Buyouts A Guide for the Management Team
Garry Sharp Edited by Alex Shinder, Montagu Private Equity
Buyouts A Guide for the Management Team
Garry Sharp Edited by Alex Shinder, Montagu Private Equity
Copyright © 2009 Montagu Private Equity Limited. All rights reserved. Published under licence by Montagu Private Equity LLP.
Contents
ISBN 978-0-9561045-0-2 This publication is not included in the CLA Licence and must not be copied without the permission of the copyright holders. Application for the permission of the copyright holders should be addressed to the publisher. All rights reserved. No part of this book may be reproduced or used in any form (graphic, electronic or mechanical, including photocopying, recording, taping or information storage and retrieval systems) without the permission of the copyright holders. Where permission is granted, full acknowledgement of copyright holder, publisher and source must be given. The views and opinions expressed in the book are solely those of the authors. Although Montagu has made every effort to ensure the complete accuracy of the text, they and the authors do not accept any legal responsibility whatsoever for the consequences that may arise from errors or omissions or any opinions or advice given or for any loss, damage, claim, demand, expense or other liability, whether direct or indirect, sustained by any person placing reliance on its contents. This book is intended to serve as a guide only; it is not a substitute for seeking professional advice.
Design and production by Whorrell Rogers
About this Book
vi
Foreword
vii
About the Author
ix
Module One - The Big Picture
1
The Essence of a Buyout
2
Growth and Evolution of the Buyout Market
4
Creating Value in Buyouts
7
The Management Challenge
8
Private Equity and Public Perception
10
Module Two - Starting the Process
17
Positioning for a Buyout
18
Characteristics of Successful Buyout Companies
26
Understanding the Sale Process
31
Public to Private Buyouts
34
Secondary Buyouts
37
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Contents
Contents
iv
Module Three - Buyout Players and Processes
39
Module Six - Making the Partnership Work
94
The Private Equity Universe
41
Investor Involvement
95
The Investment Process
42
Budgets, Plans and Value Enhancement
95
Approaches to Investing
44
Communicating and Reporting
101
Debt Providers
49
Board Structure and Composition
102
The Corporate Finance Adviser
50
How the Board Functions
105
Underperformance
107
Module Seven - Making it Pay
111
Module Four - Structuring the Buyout
55
The Buyout Model
56
The Acquisition Price
57
The Management Perspective
111
The Financing Structure - The Debt Element
58
Exit Methods
115
The Financing Structure - The Equity Element
67
Secondary Buyouts
117
The Management Stake
71
Trade Sales
119
Investment Documents
75
IPO’s
119
Recapitalisations
123
Ten Golden Rules for Buyout Teams
125
Appendices: - Directors’ Duties
126
Appendix I - UK
126
Appendix 2 - Germany
131
Appendix 3 - France
140
Appendix 4 - Sweden
144
Module Five - Due Diligence
79
The Management Role
80
Types of Due Diligence
81
Reporting
91
Vendor Due Diligence
92
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About this Book
Foreword by Alex Shinder, Montagu Private Equity
This book has been written as a practical, market focused and above all realistic guide for management teams contemplating, or undertaking, a buyout. It is divided into seven separate modules, each of which covers a key part of the process. Each module is designed to work as a stand alone section, so that there is no need to read the entire book from cover to cover if you are looking for insight into a particular aspect of buyouts.
Alex Shinder is a Director of Montagu Private Equity and has been a practitioner in the industry since 1981. He is responsible for Marketing and Business Development at Montagu. As editor, he worked closely with the author in achieving consensus in this and the previous edition.
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One of the prized elements of a private equity transaction is what can be achieved in the partnership between the management team and its private equity backers. Whether you call it collaboration or true partnership, the essence is of trust, mutual respect and pulling together to achieve the common goal of growing shareholder value and to participate significantly in the success. The growth in shareholder value is often dramatic and takes place in a dynamic environment. It is not unusual for a chief executive to describe a buyout as the most stimulating period of his or her career. It is understandably satisfying to grow a business, strengthen it, and at the same time to be challenged. As this book goes to press, in early 2009, we are in an unprecedented debt liquidity crisis and in the early stages of what many expect to be a deep and long lasting recession. The book was written as these events emerged and we have tried to strike a balance between where we are now and what we expect to evolve during the book’s life as a new normality emerges. Looking past the immediate difficulties it is important to remember that some of the best private equity performances - and the greatest gains for the management teams they backed - were achieved from investments made in a previous deep recession, that of the early 1990s. There is no doubt that the future holds similar prospects. Reduced valuations, lower levels of debt and a cautious view of the future will form the basis of excellent returns for both entrepreneurial management teams and investors. The inherent strengths and flexibility of the buyout model, which we explore in depth in this book, will allow us to adapt to the new environment without losing sight of the key principles that make buyouts work. One of the principal aims of this guide is to help management teams know what to expect so as to be able to make the maximum contribution to the buyout. There is possibly no more important event that management teams face. As the structure of this guide is to match the sequence of a buyout, starting with preparation and culminating in the exit, some of the issues only
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Foreword
come out in the later modules. However the private equity relationship is a big factor and can be explored well before a buyout, so this is one of the main themes developed in the earlier modules. This is the fourth buyout guide sponsored by Montagu. The guide is updated every few years in order to remain relevant. Quite a lot has changed in the buyout world since the 2003 edition and so therefore has the guide. That said the central themes have not changed. Garry Sharp ends up again with ten ‘golden’ rules for managers and he made few changes to these. So what has changed over the past six years? Deals and the market players (management teams, vendors, finance providers, advisers) have continued to become more sophisticated in a huge market which in Europe 30 years ago was hardly even noticeable. In line with the greater sophistication is the ability to do larger and more adventurous deals and to find more value from experience of what works and what doesn’t. As with previous editions this book uses case studies and is aimed to be as balanced as possible. It has become impossible to produce a guide that is comprehensive and at the same time is concise and readable and this too was recognised in earlier editions. We also did not want the guide to be superficial and so have chosen areas that we think represent the most important and difficult, such as the a need to act independently and how to assess whether a company is suited to the process. We try to give a feel of what it is like to be in a buyout environment. However, we make no attempt to go into the complex technical issues such as tax and nor this time into the legal documentation. That would be too complicated in an introduction and probably not terribly relevant as the issues and negotiations vary from case to case. We launch this guide to coincide with Montagu’s 40th anniversary. We aim at Montagu to be the buyout team’s private equity backer of choice and have felt since we started producing the guide that it is fitting to produce something that will help the team even before we know them. If you are considering a buyout of your own, we wish you every success with it.
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About the Author Garry Sharp has been active in private equity, as a practitioner, consultant, trainer and writer, for 23 years. In 1985 he joined the London venture capital firm Baronsmead, becoming a director and shareholder in 1989. Baronsmead was sold to Edinburgh fund manager Ivory and Sime in 1996, and Garry left shortly thereafter to become managing director of Independent Direction, a specialist consultancy providing human capital services to a wide range of private equity investors. He sold the company in 2005 in order to concentrate on training, writing and advisory activities, and now has a portfolio of roles centred on private equity in emerging markets. He is a director of a Cairo based private equity fund manager, adviser to a captive fund in Mauritius, and runs training courses in a variety of countries, primarily in the Middle East and Africa. Garry’s first book on venture capital was published in 1990 and this is his seventh on this and similar topics.
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1 The Big Picture The Essence of a Buyout Growth and Evolution of the Buyout Market Creating Value in Buyouts The Management Challenge Private Equity and Public Perception
Introduction This first module looks at buyouts in the broadest sense. First we identify the essence of a buyout - and have listed five principles on which successful buyouts are built - before briefly reviewing the growth and evolution of the buyout market. The third section introduces the three key measures of value creation. We then open a discussion (which is developed later to become a central theme in the book) about the role of the management team whose company is the subject of a sale process. When a buyout represents only one of the possible outcomes of a sale process - as it almost invariably does - the Chief Executive and his senior colleagues face a complex mix of obligations, priorities and conflicts. The way in which they approach these issues, manage relationships with the company’s owner and make decisions about their own future will have a critical bearing on whether or not a buyout can be achieved. Many managers contemplating a buyout understandably find their views and thoughts coloured by the extensive and growing public debate about the
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The Big Picture
The Big Picture
private equity industry. Unfortunately a large proportion of the contributions to this debate are only partially informed, and we seek to balance this with a section on the public perception of private equity. Finally, we introduce the first of a series of case studies which illuminate the principles discussed and demonstrate their application in practice.
The Essence of a Buyout Buyout success is built on five basic principles: a close partnership - built on the basis of mutual dependence - between the buyout company’s management team and the investors who finance its acquisition; the considered use of debt leverage, carefully tailored to the company’s capacity to generate cash; clear objectives, shared between management and investors, which enable a high degree of focus in setting the company’s strategic and operational priorities; ownership structures that reinforce the management team’s motivation to achieve these objectives by sharing the rewards; and the careful selection of companies as buyout candidates.
Partnership The key difference between the private and quoted equity worlds is that private equity is characterised by a direct, close and continuous relationship between investor and management team. Although quoted company investors will also support management teams in whom they have faith - by participating in rights issues, for example, or voting in line with directors’ recommendations at general meetings - the relationship between investor and management, who between them own all the equity, is far closer in a private equity structure. The main driver for this relationship is a strong sense of mutual dependence - each party brings something that the other cannot, and each is dependent, in the make or break challenge that a buyout represents, on the other to perform. Whilst the management team holds the definitive responsibility for running the company, it does so in pursuit of strategies and objectives clearly agreed with the private equity investor. The investor, informed by a clear understanding of the business, its markets and its key
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drivers, faces financial and reputational risk and will take an active, participative role at board level and can support management with additional resources to help accelerate growth and create value.
Financial structuring The underlying principle behind structuring a buyout is the use of a target company’s future cashflow as the basis on which partly to fund its acquisition. Private equity enables the development of financing structures - using a mix of equity and debt funding - that are carefully tailored to the anticipated cash generation profile of the target company. The predictability, consistency and reliability of operating cash flow is a prime determinant of how much debt, and on what terms, the company can be expected to service. This debt leverages the equity return and hence affects the price that can be paid for the business.
Clear objectives The fundamental objective is not only to enhance shareholder value, but also to realise this growth in value by achieving an exit - which as we shall see may be through selling, floating or recapitalising the company - and crystallising a capital gain within a defined period, typically three to five years. This clear focus on the exit will drive the company’s strategy, positioning and decision making.
Shared motivation Unlike some quoted, subsidiary or family owned companies, whose senior executives may own negligible shareholdings and be motivated by a complex mixture of short and long term factors, the buyout team will always have a significant equity stake. This stake will present them with the opportunity to earn, over the three to five year period, an otherwise unachievable level of personal wealth. It will also align their objectives closely with the investor’s, as they share the pursuit of realising a capital gain.
Selection Not every good company is an appropriate target for a buyout. Whilst the inherent capacity to generate a consistent cashflow from operations and the ability to operate independently are clearly essential, they are not sufficient.
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A successful buyout also requires the company to offer a clear route to creating, and realising, shareholder value. This theme will be explored in more detail in Module 2.
Growth and Evolution of the Buyout Market As Chart 1.1 demonstrates, the value of the buyout market across Europe has almost quadrupled over the last decade, to a total of D171 billion in 2007. This expansion came in three phases; total buyout values rose consistently to a peak in 2000, flattened in the wake of the 2001 market turbulence and resumed growth - this time at an explosive rate - after 2004. More recently, the critical importance of debt was highlighted by a marked reduction in buyout activity following the contraction of the credit market in mid 2007 (this is not reflected in the chart below as the first half of the year saw a great deal of activity, including Europe’s largest ever transaction, the D16.4bn Alliance Boots buyout).
1.1 European buyouts Source: Centre for Management Buyout Research
200
F billions
Number of buyouts
150
1350
100
1200
50
1150
0
1997
1998
1999
2000
2001
Value Number
4
1500
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2002
2003
2004
2005
2006
2007
900
The key factors behind this growth are: private equity investors’ ability to match the valuations offered by corporate acquirers (this ability was underpinned by confidence that buyout companies could subsequently be sold to those strategic buyers at similarly high profit multiples); the unprecedented expansion in the volume of capital - both equity and debt - allocated to buyouts from 2004 to 2007. Buyout funds increased dramatically in size - with D10bn and larger funds beginning to emerge whilst their capacity for acquiring ever larger companies was amplified by the capital markets’ appetite for buyout related debt. Highly liquid capital markets, coupled with the demand for higher absolute returns, generated high volumes of investment funds seeking long term, stable income at levels greater than those achievable from conventional corporate debt. The buyout model, with its emphasis on consistent cash generation, proved to be a highly attractive source of these returns to debt investors, although this was tempered as deleveraging started to take effect in the credit markets from mid-2007; the credibility of buyout investors (generally referred to as Financial Buyers in the Merger and Acquisition context) as acquirers. They have demonstrated their ability to complete acquisitions, delivering both equity and debt funding, to tight timescales with execution skills comfortably matching those of corporate acquirers; and the growth in secondary buyouts - that is, buyouts of companies by one private equity firm from another. These transactions reflect the fact that, for many companies, the combination of private equity and management ownership is viable as a long term structure. Whilst it was historically assumed that a private equity owned business would revert to corporate ownership or the stock market at some point, it is now accepted that the right company can thrive under several different private equity owners over the medium term. The combined result of these influences has been a radical change in the European buyout market since about 2004. Chart 1.2 shows the resulting growth in average deal size, although this does not reflect the polarisation of the market with mega-buyouts, while small in number, deploying the majority of capital. Chart 1.3 shows how the levels of debt (as a multiple of target company earnings) have increased.
