This is an extract from a Catalyst White Paper which you can download in our Resources section
Three factors are essential if a management buy-out is to be achieved: an effective management team (explored in part 1), a strong business and a suitable exit opportunity.
A Strong Business
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.
As a general rule, the following characteristics help a buy-out;
• a consistent track record of turnover and profit growth or demonstrable scope for improvement;
• a strong competitive position within a growing, stable industry;
• a spread of products and services;
• strong asset backing or demonstrable cash generation.
As a result, most businesses lend themselves to a buy-out if they possess the above features. There is a common misconception that ‘people’ or ‘creative’ businesses are more difficult to buy out. This is not true provided that the business shares most of these features.
Suitable Exit Opportunity
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 loan.
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 sale of the company to a trade buyer;
• a flotation of the business on the London Stock Market, the Alternative Investment Market (AIM) or Easdaq;
• and the management team may buy out the shareholding of the institutional investor, or even a manager wishing to leave or retire, if the business has generated sufficient profit and has adequate cash or borrowing resources.
In a substantial majority of cases, however, the most likely exit will be a sale to a trade buyer.
For an attractive exit, it is important that the business:
• has achieved satisfactory sales and profit performance for the preceding 2 or 3 years, compared with other companies in the market sector;
• is capable of sales and profit growth during the medium term;
• is not unduly dependent upon either one or a few customers;
• and has a management team committed to the development of the business.
Consequently, a management team will have to demonstrate how they will achieve continued sales and profit growth throughout the foreseeable future in order to get financial backing. Attempts by a management team to mount a management buy-out simply to retain their jobs would not receive backing unless the prospects for a successful exit are demonstrated. As a potential purchaser will generally require the management to continue after the acquisition, the management team should not assume that they will exit at the same time as the institutions.
The casting vote regarding exit is a matter for negotiation. There are likely to be detailed discussions as to the circumstances in which either management team or investors can sell their shares and the rights and obligations of other shareholders in such circumstances. Investors will not want to coerce a successful management team into an exit.
It is quite common for a participating or accelerating dividend to come into operation after, say, 2 or 3 years, giving the equity investors a right to a proportion of profits. This form of finance is expensive and is intended to focus the management team on the advantages of an exit. In addition, a majority of the equity investors’ investment may be in the form of loan notes or preference shares repayable or redeemable to a fixed timetable, sometimes at a premium.
See Part 3 next week for an overview of the stages of the buyout process. Or you can download the white paper from our resources section.
I have Just came back from a two day biotech conference. I go to conferences to meet people, find opportunities, and keep up to date with the sector – probably in the that order. Inevitably I get my fair share of impromptu pitches and I am always amazed at the gap between the expectations of entrepreneurs and investors. Entrepreneurs typically play down risk, over value propositions, and under estimate the time it takes to do anything. Excessive bullishness does not instil confidence it breeds suspicion and a lack of credibility. Investors want to see realistic targets. I would much rather have the view that the entrepreneur was being excessively cautious rather than over optimistic. The mantra should be “under promise over deliver”.
