Executive Summary
This article is aimed at prospective managers of a management buy-out (MBO).
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MBOs are inherently risky, with a relatively high failure rate.
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It’s the leverage in the deal structure that makes success so rewarding. Unfortunately leverage works just as impressively in reverse!
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Every year around 600 deals will be completed, and every year broadly that number will reach the exit stage. Unfortunately, one of the most common “exits” over the last 20 years has been receivership!
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Research, good advice, and planning will increase your chances of success
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You can increase your chances of success by knowing what the common elephant traps are.
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Setting out on an MBO without the best advice and support you can muster is akin to walking blindfold through a minefield. You have been warned!
MBOs: The Beast Explained
MBOs—shorthand for MBIs, BIMBOs, IBOs and the like, as well as management buy-outs—make or lose fortunes for the risk-takers because of the leverage involved. Leverage is the fulcrum on which these deals seesaw between success and failure. Every venture capitalist’s portfolio has a range of leveraged companies, and average returns to their investors are determined by the balance between their star investments and those which stagnate or go bust. Leverage is a business school type word—my eldest daughter would probably say it was cool! If your company were an automobile, leveraging it would be like filling the trunk with high explosive and then driving off on a long journey with your fingers crossed.
Management buy-outs and buy-ins are a high-octane part of the business world. Since 2001, the most common exit from MBOs/MBIs hasn’t been flotation, or even trade sales, but receivership. It is a high-risk/reward arena. Metaphorically, an MBO/MBI is like fitting an eight-liter V12 engine into an aged VW Beetle and expecting it to perform much better than before.
I’ve worked with twelve MBOs since 1991 in a variety of roles: as chairman, executive director, nonexecutive director, and as a personal coach to a managing director. The experience has varied greatly: from staggering success to the verge of financial oblivion—and fortunately back again. The deals have ranged across very different markets: from the sophisticated world of global drug discovery in mythical Tintagel to heavy-metal bashing (dustcarts) in the West Midlands of England, and from the rarefied academia of international publishing to horticulture in the Welsh valleys. The deals have been backed by many different venture capitalists and financed by UK and international banks.
I have been very fortunate to have seen many MBOs through the prism of management. There are many good books written by academics and professionals that describe the process, structure, and chronology of an MBO. It is important that you understand these topics; however, it’s crucial that you also understand other aspects: where the main elephant traps are; what the key success factors are likely to be; and how an MBO’s chances of success can be maximized.
After 12 deals I have no idea what constitutes “best practice” because I’ve discovered that every MBO is unique. I have reflected long and hard on the lessons I’ve learned on these deals over 18 years, and they are set out below.
MBOs: The Main Lessons I Have Learned
1. Do an MBO with your eyes wide open
Conducting an MBO is extremely demanding. The demands on you, your colleagues, and your family and friends will be severe. And this is just to complete the deal. After completion, the difficulties and pressures are unlikely to abate. The risks are significant, even for a well-managed and successful business. You can materially reduce the odds against you by understanding the lessons learned by those who have gone before you.
For a manager, an MBO/MBI is a life-changing experience.
2. Ensure that you are an effective team
A talented group of individuals isn’t enough! You must be a team. I don’t need to amplify this—any senior manager will understand the difference. If there are fault lines within management, they will be exposed.
You should make any changes that may be needed before you set out on the deal—or at worst during the deal. Afterwards is far more difficult, and it might be too late.
3. Don’t overpay—Work to a realistic business plan
There is an inevitable conflict between preparing a plan which, on the one hand, is achievable, and, on the other, is capable of supporting a price high enough to ensure that you can buy your target company. You need to strike the right balance—but this is easier said than done.
It is said that it is better to overpay for the right business than underpay for the wrong one. The thrust of this must be right; however, if you knowingly overpay, with the purchase price predicated on optimistic numbers, you will almost certainly regret it. In any business, performance will deviate from budget or plan. In a highly leveraged business, the margin of underperformance that can be accommodated is relatively small. Some excellent businesses have failed in this way. There was nothing wrong with the company, its management, or its prospects. Its financing structure simply couldn’t withstand an unforeseen financial shock.