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The Big Picture
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Creating Value in Buyouts
1.2 Average acquisition price of European buyouts
There are three measures of value creation in a private equity-owned company, and whilst most investments demonstrate a blend of all three, modern market conditions have profoundly altered the mix. These principles can be demonstrated through a simple example, as shown in Chart 1.4. BuyoutCo is the subject of a buyout at a total cost (including professional fees) of D100m, which is a multiple of 10 on its current EBITDA of D10m. This is funded with D30m of equity and D70m of debt. During the three years following the buyout, the company grows its profits, and repays a part of the acquisition debt, before it is sold to a strategic buyer at a total Enterprise Value (equity and debt combined) of D140m. After repaying the outstanding debt, the equity holders share the remaining equity value of D80m. Chart 1.4 demonstrates how this value creation can be allocated to three measures:
Source: Centre for Management Buyout Research
120
F millions
100
80
60
40
20
0
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Average deal size
earnings growth - EBITDA grows from D10m to D13m, leading to a higher valuation for the company on the basis that it is still valued at 10 times EBITDA;
1.3 Leverage in European buyouts
1.4 Value Creation Analysis
Source: Montagu
Source: Montagu / Author
EBITDA: Earnings Before Interest, Tax, Depreciation and Amortisation
8.0
80
Multiple (x)
7.0
70
6.0
60
5.0
50
4.0
40
3.0
30
2.0
20
1.0
10
0
2001
2002
2003
2004
2005
2006
2007
IH08
Equity Value Fm
0 Original cost
Fees
Earnings growth
Debt repayment
Multiple uplift
Exit value
Total Debt to EBITA Senior Debt to EBITA
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debt repayment - the D10m of debt repaid from operating cashflow increases the value of the equity by the same amount; and multiple uplift - the price at which the company is sold represents a multiple of almost 11 times its EBITDA, compared with the acquisition multiple of 10.
The future for value creation Although most buyouts exhibit a blend of all three of these elements, their relative importance has changed dramatically. Buyouts of the 1980’s, especially in the US, relied heavily on the use of leverage, creating equity value by debt repayment, whilst the sustained rise in stock markets during the 1990’s allowed for many exits at high profit multiples. This was followed by a trend up to mid 2007 of the use of surplus cashflow to repay debt and enhance equity value rapidly reducing in importance as an element of value creation. The demand from debt investors for non amortising debt (explored in detail in Module 4), and the sheer levels of leverage incorporated in modern transactions, mean that companies are increasingly servicing interest but not repaying principal. However in recent times the pendulum has swung back to amortising debt. There is, and always has been, uncertainty about the prospects for multiple uplift. Although the scarcity value and demand for high quality companies may well lead to a continued increase in earnings multiples, investors do not assume any such increase when forecasting exit values in their investment models. The clearly emerging trend is that buyouts will increasingly be dependent on earnings enhancement to generate value. This is being demonstrated in practice as many companies exhibit sharp improvements in operational performance in the immediate post buyout period, a phenomenon directly attributable to the very nature of the buyout model.
The Management Challenge From the management perspective, the MBO acronym could stand equally well for Make or Break Opportunity. Alongside the attractions - which in addition to the financial rewards include the opportunity to operate without head office strictures, to develop and implement a value creation strategy of its own making - lie significant demands. For a team to operate independently of a parent company or group, exposing its performance to the unforgiving light of
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the investment community, will represent a radically new blend of opportunity and personal risk. The imperative to deliver increased earnings will in most cases demand the development and implementation of a detailed post buyout operating plan; this will normally be produced by management with the close involvement and support of the investor. Where significant and rapid changes need to be made (for example if targeted earnings growth has to be achieved very quickly to justify a high acquisition price) this investor support may involve the provision of resources such as external expertise and, often, additional funding. The various case studies throughout this book provide examples of how changes have been made and, in some examples, of the role of the buyout investor in working with the management team to help identify and implement them.
Getting to the deal Before any of these benefits can be realised, of course, the buyout has to happen in the first place. It is during this critical phase - the sale process - that management first has to play a key, and difficult, role in an unfamiliar environment. A clear issue for all management teams is the potential for conflict of interest when the possibility of a buyout emerges as an alternative to a conventional strategic sale. The starting point here is the commonly held - but simplistic and misleading - assumption that management’s fiduciary and contractual obligations to the company’s existing shareholders mean doing all they can to ensure the company is sold for the highest possible price, at the expense of all other considerations (such as, for example, the way in which the acquisition is financed and the potential acquirer’s plans for the company). This is reinforced by a suspicion in some quarters that management may ‘engineer’ a buyout at less than the best value by dissuading, failing to support or not sharing the best information with alternative potential acquirers. Such doubts are often most publicly visible with quoted companies, where formalised rules exist to prevent collusion between management and buyout investor (see Module 2). In the more common case, the disposal of a subsidiary by its parent group, it often leads to the exclusion of the team from close involvement in the sale process or a refusal by the vendor to contemplate a buyout. (We return to the practicalities of this process, their implications and alternative approaches in more detail in Module 2.)
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Important though it is to recognise the potential for this conflict of interest, and management’s obligations to shareholders, they are not the only elements to consider. The management team also need to think, independently, about balancing the interests of all involved. There is a particular risk that, in the drive to make the company, and its prospects, look as attractive as possible they will find themselves in an invidious position where they are expected to deliver an immensely challenging set of forecasts for a new owner without either the freedom to operate as they would wish or a meaningful stake in the rewards. This danger is intensified when the members of the team do not play a leading role in discussions and negotiations, either because they have been excluded from the process or because they fail to recognise the importance of their role in selling the company. In the absence of input and realistic guidance from the management, a bidder and its advisers, determined to win, may be tempted to make assumptions about future performance - often from a less than fully informed perspective and in some cases based on incorrect information - which management will then be expected to meet. Hence the vendor’s apparently neat solution to a negotiating impasse can become the management team’s insoluble problem. (We say ‘apparently’ neat solution because in practice these forced situations are unreliable and can lead to the failure of the sale process.) In a sense, the management team’s approach during the sale can be seen as an acid test of whether they are temperamentally and psychologically suited to run a buyout company. The strongest teams will take a robust view, acting (as they are required to do) in the company’s best interests but also thinking independently about their own objectives, and ensuring that the buyout route remains in play so long as it promises to match or beat the alternatives. This demands fine judgement and a blend of entrepreneurial spirit and corporate managerial responsibility.
Private Equity and Public Perception It was inevitable that, as buyouts became larger and the targets started to include major household name companies, they would begin to attract press, political and public interest and comment. It was also inevitable that, as conveyed in the press, the commentary would seek to incite controversy, trying to identify some kind of financial sleight of hand leading to the extravagant
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enrichment of a few at the expense of employees, shareholders and the public as a whole. A central tenet of a buyout is that, by aligning the interests of managers and shareholders, the buyout model enables clearer commercial focus - and hence the development of better performing and more robust companies - than any of the alternatives. However this is not as widely understood as it could be, and here we identify some commonly repeated criticisms of - or rather misconceptions about - buyouts and private equity. ‘Private equity is focused on short term gains’
Most buyout funds will hold an investment for a period of three to five years. In order to achieve their objectives, the company needs to be sold to an acquirer (whether that be a strategic, corporate buyer, another private equity fund or to quoted investors through a flotation) who in turn sees the potential for longer term growth and value creation. Therefore a buyout company has to be managed, structured and positioned for continuous growth and strategic viability over a far longer time period. Contrast this with the quoted markets, where investors can buy and sell shares at any time, leading to continued pressure to maintain short term results to retain the market’s favour. ‘Private equity gains are not widely distributed’
The vast bulk of gains from buyouts are returned to institutional investors in private equity funds. As we show in Module 3, these investors are predominantly pension and insurance investment funds. The benefits are distributed as widely as in any other form of ownership. ‘Private equity is too secretive’
Reporting by buyout companies to the funds that own them, and from those funds to their investors, is more detailed, explicit, timely and relevant than is required by any other form of shareholder / management model. However these detailed reports are not made available to the public, and disclosure requirements are governed by the far less exacting requirements that apply to private rather than quoted companies. Indeed, the commercial consequences of full disclosure would potentially be disastrous for the companies themselves. Nevertheless, as buyouts have grown to encompass ever larger and publicly visible companies, whose stakeholders include broad sections of society, the
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private equity industry has come under increasing pressure to disclose the types of information commonly associated with quoted company reporting. This goes beyond financial reporting to include statements on areas such as strategy and operations, corporate social responsibility, employee policies and environmental impact. In the UK, private equity has been invited to respond with the adoption of a voluntary reporting code, based on a 2007 review by Sir David Walker. This code applies to buyout companies whose total acquisition cost exceeded £500m (£300m in the case of a quoted company target) and, in essence, requires them to produce annual reports which closely resemble those produced by quoted companies. ‘Private equity loads companies with excessive levels of debt’
Module 4 describes in detail how debt is used as part of a buyout funding package, and it is certainly true that the availability of debt in the capital markets is a major driver in valuing and pricing buyout companies. However, as we make clear, calculations of levels of sustainable debt are based on carefully, and conservatively, prepared forecasts of future cashflows, after making full allowance for future investment required to ensure continued growth (without which, as we noted above, buyouts are simply not viable). This ability to sustain relatively high levels of debt is underpinned by effective forecasting, planning and reporting systems. All of this works in practice; it is rare for a mid-sized private equity backed business to fail completely. Between 2002 and 2007 there were 67 UK private equity-backed transactions in the £250m - £750m range. At the time of writing (early 2009), only two of these companies had gone into administration, despite the effects of the recession. A number (less than 10) are believed to be trading poorly enough for the equity investor to be facing a write-off or a permanent diminution of value. In these cases, however, the businesses remain solvent and there have been few direct consequences to employees, customers or creditors. The remaining 80% of the companies have either exited successfully at a profit or are believed to be trading satisfactorily (source: Montagu).
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The Big Picture
Case Studies Throughout this book we will use examples of Montagu investments to illustrate key points. The first of these, Dignity Funeral Services, demonstrates: a complete buyout cycle, from investment to exit; the creation of value through a combination of all three measures (profit growth, debt retirement and multiple increase); the importance of the management / investor relationship, and in this case how it evolved in the period leading up to the buyout; and how value - created by performance improvements - can be capitalised without achieving a full exit.
CASE STUDY
Dignity Funeral Services Dignity is the largest funeral service provider in the UK, formed in 1994 through the acquisition and merger of two smaller companies by Houston based SCI Corporation. The creation of Dignity reflected SCI’s strategy of growth throughout the 1990’s through a series of acquisitions across the globe, heavily funded by debt. Buyout investors do not wait for opportunities to present themselves but rather actively research markets and sectors, building an understanding of these markets and identifying companies that represent viable buyout candidates (see Module 3 for more on this topic). Montagu’s research identified Dignity as an attractive candidate in 1999, occupying as it did a dominant, defensible position in a fragmented market with stable revenues, strong cash generation characteristics and limited exposure to economic cycles. (The characteristics of successful buyout targets are explored in detail in Module 2.) Following discussions with management in 2000, SCI made it quite clear that the company was not for sale. This rebuttal, however, marked not the end but the beginning of the buyout process, as Montagu kept in touch with the management team, building both a relationship with them and a deeper understanding of the business.
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Alex Shinder, Montagu: ‘We know that even though a company may not be for sale right now, there is always a good chance that this will change. So we like to stay in touch. If the prospect of a sale does arise, and the management team has to start thinking very quickly about the possibility of a buyout, they are going to feel more comfortable with people they already know.’
