Newco then raises different types of financing from different sources. Funding for a MBO will come from a variety of sources. The bulk of the funding will normally be provided by financial institutions, primarily from banks and venture capitalists / private equity houses. Debt and working capital facilities (loans and overdrafts / invoice discounting) are typically provided by a or asset-based lender (―ABL‖). Equity investments are most frequently provided a venture capitalist / private equity house. A venture capitalist and private equity house are similar in that they both provide third party equity to buy businesses – typically a venture capitalist looks at smaller deals and a private equity house at larger deals – so we will refer to them both as venture capitalists for the rest of this guide. In addition, in certain circumstances, the vendor may be willing to defer some of the consideration for the business and, in the current market place, this has become a regular feature. The management team will also be expected to invest but in reality this investment is more to show their commitment rather than to be a major source of funding.

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The various important document required to carry out MBO are illustrated above.

XI THE MBO VALUE MATRIX  Each party involved in this MBO has different conflicting interest. The business owner is seeking the highest price for the company, management is looking to acquire the largest equity stake possible, and if a private equity

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firm is involved in the transaction they want to maximize their return on invested capital. For an MBO to be successful a facilitator should be appointed and all the parties concerned must compromise and structure a deal that is beneficial for all the parties concerned in the MBO.  The facilitator is the financial an advisor who not only understand the MBO but also provide the pros and cons associated with MBO. The role of a facilitator is to enable the owners and the management team to identify and attract the right financial partner that would be beneficial to all the parties and helps in fulfilling the collective needs. He also ensures that fair value transaction takes place.

XII SOME RECENT MBOs  Cerberus Capital Management agreed in March to buy Safeway Inc. in a transaction valued at more than $9 billion. The firm planned to combine Safeway with fellow grocery chain Albertsons to create a food retailer with more than 2,400 stores and more than 250,000 employees.  In , another group of music and entertainment stores were subject to a management buy-out in September 2009, when 's owner and founder, Brett Blundy, sold BB Capital's Entertainment Division (including Sanity, and franchises of Virgin Entertainment and HMV) to the company's Head of Entertainment, Ray Itaoui. This was for an undisclosed sum, leaving Sanity Entertainment to become a private company in its own right. (Source: Wikipedia)  In the UK, New Look was the subject of a management buyout in 2004 by Tom Singh, the founder of the company who had floated it in 1998. He was backed by private equity houses Apax and , who now own 60% of the company. (Source: Wikipedia)  An earlier example of this in the UK was the management buyout of from Viacom which was led by Mark Dyne.The has undergone several management buyouts. On September 17, 2007, announced that the UK arm of was to be sold off as part of a management buyout, and from November 2007, it is known by a new name, . On September 24, 2008, another

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part of the Virgin group, Virgin Comics underwent a management buyout and changed its name to Liquid Comics. In the UK, also underwent a similar process and became . (Source: Wikipedia)  2014 proved to be a big year for marketing deals, as Carlyle Group offered nearly $5 billion to acquire Acosta Inc., which helps consumer goods companies plan product launches and develop in-store displays. The deal came just weeks after Acosta’s rival Advantage Sales & Marketing LLC passed from one set of buyout owners to another in a deal valued at around $4 billion.  3G Capital, the firm behind the $23 billion of H.J. Heinz in 2013, was also party to the largest deal of 2014 when Burger King Worldwide Inc. moved to acquire Canadian coffee-and-doughnut chain Tim Hortons Inc. 3G retained control of Burger King, the fast food chain it bought in 2010, even after the home of the Whopper went public. Burger King‘s $11 billion offer for Tim Hortons got the seal of approval from Berkshire Hathaway’s Warren Buffett, who offered to finance the deal, but drew ire from lawmakers eager to curb so- called inversions, in which a company.

XIII CONCLUSION  It may be said that MBO is a viable exit strategy for business owner particularly those business which have strong growth potential and good financing is available.  The MBO Value Matrix will provide a great framework to identify each party‘s advantage and disadvantage.  For a deal to occur, the MBO price must reflect a ―fair market value‖. A business valuation by an independent appraiser is the best way to establish value in an MBO situation  The management team should be well committed and hardworking relating to their work.  Management Buyouts present significant opportunities for business owners, financial sponsors and entrepreneurial management.  For the business owner it is often a chance to retire and unlock their wealth in the business. For corporate parents, these transactions provide an opportunity to divest non-core operations and raise cash.  From the perspective of management, Management Buyouts provide an opportunity to gain direct equity ownership of their business and create an entrepreneurial environment. And a Management Buyout is likely to be the best way to create/build significant personal wealth.  The keys to good management led buyouts include excellent professional advisors and lots of patience when putting the deal together.  However, just like any other successful deal, want you need most of all is the right people with the right attitude, openly communicating, and mutually committed to a win-win transaction.

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REFERENCES 1. Todd D. Peter, Evarts Capital 2. NORTH BAY BUSINESS JOURNAL, August, 2009 3. Guide to mbo 4. en.wekipedia.in 5. The Management Buyout — Anatomy of a Deal By Peter V. Anania

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