4. Choose advisors and backers you feel comfortable with
There is no shortage of accountants, legal firms, bankers, and private equity houses that will have an appetite for a good deal. It is, however, important that you feel very comfortable with your advisors and backers.
Your respective commercial and career prospects will be in each other’s hands. There must therefore be openness, trust, and mutual respect. This is obviously a totally personal and intangible matter. It may well be that you need to kiss a lot of frogs before you find your prince.
5. Do your deal on a contingent basis
This might be stating the obvious, but some management teams have been caught out in this area. Provided that you are well advised, it is usually possible to ensure that you are not exposed, or left holding the baby, if the deal falls over and fails to complete.
At the right time in the process, advisors are quite adept at securing some degree of cost underwriting from the vendor. These break-fee arrangements are useful in that they tend to provide some security and incentive to see a deal through.
6. Your strategy must be capable of being understood and implemented
Warren Buffett says that if a plan can’t fit on a side of A4 it can’t be understood. Given that 80% of strategy is about implementation, what he’s probably referring to is the difficulties businesses have of actually achieving their objectives if there are not absolute clarity and understanding of strategy throughout the company.
Put another way, if you can’t explain your strategy during an elevator ride (i.e. in 20 seconds), you probably can't explain it at all.
7. Take heed of the due diligence report
You will meet many managers who have been scarred by the due diligence process. While due diligence is in many ways akin to a lifebuoy for the backers, it nonetheless shines a torch of some intensity into every corner of your business. Recognize that any management team’s first instinct when faced with criticism is to deny it. Make sure it isn’t you who is in denial.
Further, task a member of the management team with analyzing the due diligence report, and draw up a list of points to be addressed post completion.
8. Your board must be effective
As Patrick Dunne of 3i Group wrote: “Bad boards destroy value.” Directors must be individually and severally effective. The nonexecutive directors must add value and fit in as part of the team. An annual board calendar should be prepared and adhered to. Board papers should be circulated at least three working days before meetings and must contain information, not data. Really important performance indicators (e.g. cash forecasts and covenants) should be graphed so that they can easily be understood. The board agenda should focus on key issues and decision-making and not allow endless waffle or a mere exchange of information. Research shows conclusively that the most effective board meetings last between two and three hours. Communications between the board and fund providers must also be frequent, candid, and well-managed.
9. Incentivize your important managers
Businesses are run by people. Retaining all of the potentially very valuable sweet equity amongst just the top team can be divisive. It may create an us-and-them mentality, which can be very counterproductive. Consider incentivizing managers who are significant in the running of the business. Some companies have incentivized all employees, which is said to have had a very positive effect on the company’s performance.
10. If it goes wrong, act fast and get outside help
Many MBOs/MBIs experience a drift from plan which invokes a recovery situation. If a company drifts from plan, remedial action must be taken very fast. If analysis indicates that this is not a one-off but a recurring problem, then your survival is at stake. Recognize this and act accordingly. Frequently, the skills needed to reduce costs and generate cash are not available in the management team. You can train a rabbit to climb trees, but it’s better to hire a squirrel! There are experienced individuals who specialize in these situations. You should consider getting them on board to help you negotiate the choppy waters ahead.
11. The exit: Seize the moment
It is highly unlikely that there will ever be a perfect time to exit. Inevitably, there will always be some clouds in view: a potential loss of a contract, a delisting, significant price increases in raw materials, etc. However, if you have the opportunity to unload your trunk load of high-explosive (debt) and it is within the time frame originally envisaged, then you will be well-advised to take it. In short, carpe diem.
12. Be true to yourselves and the company
There will be several occasions when you face a moral maze. Whichever way you turn, someone stands to lose. Advice may conflict, and you will be subjected to the most passionate advocacy from parties with different objectives. This is especially likely if you require a second, or third, round of fund-raising. In these situations, do the right thing for the business as invariably this will, over differing timescales, benefit just about everyone involved with the company. Again, easier said than done, but it’s the best compass. A great example is that of one serial entrepreneur I know: when trading was tough in the early stage of an MBO, he had a choice: pay the wages or pay the VAT. He got it right—he paid his employees!
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