By early 2001, SCI’s debt fuelled growth had led to serious difficulties as its domestic markets weakened, its share price collapsed and the Chapter 11 filing of its major competitor cast a shadow across the whole sector. With a major loan repayment due in July 2001, SCI needed to raise cash and Montagu was invited to reopen discussions. Although these again foundered - SCI found the answer to its cash needs elsewhere - they highlighted Dignity’s viability as an independent business and triggered the adoption by SCI of a new strategy for its underperforming European subsidiaries. An expensive, and non productive, Europe-wide management structure would be abolished and local management would run local businesses. This new strategy which ironically mirrored one Dignity would have pursued had it been independent - increased efficiency, enabled greater management flexibility and produced improved operating results. The greater independence of action also heightened the Dignity management team’s enthusiasm for a buyout. By December 2001 SCI’s problems had worsened and the decision was taken to sell all of its overseas subsidiaries. With no prospect of a trade buyer for Dignity - there being no European companies in the sector large enough to acquire it, and all of the US companies were in difficulty - six private equity firms were provided with an Information Memorandum, including a copy of the new business plan, and invited to bid. SCI set a very tight deadline, requiring completion by the end of January 2002. Peter Hindley, Chief Executive: ‘We made six presentations in three days, and made them as well as we could. The venture capitalists were very slick, well prepared and well informed. But Montagu was in an ideal position to move fast, and knowing more about us was able to make the highest offer, at £220m.’
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The Big Picture
The buyout, funded by £70m of equity from Montagu and £150m of debt, completed within six weeks.
Recapitalisation / Exit At the time of the buyout, it was not immediately clear how an exit would be achieved. There were no natural strategic acquirers - although the company would make an ideal fit for a large group in the Support Services sector, for some the stigma of ‘owning death’ would be a major concern - and it was not clear that the company was an attractive candidate for a flotation. The answer, or at least a partial answer, came from a piece of lateral thinking that raised the prospect of refinancing the business. Dignity had an inherent capacity for generating stable, consistent cashflows which, provided a series of improvements could be effected, would make it a strong candidate for a bond market securitisation (see the ‘Types of Debt’ section in Module 5).
Performance enhancements The greater freedom to operate independently was already beginning to produce improved results, and the management team were able to accelerate this trend after the buyout. In support of the team, Montagu made financially related contributions - designed specifically to improve its suitability as a candidate for securitisation - which included: the preparation of a clear, unambiguous set of trading results, which hitherto had been incorporated as part of a confused, aggregated summary for all of SCI’s European operations. This not only enabled more informed financial management, but the ability to produce a clean set of audited accounts allowed - and formed the basis for - a restructuring of Dignity’s capital base (see Securitisation below); Dignity offered a range of funeral savings plans, the proceeds of which were retained in segregated accounts and invested in a range of financial assets. By restructuring this investment portfolio, focusing it on government securities, Montagu enabled the delivery of more consistent, predictable returns which made financial planning simpler and increased the level of reliable profit; and
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Dignity’s vehicle fleet, a significant part of its expense base, was originally leased. Profitability was enhanced by bringing it onto the balance sheet, funded with much cheaper debt.
Securitisation The recapitalisation entailed the issue of long term, fixed interest bonds, which were secured by an entitlement to all of Dignity’s operating cashflow. The proceeds from this bond issue enabled the repayment of the original acquisition debt (with the bonds providing a lower cost source of finance) and in addition the payment of a dividend to investors and management. Hence Montagu was able to recoup virtually the entire cost of the investment whilst maintaining its equity ownership. Proceeds from Securitisation
£220m
Less repayment of acquisition debt
(£150m)
Dividend to shareholders
Peter Hindley: ‘The securitisation was much worse than the buyout, the rating agencies were unbelievably detailed. It highlighted the difference between our approach as managers - which is to ask ‘what if this happens, and this, and this’, focusing on combinations of events which could conceivably occur - and the financial analysts’ approach. Some of their stress tests seemed far too extreme. ‘The financial covenants were infinitely more complicated than those for the original buyout debt, and led to lots of late night discussion. We were distinctly nervous at the time, it really focused the mind, but we are comfortable with it now’
The bond issue closed in early 2003. As a consequence of the exhaustive verification process, it soon became clear that Dignity had undertaken the bulk of the work required to become a quoted company. Stock market investors at the time (not long after the dotcom crash) were seeking stable, cash generative businesses, and a little over a year later Dignity floated on the London Stock Exchange, at a market capitalisation of £394m.
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Starting the Process Positioning for a Buyout Characteristics of Successful Buyout Companies Understanding the Sale Process Public to Private Buyouts Secondary Buyouts
£70m
The bond issue did, however, make major demands on the management team. As they are tradeable in the public markets, the bonds are regulated financial instruments and must be rated by the major rating agencies.
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2 Introduction This module reviews the initial stages of the buyout process, and in particular the management team’s role in developing a credible buyout proposition that establishes and maintains its place on the sale agenda. The first section, Positioning for a Buyout, looks at the issues faced by a management team before and during the early stages of developing the proposition, and identifies the general principles to be followed in addressing them. The points addressed in this section are put into a legal context in the appendices, which provide a more formal summary of directors duties and obligations in different European jurisdictions. A case study, the buyout of Risdon Pharma, illustrates many of these principles. The second section, Characteristics of Successful Buyout Companies, reviews the criteria which guide private equity investors in deciding whether or not to pursue a buyout proposal. It is intended both to help managers form a judgement, at an early stage, about whether their company represents a viable buyout candidate and to provide some pointers as to steps that might be taken to enhance its prospects. BUYOUTS - A GUIDE FOR THE MANAGEMENT TEAM
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The Understanding the Sale Process section outlines the three main approaches to selling a company, and looks at management tactics during the sales process in more detail, and the Public to Private Buyouts section highlights the specific issues relating to buyouts of quoted companies. Finally, issues specific to secondary buyouts are addressed in the section Secondary Buyouts. Although most senior managers will have some experience in buying and selling subsidiary companies, the buyout challenge is significantly greater. It entails: dealing with the unfamiliar language, philosophy and approach of investment banks, corporate finance advisers and investors; addressing issues of loyalty and obligations in an environment where all the rules have changed; contemplating the prospect of a transition from employee to significant shareholder; and ensuring that the business continues to operate successfully under the pressures of a sales process. Many managers who have been through a buyout describe the process as the most challenging of their careers.
Positioning for a Buyout During 2007, more than one corporate acquisition in every five across the globe involved a financial buyer - i.e. a buyout investor. This proportion has doubled in the last three years, reflecting a trend which shows every sign of continuing. With buyouts achieving this level of prominence, it might be expected that the inclusion of a buyout option in every corporate sales process would have become common practice. Management teams should be encouraged to explore a partnership with a financial buyer as a potential route to achieving the best outcome for all involved, and with more than 12,000 buyouts having completed in the last decade in Europe alone, the techniques and processes for positioning a buyout as the best option should have become refined and broadly understood. In fact none of these assumptions holds true. Management teams are not always encouraged to pursue a buyout, and when they work with a private
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equity firm to produce a realistic, deliverable offer that exceeds the best available from a corporate acquirer it is sometimes despite, not because of, the vendor’s approach and actions. And because every situation is different, there is no universally applicable process the management team can follow to get themselves into this position. There are, however, some guiding principles that management teams should follow throughout the sales process, to protect and enhance their own position and, when it is appropriate, to ensure that the chances of achieving a successful buyout are maximised. In this module we explore the steps the management team can take to increase the chances of ensuring that a buyout is on the agenda. Before discussing detailed practicalities though, we must establish two central, driving tenets of a successful buyout team’s approach: be prepared be robust
Be prepared Every business unit, division or company that has its own identity, markets and autonomy is likely, at some point, to be a candidate for sale. Parent companies change strategic focus (or have change forced upon them), quoted groups become takeover targets, private company shareholders decide to sell their shareholdings, public sector organisations are privatised or strategic acquirers (and, indeed, buyout funds) make direct approaches; no state of ownership is permanent. Therefore, while the issues reviewed in this module are of course critical when a buyout becomes a live possibility, forward thinking management teams will want to consider and understand them well in advance. As the case study in Module 1 demonstrated, a buyout can have a long gestation period (nearly two years in that case) - often including spells where the chances of it actually happening appear extremely remote - but can develop with bewildering speed once the trigger for a corporate sale is pulled. The team that thinks in advance about positioning itself for a buyout, and - as far as it reasonably can - takes steps to enhance this positioning will be at a natural advantage if, and when, the sales process starts. In practical terms, it is a useful exercise for the management team to review, perhaps once a year:
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would the company we run make a strong buyout candidate if it were for sale? would we want to run a buyout company? would we make a capable buyout management team? if the answer to any of the above is ‘no’, can - and should - we take action to change this? what sort of backer do we want? and can we communicate the case to get backing?
the vendor. The team should be listened to and command respect - due to the fact that in many cases it is essential to run the business being sold - rather than being swept along in the sales process . The vendor’s advisers may, in an aggressive and slickly managed sales process, deliberately marginalise the management team, limiting their influence as far as possible. In order to counter this, and maintain its influence, the successful buyout team will:
The box out section later in this Module, Characteristics of Successful Buyout Companies, identifies the key points which will guide this self appraisal.
take a robust, commercial approach which encompasses the vendor’s objectives, the team’s own drivers and motivators and the best interests of all stakeholders; think as an independent group; demand to be heard, using the leverage of their central role, and expertise, in managing the company and delivering results to ensure that they have a voice in the negotiations; make it clear that they will not necessarily agree to be a part of a sale on terms they do not agree, and will not automatically cooperate with unreasonable requests or decisions; complain when decisions or actions by the vendor or its advisers act against their own interests or those of the company’s stakeholders; and demand, and maintain, direct links with the principals - the vendor and potential acquirers. Advisers and intermediaries play a valuable role in the process, and their experience and impartial advice can often help the management’s case, but there are occasions when points and arguments need to be made directly rather than run the risk of being diluted by a third party.
Be robust Here we continue the discussion, introduced in Module 1, of the management team’s role in protecting and forwarding its own interests, together with meeting its contractual, ethical and statutory obligations to its employers and shareholders. The main danger for the management team is that, at the end of the sale process, they find themselves committed to delivering on a demanding, or even unworkable, set of forecasts and targets which have been produced in order to achieve the maximum price from an acquirer. The risk of this outcome increases the further removed the team is from the sale negotiations, and the worst scenario - which is not uncommon - is to swap one employer for a new one with unrealistic expectations, which must be met in order to justify an inflated acquisition price. The essential point is that the owner’s decision to sell will fundamentally change the relationship with the management team; there is no longer any question of displaying longer term loyalty towards a team from which he is, in effect, seeking a divorce. Life will not be the same and the team will have to fight for its own interests, pursuing the opportunity to run the business as it sees fit and to gain an element of equity ownership. The intensity with which it presses its cause will be driven by personalities and culture - and sometimes restraint, and using the goodwill of the vendor, can be more effective than open aggression - but the management team must be clear that it is facing a tough negotiation. The outcome will have career changing significance, because whilst the prize for winning can be independence and opportunity, the consequences of losing may well involve an untenable position or even abrupt termination. It will be a complex and many sided process, with participants including a host of advisers and potential acquirers, in addition to the team and
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Caveats and cautions Taking this approach reduces the danger of the team being forced into an impossible corner but does, of course, bring risks of its own. The three key issues are: will the team breach, or be perceived to have breached, its obligations to its employers in either a moral or legal sense? will a sharp difference of views between vendor and management lead to the team being dismissed? and if the team is, in effect, indicating that it will walk out rather than subscribe to an unrealistic plan, are its members prepared to carry this out if necessary?
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The best protection is to establish, with the vendor and his advisers at the very outset, an open and transparent process which: acknowledges management’s central role and ensures their involvement in the sale process; clearly sets out the vendor’s objectives, priorities and deal breakers; and incorporates a mechanism (usually a direct meeting between the principals) for addressing and resolving conflicts of interest. The key principles that guide this process will be: shared understanding that the best offer in the vendor’s eyes (in almost every case, the highest price after allowing for certainty of delivery and the effect of any preconditions) will win; the management team will use its best endeavours, but without attaching itself to unrealistic or unreasonable conditions, to deliver the best offer; and financial buyers will be openly and explicitly included in the bidding process. This is close to a counsel of perfection of course, and is often not achieved in such clear cut terms; more commonly the management position is clouded in ambiguity, an element of mistrust and lack of clarity. In these cases the team will have to fight harder to defend its position. Key tactics to adopt and limitations to implementing them are: be prepared to commit, or withdraw, support for an offer. This is the most powerful single tool at the management team’s disposal; and help the preferred bidder to cross the finish line first with the best viable offer. This assistance can include validating, or refining, assumptions in the bidder’s business plan, or providing their own views on achievability of forecasts. The team will need to prepare carefully and thoroughly for meetings to discuss plans and forecasts. While providing support to, and sharing their own views with, any bidder is perfectly legitimate, the management team must not: block a deal that is not in their interest; mislead any selected bidders; cease to fulfil their obligations as directors; or divulge confidential information without specific consent from the vendor.
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In some cases the vendor will refuse to countenance a buyout proposal, and the team will need to make a strong and carefully laid out case to overcome this stance. Commonly heard objections, and informed responses to them, include: Management will want to buy it cheaply
A properly managed sales process, for a business in demand and with competing buyers, will secure a full market price for it. Adding competition from private equity investors is likely to increase the price achieved.
Buyout funds only buy cheap
There is overwhelming evidence of financial buyers outbidding, sometimes by significant margins, corporate strategic acquirers.
