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Management buyouts - Mergers

Management buyouts - Mergers

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Published by Balaji

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Published by: Balaji on Feb 09, 2010
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11/04/2012

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MANAGEMENT BUY OUTMeaning
Essentially, a management buy-out (MBO) is the purchase of a business by its existingmanagement, usually in cooperation with outside financiers. Buy-outs vary in size, scopeand complexity but the key feature is that the managers acquire an equity interest in their  business, sometimes a controlling stake, for a relatively modest personal investment. Theexisting owners normally sell most or usually all of their investment to the managers andtheir co-investors. Often the group of managers involved establishes a new holdingcompany, which then effectively purchases the shares of the target company
.
How Most Management Buyouts are done
Private equity firms do hundreds of buyouts a year. Their typical approach is to offer to buy a controlling stake in a company using leverage they obtained from banks based onthe financials of that company. Often times these firms commit very little of their ownmoney to purchase the business. With little cash invested, these deals create spectacular returns for the buyout firm.Buyout firms also collect large fees up front, as well as additional advisory fees whileoperating a company they've acquired, and a big share of the investment profits. Theaverage annual management fee to do business with a private equity firm is about 1.5%to 2.5%. The average share of profits is about 20%. While buyout firms givemanagement ownership, it's usually less than 20% of the company. This type of buyoutis the most common and is typically called a Sponsored Leveraged Buyout, where theequity player is the "Sponsor."
 
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The Essential Components of an MBO
As illustrated by the previous example, financial investors generally seek companies thatoffer the following:
Organic growth potential
. Financial investors generally are more interested incompanies having a sustainable differential advantage in the marketplace and thatoperate in a growing industry, as opposed to ‘me too’ types of businesses and those indeclining industries;
Ability to leverage
. By using debt to finance a portion of the purchase price, thereturn on equity is higher (as is the risk). The debt capacity of a company is afunction of the nature and quantum of its underlying tangible assets and its ability togenerate cash flows to service debt; and
Exit strategy opportunities
. Financial investors generally have a 3 to 7 year timehorizon. They seek companies that can either be sold to a strategic buyer or are believed to be good candidates for an initial public offering. These avenues offer ‘exit multiple expansion’, which means that the effective price multiple paid on exit isexpected to be richer than that paid on acquisition.MBO’s are facilitated where the owner has realistic expectations in terms of the pricethatwill be paid for their company. This is not to suggest that financial buyers will not pay afair price, but that they are less likely to pay a significant premium as contrasted withwhat might be paid by a strategic buyer. The advantage of dealing with a financial buyer is that they usually will offer a cash deal, whereas other, less attractive, forms of consideration may be offered by a strategic buyer. It also is helpful where the owner is prepared to accept a deal structure that facilitates a transaction. For example, where theowner agrees to retain a partial equity interest in their company, the financingrequirements are reduced and financial buyers generally are encouraged by the owner’s belief in the exit strategy prospects. Finally, the owner should expect to offer transitionalassistance to the financial investor and management team, where required. For example,
 
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an owner who was active in the business should expect to remain active for a period of time following the transaction in order to ensure a smooth transition with employees,customers and suppliers.
Reasons for Management buy out (MBO)
Common reasons for companies or individuals to consider adopting a MBO strategyinclude the following.
1.Non-Core Divestments and Efficiency Improvements:
An organization focusing on efficiency improvements or consolidation of its coreactivities will often look to divest business units that are a financial burden or represent adivergence from a new strategy. In these situations, a MBO can provide a smooth andefficient transaction that avoids the inconvenience of finding external buyers or the needto release sensitive organizational data.
2.
Management Incentivisation:
Management faces constant pressure to maximise profits and implement new growthstrategies. However, it is often recognised that linking managerial compensation tosubstantial direct equity ownership can provide a powerful incentive. A MBO can be aneffective way to implement such an incentive structure. 
3.Insolvency :
In the event that the company has become insolvent and a receiver or administrator has been appointed, current management may represent a viable acquirer for specific business units. However, appropriate financial backing will often be required in this typeof buy out.
4.Succession :
A MBO can provide a feasible solution to business succession issues such as theretirement of a key founder or partner. The experience of the current management team

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