MBOs: Making a welcome return
David Rowan, associate, Mergers & Acquisitions and Corporate, A&L Goodbody, takes us through the welcome return of the management buyout and the key issues that must be considered in the majority of cases.
Management buyouts (MBOs) and management buy-ins have been relatively thin on the ground over the last few years due to the economic recession in 2008 and the resulting lack of available credit. However, as was the case immediately following the last market downturn in the early 1990s, we expect activity levels in these areas to increase as liquidity improves. Managers who have made it through the last few years will start to recognise the opportunities available to them, focusing on the medium term with a degree of confidence rather than having to focus solely on mere survival in the shorter term.
From our own pipeline, it appears that MBOs are already making a welcome return as a result of the renewed confidence within the Northern Irish business community and the return to the market of private equity investors and financial institutions looking to support the right management team to take local businesses to the next level. As a result, now is the ideal time for management teams to take the initiative and seek to start discussions with shareholders, many of whom are starting to review whether certain divisions of their business are “core activities” and to plan their exit strategy as businesses start to recover in earnest.
MBOs are attractive to sellers for a number of reasons including: (i) the existing management knowing and understanding the business, (ii) avoiding the disclosure of sensitive information to competitors, (iii) providing a preferred succession route for businesses which are owner-managed and (iv) management accepting more risk during the sale process than a third party purchaser would accept due to their knowledge of the business.
MBOs are demanding on the management team because of the various competing interests and the requirement to ensure that the business continues to function efficiently throughout the purchase process. Early consultation with legal advisors and corporate financiers will greatly assist management and their funders with structuring and co-ordinating any proposed buyout. Although each transaction will have its own specific issues to work through, the following key issues should be considered in the context of the majority of MBOs:
- Conflicts of interest – These arise at various levels during the MBO process, including where some directors of the target company are also directors of the bidder and the allocation of risk between the seller, management and any private equity investor/financial institution.
- Control of bidder – Both management and the private equity investor/financial institution funding the acquisition will enter into a shareholders’ agreement relating to the governance of the bidder. Different classes of shares will typically be issued to management and the private equity investor/financial institution in the bidder, with certain rights and limitations attaching to each class. Specific rights commonly included are those relating to exits, leaver provisions, transfers and ratchets.
- Extent of warranty cover – This is one of the most contention areas in any MBO as warranty coverage is generally lower compared to transactions between arm’s length parties due to the knowledge of the management team. This lower level of coverage is acceptable to the management team as it knows the business but it is often unacceptable for the private equity investor/financial institution funding the transaction.
- Financial and timing limitations – There is a delicate balance to be struck between the limitation on the extent of management’s liability, where management and the seller will be seeking to minimise the period of liability and the private equity/financial institution will want to maximise the period of liability and ensure that the warranty cap is sufficiently high to ensure that the management team focuses on the accuracy of warranties.
- Disclosure – Management will be required to prepare and contribute to a disclosure letter on behalf of the seller in favour of the bidder which is obtaining the benefit of the warranties and of which they are to become directors. Sellers will often ask for a reverse warranty in such circumstances.
- Tax implications – Management should obtain tax advice at the outset as returns are most likely to be through gains on their equity investment and subject to capital gains tax. Share schemes and employee benefit trusts should be considered.
- Security over assets of bidder – The private equity investor/financial institution will typically seek to take security over the assets of the bidder following completion of the acquisition.
We are returning to a market where there are numerous opportunities for management seeking to take control of their business and the current environment means that MBOs are now viable for both management and shareholders looking for an exit route.