Management will use their inside knowledge to deter strategic bids that compete with the buyout
This would represent a clear breach of the team’s legal obligations. A transparent process affords the best protection.
Buyout offers take too long, need too much due diligence, will be too conditional and are likely to fail at the last minute
This is no longer the case. Buyout offers will be fully funded, have precisely defined due diligence requirements and can be unconditional provided full access to management has been available.
The way in which the possibility of a buyout is introduced, and tactics the team can adopt to further it, are reviewed in the Types of Sale Process section below. Irrespective of the approach, however, it is essential to establish that the company and its management are suitable buyout material.
CASE STUDY
Risdon Pharma This case represents an excellent example of how a determined - and robust - management team achieved a buyout, and delivered a better result for the vendor, despite the vendor’s consistent refusal to countenance a sale to private equity.
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Risdon Pharma (now Rexam Pharma) is a leading European manufacturer of primary plastic packaging for the pharmaceutical industry. It is the European leader in blow moulded containers such as eye droppers and nasal sprays, and a major player in the fast growing segment of drug delivery systems, such as metered dosage anti-asthma inhalers. Risdon operates in a fragmented market made up of a series of niches in which barriers to entry are high. These include tough regulatory constraints (such as health authority approvals), where significant investments are required to achieve the stringent requirements necessary to meet the approval criteria, and the need to have the specific capability to manufacture high volumes of product in clean rooms at quality levels that meet pharmaceutical industry standards. The company serves its clients, the blue-chip pharmaceutical companies, from production facilities in France and Germany. In early 2001 the company’s then parent, Crown Cork and Seal (‘CC&S’), decided on the sale of a number of its subsidiaries as a single group, and instigated an auction process from which private equity firms were specifically excluded. Risdon Pharma’s CEO, Amaury de Menthiere: ‘They believed that trade buyers would naturally pay more, for the synergistic benefits, than private equity could offer. I was a good corporate soldier, I knew nothing about buyouts at that stage.’
The auction produced no bids for the group of subsidiaries, but a single offer for Risdon Pharma alone was received. Its terms were accepted by CC&S, and the successful bidder granted exclusivity. However de Menthiere had concerns about the company’s strategic fit with the proposed acquirer, and a suggestion from a trusted adviser resulted in an informal conversation with Montagu. This, together with the fact that the acquirer was making slow progress and seemed unlikely to complete the acquisition within the exclusivity period, led him to conclude that a buyout would be both viable and a better solution. ‘That first meeting was important - how we were welcomed, did they ask the right questions, did they demonstrate credibility? We had to tread very carefully.’
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With the finance and sales directors on board, the team had to broach the possibility of a buyout with CC&S. ‘We were nervous about taking the risk, but took the idea to my immediate boss, who opened the door to the European CFO. He didn’t believe a buyout was possible.’
Despite this apparent rejection, the issue had been raised and the team became increasingly determined to pursue a buyout. ‘We were not saying ‘sell us the company’, we were saying ‘give us a chance to make an offer, to create a competition for a better proposal’.’
The team faced three hurdles: they didn’t know the amount of the offer from the trade bidder; the vendor didn’t believe that a buyout was credible; and although the trade bidder’s exclusivity period had expired, it was still working towards completion and there was very little time. The first priority was to establish that a buyout was viable and could produce a better alternative for the vendor. Montagu at this stage was being asked to produce a financing package and acquisition proposal in competition with a buyer who was close to completing. The team’s growing determination to pursue a buyout was persuasive, while their continued pressure on the parent to open this avenue culminated in a visit from the CC&S Group CEO and CFO. ‘We used a powerpoint presentation to make our case; Montagu met them as well which added credibility; and my boss helped try to persuade them. We said we could deliver a fully funded offer within eight days of that meeting and while they didn’t believe we could make the deadline, they agreed to our progressing the buyout proposal.’
Montagu and the team met the deadline to make an offer. This triggered an increased counterbid from the strategic buyer when it became aware of Montagu and the team’s proposal, in a clear demonstration of how inviting a buyout bid can add significant value for the vendor. However Montagu was able to push the buyout bid even higher, reaching agreement with CC&S and completing the buyout within a tight timescale.
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Characteristics of Successful Buyout Companies
Strong, defensible market position
Not every successful company represents a suitable candidate for the particular demands and rigours of a buyout. With the modern market’s focus on enhancing performance, most buyout companies are in better shape a year or two after the buyout, in terms of operational efficiencies and strategic focus, than they were at the start of the process. However these improvements need to be built on a sound foundation, and this section reviews the characteristics of the company itself which, experience shows, are prime influences on success or failure. Whilst every buyout is different, and there is no guaranteed formula for success, we can break these success factors into three broad groups:
Whilst market share can often be measured objectively, this is nevertheless often the most subjectively judged of all the company criteria, the factor most vulnerable to changing circumstances after a buyout and a key driver in value creation. A defensible market position will be built on a combination of brand strength, ownership of proprietary products, services or technology, natural competitive advantage and barriers to entry. The clearest evidence of strong positioning is a company’s ability to maintain its margins and pass on its input costs; a company whose margins are at the mercy of an erratic market, the actions of strong competitors and volatile material prices will not represent a strong proposition. Investors will focus on both the company’s current market position and its prospects of maintaining and developing that position in the ensuing years.
the company itself; the management team; and the scope for value creation and realisation.
The company The successful buyout company will, in the majority of cases, demonstrate inherent strengths in most of the following areas: growth momentum; strong - and defensible - market position; predictable revenues/earnings; correlation of cashflow to profit; separability; and broad supplier and customer base. The case studies included in this book will amplify and demonstrate many of the points below.
Predictable business The high levels of debt which characterise most modern buyouts (introduced in Module 1 and reviewed in more detail in Module 4) demand a stable, consistent flow of earnings. Companies whose income is inherently volatile, or whose earnings are difficult to forecast with a reasonable degree of confidence, will be able to raise lower levels of debt than those with stable earnings and will consequently attract lower valuations.
Correlation of cashflow to profit The buyout case is strengthened when operating cashflow is closely related to reported profits, as it is on cash generation rather than accounting profit that buyout investors will focus. Apart from the obvious need for cash to service debt, the fact that profits convert to cash provides comfort about the credibility of published accounts and the accounting policies underlying them.
Separability Growth momentum Signs that the company is on an upward trajectory will include a strong order book, current trading meeting or exceeding budget, a generally positive and buoyant feel throughout the business with constant initiatives for improvement, and market trends that support continued growth.
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This refers to the company’s ability to operate independently of its parent group or owner. Some separation issues arise regularly and can be addressed as part of the buyout - for example, the company may need to replace finance, R&D, human resources or other functions previously serviced by a parent group. The need to provide these functions adds a measure of complexity - and risk - to
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the transaction, but provided the additional costs do not unduly burden the profit and loss account (and of course they are usually offset by a saving in management charges from the group head office) they will rarely affect the underlying proposition. However, more strategic issues may not be resoluble; for example if the credibility and financial strength associated with belonging to a larger group is essential to winning contracts, or access to group bulk purchasing is critical to profitability.
Broad supplier and customer base Although some businesses are, by their very nature, reliant on a small spread of customers, or to key specialist suppliers, the vulnerabilities associated with such reliance will weaken the buyout case and affect the valuation. At the very least, a potential buyout investor will want to see a clear and viable plan for diversifying away from this risk.
The management team ‘We’re looking for a combination of corporate management and entrepreneurial skills. By corporate skills, we mean measured, disciplined, team focused professionals, and the entrepreneurial element implies energetic, talented, risk taking money makers. The team has to be able to run the company as disciplined professionals, but we also need that entrepreneurial spark, the ability to see an opportunity to create value.’
This section looks at the characteristics of a management team able to run the company once the buyout has been completed, rather than the issues and demands they face during the process itself (which are covered elsewhere in this Module). It is not unusual to supplement the management team with nonexecutive directors as part of the overall buyout structuring exercise. However the stronger, and more suited for a buyout, the team is at the outset the better the chances of success. The factors associated with strong performance in a buyout team are: experience and competence; partnership oriented; motivation; range of functional skills; and trust and reliability.
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Experience and competence ‘You have to be robust, and very confident in your ability to manage the company operationally’
Running a buyout company is no time for a management team to be learning its job in an operational sense; there are enough challenges to be found in independence alone without having to learn about new markets, processes or management challenges. Sound operational skills are absolutely essential and the successful buyout team will in most cases have been operating well within its capacity prior to the buyout. ‘Under promise and over deliver - then you are bullet proof’
The team will have had direct P&L responsibility and, crucially, extensive experience in setting and meeting budgets. The ability to produce realistic, soundly based forecasts is key here; if the team meets its predictions the buyout will be a success. While the quote above is certainly valid, balance is needed because excessively conservative forecasts will make it difficult for a buyout fund to produce a winning bid.
Partnership oriented Whilst a buyout investor is, in effect, almost totally reliant on the management team in terms of day to day operations, and to a lesser but still significant extent in predicting and forecasting, he will be very closely involved in the strategic and financial aspects of growing the company. For this to work, therefore, the team has to embrace partnership with the investor, and avoid the territorial approach found in so many large groups. The starting point for this is the ability to explain the business, its drivers and influences clearly and patiently and to provide sound, reasoned answers to difficult questions. A strong, commercial Finance Director has a central role here in translating business issues into credible financial numbers.
Motivation The partnership between investor and management team, which we introduced in Module 1, is driven both by shared objectives and mutually compatible views about how to achieve them. It is essential that the motivation to achieve these objectives - i.e., the creation and realisation of value within a
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specific timeframe - is fully and genuinely understood by all members of the team because they will represent a significant influence on making strategic decisions. It is important for the team to appreciate what this means in practical terms. Although the short term pressure for quarter by quarter earnings growth associated with quoted companies is not a concern for a buyout company, they are replaced by the demands to: consistently generate sufficient cash to service debt; deliver strong, sustainable medium term growth; and position the company so that value can be realised in, typically, a three to five year timeframe.
Range of functional skills ‘Our roles, and the pressures on us at board level, changed dramatically after the buyout, but for everybody below that it was just business as usual’
As we identified in Module 1, the most significant recent trend in the buyout market is the increasing degree of operational expertise and added value available from buyout investors. However this is in addition to, and not a substitute for, a management team which incorporates the whole range of skills necessary to run the company. Analysis, as part of a detailed operational review, of all the company’s managerial requirements as an independent entity, and identification of how they will be provided, is a part of the buyout process. This analysis will in most cases highlight issues in two key areas: review of each team member’s ability to perform their role in the context of a buyout company; and replacement of support and input previously provided by a parent group or shareholders. The analysis of support provided by the existing parent needs to go beyond simply reviewing the functions discussed in the Separability section above, to identify other, less tangible areas. For example cross referrals from fellow subsidiaries may represent an important source of new business leads, or the availability of specialist marketing support may have enabled a new product launch.
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Trust and reliability ‘It struck me early on that if our sales director screws up, it’s my future on the line as well’
The buyout will see members of the team relying on each other in a totally new way and a high degree of mutual trust and professional respect is essential. Any issues in this regard must be identified, and addressed, at the very start of the process.
Scope for value creation The different sources of value creation were introduced in Module 1, and we return to this topic in more depth in Module 6. A profitable, cash generative company with a strong, defensible market presence and an excellent management team are essential for a successful buyout but are not, by themselves, sufficient. The third element is a clear and viable route to value enhancement, which will in most cases entail a blend of: operational enhancements - increasing profits through greater efficiencies, and creating greater earnings stability; organic growth - clear management focus on driving the business forward; repositioning - making the company more attractive to potential acquirers; and acquisitions - consolidating, or enhancing, the company’s strategic positioning and attractiveness to an acquirer.
Understanding the Sale Process There are, broadly speaking, three distinct methods of selling a company: the auction; the targeted sale; and the reactive sale.
The auction The auction is a highly formalised, tightly managed process designed to achieve the maximum price for a company by eliciting competitive bids from a wide universe of potential acquirers. An expensive and time consuming
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process, managed by an investment bank or corporate finance advisory firm, it is traditionally associated with the sale of very large companies, but has become more widespread and most substantial companies are now sold via an auction. The auction process is structured as follows:
Advisory firm selected
Advisers research company, markets, potential acquirers
Vendor Due Dilligence and Data Room prepared
– limited presentations to selected bidders. private equity firms will in most cases be included in the circulation lists for the IM, thus introducing the potential for a buyout from the beginning. However: – management will generally not be permitted to negotiate with private equity until the final stage in the process, if at all (although this does not prevent them from taking advice and preparing for those conversations); and – with carefully controlled and limited access to the company, and a lot potentially at risk, private equity firms will also undertake their own, independent research.
The targeted sale Information Memorandum (‘IM’) produced
IM circulated to wide range of potential acquirers
Indicative bids received; 4-6 highest bidders provided with:
Management presentation, Vendor Due Diligence Report, limited access to Data Room
Revised bids received, 2-3 highest bidders provided with:
Full access to Data Room, answers to specific questions, further due diligence and draft sale agreement
Final bids received, winner selected and granted exclusivity
Final due diligence, final legal negotiations, completion
The key issues associated with the auction process, so far as buyouts are concerned, are: management involvement is usually highly circumscribed by the advisers managing the process, and limited to: – assistance in preparing the IM, Vendor Due Diligence report and Data Room; and 32
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It is often clear that there is an identifiable group of natural acquirers for a company, particularly one that operates in a tightly defined sub sector. An alternative to the auction process is to directly approach these natural acquirers, soliciting bids in a process which tends to be less formal and faster than the auction process. This has advantages and drawbacks for the team who wish to pursue a buyout. On the positive side, the team is likely to be much more closely involved and in many cases will be relied on to identify the potential buyers and play a central role in negotiations. However the approach does not naturally lead to the inclusion of a buyout as an alternative, so that unless invited by the vendor to make their own bid, the team would have to introduce it themselves.
The reactive sale By this we mean the reaction to an unsolicited approach from a buyer. The management team which has failed to anticipate this, and does not have a buyout plan in hand, will almost certainly be caught on the back foot and find it difficult to react in time. However, for the well prepared team that has considered the issues addressed in the opening section of this Module, the unsolicited approach - which by definition will entail a valuation that has not been market tested - can represent an opportunity, raising the prospect of a sale and hence opening the door to the possibility of a buyout. The team will in many cases doubt the strategic logic of the unsolicited approach (and hence its likely value as a price maximising offer) and present the buyout as a more certain alternative at a better price. BUYOUTS - A GUIDE FOR THE MANAGEMENT TEAM
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Management tactics during the sale process The case for a buyout rests on the ability to: match the best price available (or expected) from a strategic buyer; offer speed and certainty of completion, seeking less comfort in the form of legal protection; and simplify the sales process, and obviate the need to share confidential commercial information with potential or existing competitors. The approach for the management team is to position itself as the most attractive option for the vendor, making its own bid credible by offering a price that will clearly stand up in the open market, doing so quickly and moving with certainty to completion. The early involvement of a reliable private equity investor is clearly desirable, and the team must press for clearance to talk to private equity from the outset. The management team’s key strength is a detailed understanding of the business, and the potential under their continued stewardship which this provides to allowing more informed and hence potentially higher bids from private equity.
Public to Private Buyouts Buyouts of quoted companies, a comparative rarity a decade ago, have become increasingly common. Following such a buyout, the target is delisted and becomes a private company (hence the phrase Public to Private, or P2P), and will operate in the same way as any other private equity backed business. However, as acquisitions of public companies are governed by regulations and regulatory bodies (for example the Takeover Code and the Takeover Panel in the UK), there are significant differences in the buyout process itself. This section sets out some of these key differences. Shareholders wishing to sell a private company can do so discreetly. Often the market does not know about a sale until it is achieved. No such luxury is available to a public company and, with most companies being unwilling to openly put themselves up for sale - except in special circumstances - a public company is usually passive and awaits an approach from a private equity or trade bidder. The Takeover Code in the UK has a number of rules that impact the sequence and conduct of due diligence in a public offer process. When a firm 34
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intention to make an offer is made (Rule 2.5) it can only be conditional upon certain outcomes such as competition clearance and level of acceptances. However, crucially, it cannot be conditional upon funding and so due diligence involving access has to have taken place in order to arrange that financing. However undertaking this due diligence is made more complex by Rule 20.2, which requires all information available to one bidder to be made available to any other bona fide offeror who makes such a request. An offer is thus typically made in two stages, starting with an informal approach which includes a price indication which also seeks access to be able to undertake due diligence. Only once this has been completed and funding is in place with certainty is a formal offer made. This is different from a private process where typically an indicative offer is only made after quite a lot of confidential disclosure. However, public companies will have more information publicly available at the outset than would be available in a private company sale. If a board does not welcome the informal approach from a private equity sponsor it may be able to see it off by preventing access. However private equity investors are not necessarily put off by this and if determined may start to force a dialogue by making their interest known to the media or by acquiring a small shareholding. They may even bypass the board, directly approaching the major shareholders who in turn may be willing to put pressure on the board to engage. Typically, quoted company institutional shareholders are hard nosed and rational about valuation and do not regard their holdings as strategic - everything is available at the right price. A public company board can never consider itself immune. When information is given out it has to be done so in a controlled and disciplined way so that if another bidder enters the fray it can evaluate the same information to decide upon its position. The target will almost certainly curtail the dissemination of all information to prevent leakage of commercially sensitive data into the wrong hands, and in practice public companies are often acquired with less due diligence than private companies. Another difference between a public company sale and a private one is that the seller and the buyer become fused in a public company at the point that the management team becomes part of a buyout bid and so there will be a conflict of interest. The sponsor will generally want the management to support the bid, and to be incentivised to stay with the business. However the shareholders will be looking to the board to recommend the bid. This conflict also occurs in some private processes e.g. secondary buyouts but with a public company it BUYOUTS - A GUIDE FOR THE MANAGEMENT TEAM
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has to be managed formally. As soon as the management join the sponsor on the bid an independent sub-committee of the board, usually comprising the non-executive directors, takes over bid matters including the control and dissemination of information. The Takeover Panel also monitors the incentivisation to the management in a private equity bid. Rule 16 deals with this, requiring all shareholders to receive equal treatment. This rule has to be breached for a private equity deal as management shareholders will receive equity in the acquisition vehicle. The Takeover Panel is aware of market practice and permits this breach but seeks to make sure that market practice is being observed by requiring, amongst other things, (i) advisors to the target public company to confirm that the management incentivisation is fair and reasonable and (ii) independent shareholders of the target in addition to accept the offer vote in favour of a special resolution to approve the management incentives. As with a private company, a management team can take steps to prepare for a private equity bid. They can evaluate the likely bid price and prepare the groundwork for due diligence in the event matters were to move quickly. They can find out about the likely compatibility and suitability of certain private equity players without disclosing confidential information. They or their shareholders may consider a private equity takeover to be suitable for any number of reasons. However, to set the ball rolling, or even to help a private equity bidder with confidential information, managers must not go out on a limb; they must act with board consent, in accordance with the views held by the board and are obliged to keep the board informed. Management owe fiduciary duties to the target and are likely to be bound by service agreements, which include clauses requiring them to devote their time and attention to the target’s business. Management will, therefore, need to agree with target to be released from certain of their duties so that they can assist the bidder with the public to private. Management are also likely to be bound in their service agreements not to disclose the target’s confidential information. This will restrict the information they can disclose to the bidder. Moreover, they must not release confidential information without the express agreement of the board who should allow this only after acting independently. In many ways these principles do not differ from the management team’s obligations to vendors of unlisted companies discussed earlier in this Module but, in practice, there are two key differences:
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whilst the management team of a subsidiary or privately owned company can come to a pragmatic agreement with the vendor on how to handle the process, based on individual circumstances, this is not possible with a quoted company target where the formal rules must be followed; and the behaviour of all parties will, to a much greater extent, be exposed to public scrutiny and comment.
Secondary Buyouts The Secondary Buyout presents specific issues for the management team, the selling private equity investor and the incoming investor. These issues arise because: the team running a successful buyout company will, in almost every case, demonstrate a more independent approach and a clearer focus on their own interests than a primary buyout team. They will also be able to make a more focused presentation to potential investors, whose language and priorities they understand; the team will continue to participate in the company’s equity following the secondary buyout, making them both buyers and sellers and introducing a new set of potential conflicts; secondary buyouts usually see the management team receive a substantial capital sum in cash on completion as proceeds from the original deal, in addition to a completely renegotiated equity percentage. This raises the key issue of management motivation if the sum is ‘life changing’, although the team will be driven by the wish to continue running a refinanced company. Refreshed motivation is usually reinforced by a restructuring of the senior management team and the introduction of new members to equity participation; the team, having established trust and a relationship with one set of investors now has to start the process all over again; and it is difficult for the selling investor to take a dominant role in negotiations, without running the risk of marginalising the management team. The complexities of secondary buyouts are revisited in more detail in Module 7.
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Conclusion This Module has primarily been about preparing for a buyout and identifying and dealing with conflicts of interest. There is no question that the potential for these conflicts is very real; they will often surface in practice and the management team is at the centre of them. The team must behave robustly, but with careful consideration, to meet their obligations to the vendor, to protect their own interests and to act in the best interests of the company’s long term future.
3 Buyout Players and Processes The Private Equity Universe The Investment Process Approaches to Investing Debt Providers The Corporate Finance Adviser
Introduction This Module outlines the key participants in the buyout market, their roles and the influences that drive their actions and decisions. Central to this are, of course, the buyout funds, which are a subset - albeit the dominant subset - of the broad private equity industry. We look first at the universe in which private equity works, an understanding of which is essential to a successful buyout team. This is followed by an outline of the investment process, which leads to a review of approaches to investing, what differentiates buyout investors and issues that management teams should address in choosing private equity partners. Whilst the buyout investors drive the market, it is to a large extent fuelled by the availability of debt; in this module we explore the ways in which changes in debt providers are affecting the market. (For a review of types of debt, and their use in financial structuring, see Module 4.) The two categories of principals - equity and debt providers - are surrounded by a phalanx of advisory firms, encompassing investment banks,
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Buyout Players and Processes
The Private Equity Universe
corporate finance advisers, accountants and lawyers, together with a variety of specialist due diligence consultants whose work is reviewed in Module 5. The key advisers from the management team’s perspective - at least until the due diligence teams come along to submerge them - are their lawyers and their own personal corporate finance advisers (where they have them). A detailed review of legal documentation is beyond the scope of this guide, although key equity related documents are summarised in Module 4. We review the role and contribution of the teams corporate finance advisers in the appropriately titled section in this module. Finally a Case Study at the end of the module illustrates key points in the process with viewpoints from both management team and investor. Diagram 3.1 below highlights the players involved in financing a buyout and the advisers they will use:
The primary sources of capital for the private equity industry are pension funds and insurance companies, followed by banks and endowment funds. These types of investors (who are also the predominant categories of quoted company shareholders) have, broadly speaking, been increasing the percentage of their asset allocation to private equity in recent years, albeit from a very small base, and it is this increase that has driven the remarkable growth in the size of buyout funds. While private equity has traditionally been regarded as an ‘alternative’ asset class - i.e. a specialist rather than mainstream type of investment - investors today increasingly view it as a subset of the broader category of equity investments, which is of course dominated by investments in quoted shares.
3.1 The Buyout Players
Funds
Buyout Financing
Corporate Finance Advisors Management
Management Equity
Lawyers
Investor Equity
Sector/ Operational Consultants Lawyers
Equity Investors
Due Diligence
Debt Debt Providers
Lawyers
The majority of private equity investment is channelled through ‘pooled’ funds, so called because each fund is raised from a spread of investors. The most commonly used legal structure for a private equity fund is a Limited Partnership; the private equity firm itself - the fund’s manager - is referred to as the General Partner, and the fund’s investors as Limited Partners, hence the commonly heard shorthand GP’s and LP’s. Some Continental European funds use different legal structures, because domestic commercial law makes participation in Limited Partnerships difficult or impossible for European domiciled institutional investors, but they operate in a very similar fashion in commercial terms. A fund will have a fixed life (often seven years, extendable to perhaps 10). During this period the manager will be expected to invest in and realise (achieve cash exits from) a portfolio of companies. The manager will have complete discretionary investment authority, and investors in the fund will have no direct input into how it is invested, provided that it operates within clear parameters set out at the time the fund was raised. These will typically include: no one investment may account for more than a fixed percentage (usually 10 or 15%) of the total fund; investments can only be made during the first four (sometimes three or five) years of the fund’s life, referred to as the Investment Period; and
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the investment strategy (i.e. sector focus if any, range of deal sizes, types of investment and geographical scope) must be adhered to unless the limited partners agree to subsequent changes.
Buyout Players and Processes
approval stages supplemented by a more informal review, update and feedback mechanism. Although every firm’s approach in detail is different, the principal elements of the investment process are set out in Diagram 3.2 below.
Remuneration Private equity managers earn their income from three sources. First they receive a management fee from the fund, typically 1.5% to 2% per annum of the total capital committed. This is designed to cover the manager’s overheads and will generally reduce during the life of the fund, as the most active work of identifying and negotiating investments is completed during the early years, and the portfolio gradually shrinks as investments are realised. The second part is a profit share, called a ‘Carried Interest’. Having produced a cash return to investors equivalent to a basic target (called a hurdle rate, typically 8% per annum), the manager will be entitled to a share, usually 20 per cent, of all investment profits. This structure, which has remained fundamentally unchanged since the early 1980’s, is designed to incentivise a private equity firm’s executives in the same way as the management of the companies they back; providing an adequate salary but with the real rewards dependent on successful performance in generating capital gains. The existence of the carried interest has had two direct consequences. One is that partners in private equity firms are highly remunerated if their investments perform. The second is the golden handcuff effect: investment executives tend to stay with the same firm, because they generally lose their share of this profit if they leave. The third source of income is arrangement fees (or ‘deal fees’), which are charged to the company on completion of a buyout. These fees will typically equate to 1 - 1.5% of the value of the transaction, and are split between the private equity firm and the fund it manages. We revisit the topic of professional fees in Module 4.
The Investment Process The core of the investment decision making process at almost every private equity firm is the Investment Committee, made up of the firm’s senior executives. This Committee will review an investment proposal a number of times before it completes, with a formalised, heavily documented series of
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Modern practice in most firms is to bring a potential buyout to the Investment Committee - and thus make the whole firm aware of it - at an early stage, in order to: identify any fundamental objections (typically based on negative views of the sector, the management, the likelihood of an exit, the terms obtainable or the likelihood of actually completing a deal); identify the key business issues; set the parameters - price, critical due diligence points, deal breakers etc.; and agree the allocation of resources, including specialist input. As the proposal evolves, informal updates will be made, both verbally and by memo, and debated until either it becomes clear that there is not a viable
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transaction or it reaches the stage at which the firm is prepared to commit to the investment. At this stage the Investment Committee will formally approve: clear intent to proceed to completion; and incurring formal due diligence costs. The final approval stage, based on complete due diligence reports, final terms and an agreed financing structure, authorises the deal team to complete the transaction.
Withdrawal Assuming that a proposal makes it past the Initial Proposal stage, the most common reasons for a subsequent withdrawal are: failure to secure the acquisition (inability or unwillingness to beat a higher offer, or insufficient vendor / management engagement) or the emergence of other vendor related, irresolvable issues; loss of faith in the management team - whose performance is constantly appraised throughout the entire investment process - or poor feedback from management referencing; failure to address or resolve key commercial, deal related issues (it is therefore paramount that both the investor and the management team get a clear focus on what these issues are); and adverse due diligence reports. The private equity executive leading the transaction - the deal champion - will play the pivotal role in navigating the proposal through these decision points, persuading his colleagues of the case or taking the decision that the buyout is not viable. Before placing the success of their buyout in his hands, the management team will develop their own view not just of his expertise, commitment to the transaction and credibility, but also of the personal chemistry and mutual understanding that develops between them.
Approaches to Investing Buyout firms are not all the same. Although money itself is the purest of commodities, the decision making process is driven by individuals, each with a unique combination of experience, style, attitude and culture. Investors can be differentiated along the following lines:
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industry sector focus (or specific sectors excluded); size of investments made and, related to this, their willingness or otherwise to syndicate investments with other funds and hence participate in larger deals; house style; degree of operational involvement with investee companies; portfolio spread; and execution. The first two aspects are simple, straightforward and factual, and investors will rule themselves either in or out of a particular opportunity. The other four areas all have a direct bearing on the investor / management team relationship and merit some exploration.
House style This phrase is generally taken to mean the personality of the investor and their approach to negotiating, building and managing relationships. This is, of course, the most subjective of differentiators and team’s preferences will vary. Some key points for teams to ask when forming a view on a potential investor: does he clearly offer skills, experience, intelligence and insight that will add value? negotiating style is a key indicator. Does he try to trip you up, is he aggressive, or does he consistently seek reason and fairness? and does he appear nervous, or does he demonstrate a calm authority?
Operational involvement In terms of operational involvement in investee companies, buyout investors fall into three categories: those who will only invest where they can identify significant operational improvements they can bring, and where their own executives will become involved in day to day operations. Investors of this type are the least common and tend to operate in very tightly defined sectors; those who are capable of adding operational expertise if it is required, either from their own executives or through external consultants and advisers, but do not insist on close involvement and will prefer to work with a strong, incumbent management team; and
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financially oriented investors, whose input is restricted to strategic, financial and exit planning. Some private equity firms lean heavily towards employing investment executives who themselves have an industrial background, often referred to as Operating Partners. This can give an edge in finding deals, appraising them and monitoring and supporting the management team. The inclusion of operating partners is a growing trend, primarily because of the need to develop a consistent approach to achieving rapid performance enhancements in many highly priced buyouts. Others will tend to employ executives with strong financial and transaction skills. Specific sector expertise for these firms comes from independent directors and external advisers who are used on a case-bycase basis to provide informed input on specific investments.
Portfolio spread This refers to the number of investments a firm makes and the resources it devotes to each. Modern practice, particularly in the large buyout market, is to focus resources on a relatively small number of investments, with each team responsible for a handful of deals at most.
Execution By execution we mean the ability of the investor to quickly grasp the essential points of a proposed investment, to understand and navigate the issues around it, and to negotiate consistently all the way through to completion. Competent execution along these lines is the goal of every investor and negotiation skills are key. The effective investor will have the ability to anticipate and avoid brick walls, a high degree of personal credibility within his firm and the capacity to maintain focus amidst the complexity and huge resource management requirements that a buyout entails. Problems can arise when, for example, more junior executives carry a deal past the point at which a more experienced practitioner would have spotted some fundamental flaws or misinterpretation. This can lead to embarrassing reversals or restatements of position at a late stage and management teams need to make careful judgements about the credibility and calibre of the private equity executives they are dealing with. Execution skills are a straightforward test of quality and rank along with investment judgement as a critical performance issue for private equity firms.
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Management teams will want to ensure that their private equity partners match best practice in terms of decision-making and process management, and many of the questions we outline below are aimed at helping establish this.
Choosing an investment partner ‘This procession of private equity firms came to see us - it was hard to tell them apart. They all said the same things and by the end we could tell what the next page of their Powerpoint slides would say.’
This pointed comment from the sales director of a buyout team is not completely unfair - investors do not usually go on sales courses - but rather misses the point when it comes to choosing a private equity partner. As will be clear by now, and will become increasingly so, the emphasis is on the word partner. The influence that a private equity investor has on the company that it has backed ranges so deep and wide that the relationship is far closer to a strategic partnership than that between simple provider and recipient of finance. Choosing the wrong backer can have damaging consequences, because inability to communicate, conflicting motives and lack of a strategy leave management team and investor in a destructive game of double guessing. There is no doubt that personal chemistry is at the heart of a successful relationship, and mutual respect between investor and management team is of critical importance. Every private equity firm has its own distinct culture and the wise management team will take some time to develop an understanding of how their prospective partners work and think. Beyond this chemistry however lies the need for clear professionalism, and the effective private equity firm: communicates promptly, crisply and unequivocally; demonstrates a quick appreciation of the company, its business drivers and strategic logic; is as transparent and straightforward as possible in its decision-making process; negotiates constructively, on a basis that is clearly understood and strives to be fair; sticks to decision-making and implementation timetables; does not reverse earlier decisions or agreed negotiating points; and fields sufficient resources to complete the transaction.
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Every private equity investor claims - and generally strives - to meet these criteria, although there are enough disillusioned management teams to testify that reality is sometimes different. The practical consequence of this is that the management team, especially in early meetings with potential investors, should be alert to signs which indicate the style and approach of each.
Questions to ask Despite the subjective nature of the choice, there are some questions to ask of a potential investor which will help narrow the selection. The first two questions are relevant also to the individual executives working on the transaction as well as the private equity firm itself. what is your investment track record? does the track record show a consistent pattern of returns? what relevant experience do you have, both as a firm and as the individuals working on the buyout in question? outline your investment process, step-by-step with typical timings. where is the decision-making authority? When do we meet the decisionmakers? can we speak to other teams you have backed? how does the due diligence process work (see Module 5)? Who will you use, what are your key issues and how long will it take? anonymously, describe the last three deals you withdrew from, why and at what stage? how often have you had to replace management teams or team members? who will be on our board? what are your reporting requirements? who will be responsible for managing the relationship; if this is not one of the deal team, can we meet him or her? what will your approach be should we fail to hit our projections? how can you open doors for us? How else will you add value? what are your views on an exit strategy? What can you contribute and what do you expect from us?
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Debt Providers The various types of debt and their applications are reviewed in Module 4. Consistent through them all, however, is the key role that debt plays in making buyouts work. Lenders are, in essence, taking considerable degrees of risk (available security rarely represents more than a small proportion of total debt) in exchange for a capped level of return which is in most cases not much greater than that available for loans carrying better security. This level of risk and return leads to a natural degree of inflexibility on the part of the debt providers, who will require the company to operate within very tight, predefined parameters. The debt raising, structuring and negotiating process is primarily the responsibility of the private equity firm, whose deep knowledge of and range of contacts within the debt markets is an essential part of the buyout model. Debt markets are cyclical - driven by capital markets liquidity and lenders’ varying collective views as to what constitutes an acceptable credit risk - and complex, with a wide range of specialist providers focusing on specific types of debt. Beyond this complexity, however, there is an important, more consistent trend which will inevitably have a profound effect on the nature of the relationship between borrowers, equity investors and lenders, and this is the change in the nature of debt providers. During 2005, more than 90% of debt for buyouts in Europe was provided by banks - i.e. conventional, traditional lenders. Although the banks would syndicate, or sell on, parts of these loans, they would also retain a large part of it on their own books, and maintain the lead role in managing relationships. During 2006, however, the market began to change dramatically, and by the end of the year nearly 50% of European buyout debt was being provided not by banks but by specialist debt funds, managing capital subscribed by institutional investors who seek higher returns than those available in the conventional, investment grade bond market. The consequences of this are three fold: these funds will buy and sell debt, and in some cases it has become difficult for a buyout company to keep track of who its lenders actually are. Private equity firms are responding to this by negotiating restrictions on how debt can be traded, and in particular by reserving the right to block the sale of debt to any investor of whom they do not approve;
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private equity firms have in the past built relationships with lenders, which not only supported and helped the debt negotiation and structuring process but enabled a more constructive response if, for example, a buyout company hit a difficult patch. This has become increasingly difficult as debt providers become more diverse and focused on trading debt rather than building relationships. However as the institutional debt market matures, some debt investors are emerging as long term holders, and it is with these providers that private equity firms are building new relationships; and many institutional debt providers will prefer to sell debt in troubled companies at a discount. This crystallises a partial loss, rather than risking a total loss and / or having to work on a restructuring programme with the borrower. However it also opens the door to so-called ‘Loan to Own’ purchasers of debt, who will use the fact that a borrower is in default in some way as leverage to attempt to acquire the entire business opportunistically. Hence the emergence of distressed debt funds, whose objective is to capitalise on the sale of loans in underperforming companies, either through the market having discounted the loans excessively or where there is an opportunity to acquire or restructure the borrower. In short, the waters for leveraged buyout companies have become more dangerous and, as the radical contraction of debt markets in mid-2007 demonstrates, are constantly in a state of change. This reinforces the need for consistent performance by buyout companies and sound relations between equity investors (who will have the experience and market knowledge to negotiate them) and management teams (who will not).
Buyout Players and Processes
provide practical support in dealing with and organising the flow of large amounts of information as the transaction progresses; provide an alternative route for resolving conflicts or diffusing confrontation between the principals; and act as a sounding board. The corporate finance adviser can often have a significant influence over the management buyout process and its outcome, including the selection of an investor. The appointment is a key decision and demands careful consideration. The key elements in the selection of an adviser are: track record in advising on transactions of a similar size and type; personal chemistry; and allocation of sufficient resources, and in particular of senior members of the firm with the credibility and experience necessary to add value. The most successful buyouts are characterised by strong, direct relationships between the principals (i.e., the investors, the management team and the vendor) and, despite the importance of the advisers’ role, it is essential that these principals remain in control. The first time buyout team will rely on their corporate finance and legal advisers’ extensive experience, but it is important that, as principals, they do not get swept along with the views that this experience brings; it is, after all, the team that will have to live with the deal after completion. Complex and often overwhelming the process may be, but the big picture - the ultimate objectives and priorities - will always be accessible to the team’s commercial judgement and common sense, and must remain the key driver in the team’s decision making.
The Corporate Finance Adviser Management teams will often appoint a specialist corporate finance adviser, who can: give early advice on the viability of a buyout proposal; identify and introduce potential investors; provide guidance on business plans and presentations; give informed feedback on responses; advise the team on market practice; provide advice on investors’ track records, styles and approach;
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Buyout Players and Processes
CASE STUDY
Finally, in early 2005, both shareholders agreed to commit to a sale process and Morgan Stanley was appointed to handle the auction.
BSN Medical
Graham Siddle:
This study demonstrates some key issues facing the management team and investor during an auction process. In particular these include the need for the team rapidly to gain an understanding of private equity investors’ priorities and objectives, and for the investors to learn as much as possible as quickly as possible in order to prepare the most informed bid. BSN Medical was established in 2001 as a 50/50 joint venture between the healthcare companies Beiersdorf AG of Germany and Smith & Nephew plc in the UK. The objective, which was fully achieved, was to integrate the complementary product ranges of its parent companies in general wound care, non-invasive orthopaedics and phlebology (the branch of medicine that deals with veins and their diseases). The company occupied leading positions in most of its product segments, with revenues exceeding D500m and some 3,500 staff. However it was clear from the outset that its specialist areas were non core for both parents and the business would, at some point, be sold. With its positioning in specialist – and growing - market segments, independent management team and a joint venture ownership structure that would inevitably change, the company unsurprisingly attracted the attention of private equity. CEO Graham Siddle: ‘We had calls from various VC’s, starting quite soon after we had set up. I and the rest of the management team had absolutely no exposure to private equity
‘The vendors were very good. They acknowledged the importance of our role and put in an attractive incentive package linked to the sale price. Morgan Stanley’s advice was that financial buyers were likely to produce the best offers – the obvious strategic buyers would find limited scope for amalgamating BSN’s activities into their own – so that, in contrast to the Risdon Pharma case in Module 2, a buyout was on the table from the outset. The management team, for whom this was totally new territory, was independently advised as they started the process that would lead to us either becoming shareholders for the first time in our lives, or alternatively possibly losing our jobs’.
Nico Helling, Montagu: ‘By the autumn of 2005, when BSN was formally put up for sale, we already had developed a sound understanding of the business and the market in which it operates. The sale was structured as a controlled auction, in which a limited group of bidders - typically five to seven - are invited into the due diligence process. The attractiveness of the price offered is certainly a key criterion for choosing a short list of buyers that get access to more comprehensive confidential information, however, strategic vision for the target, deliverability of the proposed offer, reliability, as well as reputation of a bidder often also play a crucial role.’
The Information Memorandum elicited six credible bids, all from private equity, and the management team made a full day presentation to each, which included providing answers to previously submitted written questions. Graham Siddle:
whatsoever, we were steeped in the corporate culture. A number of offers were made but the PE buyers were trying to do a cheap deal, and the owners were always going to auction it, to get the fullest price they could.’
‘This very quickly became a full time process for myself and the FD, resulting in limited operational involvement from October 2005 right through to March 2006. The rest of the senior team effectively ran the business during this
Because of its limited strategic relevance to either shareholder, the company was unable to exploit development opportunities and ‘by 2005 the owners were clearly looking for an exit, and the company became
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period. You have to be very confident in the people around you to do this.’
Nico Helling:
increasingly unsettled. We were losing staff and the rumours were flying.
‘After having made our way into the group of buyers that were granted access
Hitherto good owners were steadily in danger of becoming bad owners.’
to the company, we actually needed to find a well balanced approach in gaining
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an in-depth understanding of the company and the related risks and opportunities on the one hand and controlling the amount of money spent on advisors etc. on the other hand. It is generally difficult to assess the probability of a successful bid in a competitive auction process with no visibility on the progress other bidders make or their willingness to pay a high price. Several million Euros can be easily spent within a short period of about four weeks on due diligence that will inevitably result in an irrecoverable sunk
4 Structuring the Buyout
investment if the deal is ultimately not secured.’
As the auction moved into the next round, informal discussions helped the bidders increase the price until the vendors chose two bidders for detailed contract negotiations that were conducted simultaneously but separately and in different locations. Nico Helling:
The Buyout Model The Acquisition Price The Debt Element The Equity Element The Management Stake Investment Documents
‘We were moved to increase our price as the competitive bidding process evolved and our due diligence confirmed the quality of the asset as well as areas for improvement and further development. The contract negotiations lasted seven days from early in the morning till late at night before we ultimately convinced the vendors that Montagu would be the best owner of the company for the future. It was not only the price that finally made the difference.’
Graham Siddle: ‘The process itself can be intimidating – the people are not, as individuals, but the jargon most certainly is. Historically we had always operated one level down from the group board and had not been directly exposed to shareholders. We quickly had to learn not to burn bridges with other bidders, we didn’t know who was going to win and you have to keep everything in play. Nothing prepares you for this.’
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This Module reviews the way in which equity and debt finance are combined to provide the finance for a buyout. The essential characteristics of a buyout, in terms of financial structuring, are: the use of the target company’s cash generation capacity to service debt; and the use of debt to concentrate the returns delivered from value enhancement to the equity investors and management. The Module first introduces the buyout model, how it is driven by the target company’s forecast financial performance and how this guides both the levels of debt that can be supported and the price that can be paid for the company. We then review the various categories of debt used in buyouts and their application, before outlining the buyout fund’s approach to structuring the equity element and addressing the essential topic of the management team’s equity participation. The key non-financial elements of the legal contracts with the investor are reviewed in a brief box-out section although here we do not cover other documentation such as the Sale and Purchase Agreement or the Debt Agreements.
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Structuring the Buyout
The Buyout Model
absorbed by working capital requirements) is clearly critical in terms of the ability to service interest payments and debt principal repayments.
The buyout spreadsheet model acts as the central tool for all aspects of structuring the buyout, ranging from setting the price the investor is willing to pay, determining the levels and types of debt the business can be expected to service through to forecasting the potential level of return on the investment. It starts with a summary of the company’s anticipated profit - and, more importantly, cash generating performance - which is extracted from the detailed financial forecasts developed by the investor and the management team. The detailed forecasts themselves will of course incorporate a variety of scenarios, from a realistic Base Case (or ‘Investment Case’) to a pessimistic Worst Case and a feasible Management Case. The results of these scenarios will be used to stress test the buyout model. Table 4.1 shows the forecast performance of a hypothetical buyout company that we will use to demonstrate the structuring process. (The numbers in this example are built around a nominal D100 million transaction size, because of its convenience as a scalable number. Most buyouts using all the instruments we cover in this Module will be larger than this). Year
-1
0
1
2
3
4
Jm EBIT Depreciation and Amortisation
7.1 1.9
8.0 2.0
9.0 2.3
9.8 2.5
10.7 2.8
11.5 3.0
EBITDA
9.0
10.0
11.3
12.3
13.5
14.5
CAPEX and working capital Taxation (post buyout)
-1.9 n/a
-2.0 n/a
-2.3 -0.8
-2.5 -1.0
-2.8 -1.3
-3.0 -1.5
Net operating cashflow
n/a
n/a
8.2
8.8
9.4
10.0
4.1 Forecast Trading Performance
Profit and cash EBITDA is used as the key measure of profits. It equates broadly to the company’s ability to generate gross cash flow and, in comparison to EBIT, eschews the effects of accounting complexities in relation to the largest non cash items - depreciation and amortisation. Multiples of EBITDA are used as shorthand indicators of both total acquisition price and levels of debt. However Net Operating Cashflow (which allows for capital expenditure and cash
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The Acquisition Price The three limiting factors on the price that can be offered are the: ability to fund this acquisition price in a way that produces acceptable returns; price as a multiple of profitability (which is more of a reality check, to ensure that this profit multiple is not out of line with the market); and the need to maintain an acceptable Debt / Equity ratio (typically, a range of 1:1 to 3:1). Acquisition cost will be expressed as multiples of the most recent historic, and anticipated current year, EBITDA. Thus at this stage we are looking at an enterprise value - the total value of all equity and debt funding involved - and comparing it with underlying operating profit generated by the business. The investor’s views on the levels of EBITDA multiple they will find acceptable as an acquisition price will vary from case to case depending on: quality of earnings (i.e., the sustainability and predictability of profits); historic and forecast growth rates; profit to cash conversion (the level of cash generation compared with profitability; a company which reabsorbs large proportions of the cash it generates at the EBIT level, through high capital expenditure or working capital requirements, will attract a lower multiple); comparable company multiples and the overall level of valuations in the sector (a highly rated sector will imply that an exit at a higher multiple is possible, and provide the investor with some comfort in paying a higher acquisition price); the size of the transaction (the greater stability offered by larger companies, and their value as scarce assets often leads to higher valuations); and the potential for rapid and demonstrable profit increases arising from, for example, new contracts, cost cutting or restructuring. (There is a natural reluctance here to pay the vendor for improvements that will be made by the management team and investor after the buyout, but incorporating the effects of clearly identifiable improvements can often help to produce a winning bid).
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Structuring the Buyout
Returning to our example, an acquisition price of D100 million is agreed. This represents a multiple of 10.0 times the Year 0 EBITDA of D10 million. The addition of D5 million of costs (see the Transaction Fees section towards the end of this chapter) produces a funding requirement of D105 million.
Flavours of debt The objective of the debt structuring exercise is to produce a blend of loans whose cash servicing profile matches the target company’s inherent cash generating capacity. The major types of debt used in financing buyouts are as follows:
The Financing Structure - The Debt Element The private equity firm will take the lead responsibility for negotiating, appraising and structuring the buyout, including negotiating the debt element of the financing, and is referred to as the ‘Sponsor’ by the debt providers. (Buyouts financed entirely by debt, with no institutional equity and where a bank or debt provider must take the lead role, are referred to as ‘Sponsorless’ transactions.) However the process of raising the debt package in detail will be undertaken by a lead debt provider - typically a specialist debt department of an investment bank - so that the sponsor deals with a single rather than multiple parties. Debt markets are complex and characterised by a range of specialist providers, each of which target different levels of return, seek different repayment (or ‘maturity’) profiles and are willing to accept differing levels of risk. The growth in buyouts in recent times - and indeed the recent retrenchment - have primarily been driven by changes in this market, as we discuss in Module 1, which to recap are: greatly increased availability of capital in the debt markets, which combined with the emergence of larger buyout funds has enabled ever larger and more highly rated companies to become viable buyout candidates. Generally speaking, the larger the company the more stable its cashflows will be; more stable cashflows naturally can underpin greater levels of debt funding which in turn gives investors scope to value companies at greater multiples of EBITDA; this trend towards higher valuations has been reinforced by the growing importance of institutional funds, rather than conventional banks, as debt providers. Many of these funds do not seek staged repayment of the loans they make, so that non amortising debt has become a trend in buyout funding. Not having to allocate cash to debt repayment means that buyout companies can service greater interest expense.
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Senior debt So called because it has priority over all other forms of finance for interest and principal payments and is secured by charges over all assets of the borrower, senior debt is the most straightforward and usually the cheapest form of loan. In most cases, senior debt will form the largest single element of the debt package and is usually sub divided into separate tranches, each with slightly different terms, referred to as Senior Debt A, B and C. Senior Debt A will have the shortest maturity, often being repaid over a relatively short time frame (7 years is typical), and carrying interest in the region of 2 - 3% over the lender’s cost of funds (e.g. EURIBOR, the European Inter-Bank Offered Rate). Debt B will become repayable after all the A debt has been repaid, usually in two semi annual instalments, followed by the C debt, which will hence have a maturity of 9 years. Longer repayment schedules imply higher risk, and therefore B debt will carry a higher interest rate than the A, usually by 50 or more basis points (a basis point is 1/100th of 1%), with the C tranche increased by a further 50 - 75 basis points. Most loans will be syndicated - spread across a number of lenders - with the lead bank underwriting; i.e. providing the full amount and selling down the major proportion of the loans soon after the buyout has completed. In this event the underwriting bank will often have some flexibility to adjust the terms - interest rates and repayment schedules - if necessary to ensure successful syndication. The arrangement between the company and lead bank enabling this is known as Market Flex and will clearly set out the conditions under which it can be invoked. In addition to the interest charges, borrowers will also bear the expense of underwriting and arrangement fees. These can become quite significant when debt markets are tight.
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Structuring the Buyout
Working capital facility (or revolver)
Mezzanine debt
As part of the Senior Debt, a working capital facility (structured as a revolving credit facility, known as a revolver) will be provided. Unlike many conventional short term working capital loans, the borrower is protected by a fixed term arrangement which means that, provided there is no default, the lenders cannot withdraw the facility.
Mezzanine debt ranks behind senior debt and carries an accordingly higher level of interest. Its availability varies according to market conditions, and it is most commonly used with companies that have strong, stable cash flows. This type of debt is often subdivided into two categories - senior and junior - and the junior mezzanine will often carry with it an entitlement to equity warrants to enhance returns in compensation for the additional levels of risk it carries. Mezzanine is repayable after all senior debt, typically in one or two instalments - in practice, it will invariably be repaid through an exit or a refinancing long before maturity.
Second lien debt A second lien loan forms the next layer of the senior debt structure and, as its name implies, is secured but ranks behind A, B and C loans. It will usually be repayable in a single (‘bullet’) repayment after 10 years, and carry interest rates higher than the Senior C. In the event of liquidation, second lien lenders will not have access to the proceeds of asset sales until the pure senior lenders have been fully repaid. Originally a feature of the US markets, demand from investors for loan instruments carrying higher returns than traditional senior debt, and with no amortisation schedule, led to them becoming more common in Europe for a period. However at the time of writing, in the wake of the liquidity problems in the debt markets, this class of debt is not available. We mention it here because it may return during the lifetime of this book.
Subordinated or junior debt All other forms of debt, ranking behind the senior, are referred to as subordinated or junior debt.
Payment in Kind (‘PIK’) interest A common feature of many types of subordinated debt is the use of an element of PIK interest. As the name suggests, these interest charges are not paid to the lender in cash but are accrued, increasing the outstanding balance of the loan. This accrued interest is compounded (i.e. interest is charged on unpaid interest on a regular basis). Whilst the use of PIK doesn’t place a current cash debt service burden on a company, the requirement to repay the accrued interest when the loan is repaid (usually on exit) imposes an additional hurdle before the equity can earn a return.
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High yield bonds These are bonds, or notes, sold to investors through the publicly traded debt markets. They will carry interest, payable semi annually, at 5-6% above the rate for government bonds and mature after 8 - 12 years. Bonds are usually unsecured, and rank behind senior, second lien and mezzanine debt in priority. As bonds are tradeable in public markets they are regulated, and will be rated by credit rating agencies (as sub-investment grade). High Yield Bonds are purchased by investors looking for high yields over long maturities, and their terms will incorporate penalty clauses to compensate the holders if the company repays them early (known as ‘Call Protection’).
Vendor note (or vendor loan) Rarely seen in current practice is the provision of a loan (or the acceptance of some deferred consideration) by the vendor. Where it is used, this loan will fill a gap in the funding structure and will generally be on terms which would not be commercially viable in the open debt markets. Related to the vendor loan, and sometimes tied in with one, is the ‘anti-embarrassment clause’, a provision which sees the vendor retain an interest of some kind in the company, so that it receives a share in the proceeds if the company is sold in a short time frame at a materially higher value.
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Structuring the Buyout
Sale and leaseback The sale and leaseback of property is a good example of how investors and lenders can add considerable value when refining a company’s financing structure by exploiting anomalies in the debt markets. When property yields are low relative to senior debt costs, this approach can unlock significant value.
Securitisation The key to securitisation is the existence of a very long term stream of future cashflows. Either a pool of assets that generate these cashflows, or an entire company (Whole Business Securitisation) are packaged and transferred to a Special Purpose Vehicle (‘SPV’) which then issues bonds. The objective is that, unlike high yield bonds, these securities rank as senior, secured debt, are rated as investment grade and thus attract a far broader market of investors, and hence a lower cost, than other types of debt. They also have the advantage, over the senior debt that they are used to replace, that they do not amortise and hence free up cash flow previously devoted to debt repayment or allow the company to service higher levels of debt.
Bridge loan Reflecting the need for speed in completing buyouts, a bridge, as its name implies, will be used to enable completion while a particular facility is finalised. Most commonly used where arrangements such as securitisations or sale and leasebacks, which take a long time to complete, form part of the funding structure. The terms of the bridge loan will be designed to drive early repayment, with initially low but escalating costs which can be penal if repayment is not achieved.
Levels of debt Arriving at the appropriate level of debt represents a balance between using leverage to increase the return to equity providers - including the management - on the one hand, and not running unacceptable risks on the other. The basic tools used to help in this balancing act are: fixed charge cover, the main test (net operating cash flow divided by fixed charge - i.e. interest and capital repayment - obligations); the debt/EBITDA multiple. We mentioned above the use of EBITDA as a
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Structuring the Buyout
guide to gross cash flow generation, and the ratio of total debt divided by EBITDA is well-established market shorthand for indicating the degree of leverage used in a buyout structure. Typically, in larger transactions, debt of five to six times EBITDA is viewed as routine (up to seven times or more became normal in the strong credit markets pre 2007), while levels above this will require particularly strong predictability of earnings; and interest cover (EBIT divided by interest charges). Other limiting factors on the levels of debt used are: lenders’ willingness to provide it. They will have their own views, and will also take into account other factors such as the percentage of the total acquisition price represented by debt funding (a limit of 60 per cent to 65 per cent is generally market practice); and confidence in the forecasts, and in particular the sustainability of profits. A volatile profit history will significantly reduce the levels of debt available. The preparation of a realistic ‘worst case’ forecast will be required to indicate a level that can be serviced even if the company underperforms on its base case plans. In the case of the example we introduced at the beginning of the module, discussions with debt providers yield a financing structure as follows: Sources of funds Jm
% of Total
Revolver Senior Term Loan A Senior Term Loan B Senior Term Loan C Additional Senior Facility
0.0 10.0 25.0 25.0 0.0
Total Senior Debt Senior Mezzanine
Year 0
Year 1
0.0 9.5 23.8 23.8 0.0
0.0x 1.0x 2.5x 2.5x 0.0x
0.0x 0.9x 2.3x 2.3x 0.0x
60.0
57.1
6.0x
5.4x
10.0
9.5
1.0x
0.9x
Total Debt
70.0
66.7
7.0x
6.3x
Shareholder Loan Ordinary Equity Total Equity
34.0 1.0 35.0
32.4 1.0 33.3
3.4x 0.1x 3.5x
3.1x 0.1x 3.2x
10.5x
9.5x
Net Sources of Funds
105.0
EBITDA Multiples
4.2 Sources of Funds
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Structuring the Buyout
These levels of debt will be tested in the model against varying levels of forecast performance, with a particular emphasis on anticipating conformance with financial covenants. The right hand columns show the calls on EBITDA (as a surrogate for cash) as each level of debt is added. Year 0 is the historic year and year 1 the forecast.
A breach will give the lender the right to demand immediate repayment of his loan, although this is unlikely to be a practicable prospect for an underperforming company. It is also likely, dependent on the wording of the documentation, to make all other loans repayable as they will have crossdefault provisions. In practice, depending upon the severity of the problem, it will in most cases lead to a waiver or renegotiation of the terms of the loan.
Financial loan covenants
Debt structure example
Financial covenants are clauses in loan agreements that give lenders early warning of problems and increased influence and scope to renegotiate their debt terms if the company breaches pre-agreed financial performance undertakings. The principle is that covenants allow lenders to take steps to protect the value of their loans when the company is missing its targets by a preset margin, but has not defaulted on its debt service obligations (i.e. cash interest payments). In practice, with highly leveraged structures, the gap between a covenant breach and a cash default may be narrow; if a highly indebted company underperforms to any significant degree it is likely to run into cash difficulties very quickly.
Returning to our hypothetical buyout, Table 4.3 shows the effects of the financing structure on our model company’s cash forecasts. A balance sheet extract shows the levels of outstanding debt; the senior debt reduces as repayments are made on the A tranche (there are no repayments on the B and C tranches during this period), while the mezzanine loan increases as PIK interest is accrued. The table also includes a typical set of cashflow test covenant levels (the Profit and Loss and Balance Sheet tests are excluded for simplicity, but work in a similar way).
Typical covenants are:
The cashflow covenant levels in our example are set at 1:1 - in other words, if a company breaches the covenant, then by definition it has failed to generate sufficient cash during the period in question to service the debt, and therefore seems likely to go immediately into default. In this event the debt providers will turn to the equity investor for a remedy, a topic which is reviewed in detail in Module 6.
minimum cash flow/fixed charge cover ratio (the cashflow test); maximum total debt to EBITDA ratio (the balance sheet test); and minimum interest cover ratio (the profit and loss account test). The covenant levels vary little from case to case, usually allowing a 20-25% headroom between forecast performance and the level at which a covenant would be breached. They are influenced by: current market practice; the approach taken by the bankers, which can vary between highly restrictive and relatively relaxed based on their own lending experience and their view of the business; the views of the investor negotiating the covenants (for example, some will seek to make the arrangements as flexible as possible, whilst others will simply be interested in achieving the highest possible level of debt funding); and the predictability of future cash flows.
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Covenants and breaches
Debt service and capitalisation Table 4.3 shows a steady increase in profit and cash generation, some of which is absorbed by increasing debt repayments. The margin for underperformance - reflected in the headroom figures between forecast performance and the minimum necessary to meet covenants - widens only very slightly during the forecast period for the cashflow test, and not at all for the balance sheet and P&L tests, reflecting the fact that the pressure to perform in a buyout company is constant.
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A new danger Year
1
2
3
4
Dm EBIT
9.0
9.8
10.7
11.5
Depreciation and amortisation
2.3
2.5
2.8
3.0
11.3 -2.3 -0.8
12.3 -2.5 -1.0
13.5 -2.8 -1.3
14.5 -3.0 -1.5
EBITDA Capex and working capital movement Taxation (post buyout) Net operating cashflow Debt interest (paid in cash)1 Debt repayment Cashflow after debt service
8.2
8.8
9.4
10.0
-5.5 -0.5
-5.5 -0.8
-5.5 -1.1
-5.5 -1.3
2.2
2.5
2.8
3.2
Balance Sheet extracts showing outstanding debt: Senior Debt Mezzanine Debt (including PIK at 5%)
59.5 10.5
58.7 11.0
57.6 11.6
56.3 12.2
Total Debt Less:
70.0
69.8
69.3
68.5
2.2
4.7
7.5
10.7
67.8
65.0
61.8
54.8
1
2
3
4
1.00
1.00
1.00
1.00
1.37 2.2 19%
1.40 2.5 20%
1.42 2.8 21%
1.47 3.2 22%
Cash (assuming 0 at start) Net Debt
Financial covenants Cashflow cover test or fixed charge cover Year Covenant level: market standard >= Actual (Net operating cashflow / Cash interest on debt and debt repayments) Headroom on this covenant (D million) Headroom as % of EBITDA 4.3 Cashflow and Debt Service (Note that some columns do not sum to one decimal place due to rounding errors) For clarity we have not shown the interest charges attributable to each class of debt; the interest rates used range from 7.0% on the Revolver, increasing incrementally on the senior tranches, to a 9% cash interest element on the Mezzanine (the Mezzanine carries a further PIK element of 5%)
1
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It is increasingly common for some of the original lenders to a buyout company not to retain their loans until their natural maturity. Highly active markets exist for trading not only quoted bonds but also private debt. This trading, coupled with the increasing importance of institutional lenders, poses additional risks for equity investors and management teams in companies that fail to achieve their forecasts. The danger is that lenders to an underperforming company will, rather than retain the debt and work with equity investors to resolve the problem, prefer to sell the debt or part of it at a discount, crystallising a partial loss but avoiding the danger of a total loss. Buyers of this debt include a range of distressed debt and hedge funds, who will use the powers afforded to lenders by the covenant breach or default clauses in the loan documentation to acquire the company at a distress sale valuation - the so called ‘Loan to Own’ approach.
The Financing Structure - The Equity Element In our example with the structure at the limit of an acceptable level of debt, the buyout investor will need to provide D35 million in equity to cover the remaining funding requirement. The major part of the equity investment in a buyout is in practice structured as a loan from the buyout fund (the ‘Shareholder Loan’, ‘Investor Loan’ or ‘Institutional Loan’) rather than as ordinary equity shares, for four reasons: it reduces the level of investment allocated to ordinary shares, enabling management and investor to subscribe for them at the same price referred to as ‘flat pricing’. Hence the management team is incentivised by investing a relatively nominal amount of capital in ordinary shares, giving the team an interest in the capital gain on sale (see below for more on the management stake). In this example, for every additional D1m in value, D150,000 is attributed to the management team, pari passu with the investor equity; on exit, or in the event of a liquidation, the bulk of the equity investor’s funds - including any unpaid interest - will be repayable first, before the management team receive any proceeds. The primary effect of flat pricing is that while management participate in the rewards of value creation, and a
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sale of the company at anything less than the acquisition price plus accumulated interest will, in practice, see them lose their investment; if the company’s cashflow permits, a running yield can be paid to the investor, as an interest payment on the debt, without the need for this to be covered by retained profits as is required for dividend payments on shares (although this is rare in practice); and as the permanent share capital is fairly minimal there is scope to alter the capitalisation structure relatively easily at some future date without, for example, the need for complex capital reduction schemes. Institutional loans are not economically viable as stand alone instruments. They are subordinated to every other form of debt, are not secured and the interest rates they carry do not reflect the risk - effectively an equity risk - they entail. Hence they look like equity to every participant in a buyout except for the management team (for whom they are effectively debt as they have to be serviced and repaid before the management receive any share in the exit proceeds) and for the company’s unsecured creditors, with whom they rank equally. The combination of an investor’s participation in the institutional loan and equity shares is known as the Institutional Strip. Table 4.4 shows the final part of the financing structure in our example, with the required D35m provided by way of a D34m Shareholder Loan and D1m in Ordinary Shares (D0.85m from the private equity investor and D0.15m from the management). The Shareholder Loan carries an entitlement to interest at 12% per annum; however this is not paid in cash but is Payment In Kind - i.e. added to the outstanding balance of the loan. The Ordinary shares are split between the investor and management, who invest D150,000 for a 15% interest. (Please note that these numbers are for illustrative purposes only, as we have adopted a nominal D100m transaction size. In practice, the numbers will often be much larger, and the extent of the management investment greater, as discussed in ‘The Management Stake’ below.) Jm
%
Shareholder Loan Investor Ordinary Shares Management Ordinary Shares
34.00 0.85 0.15
85 15
Total
35.00
100
Forecasting the investor’s return Private equity firms use two measures of equity investment performance: the Multiple on Investment and the Internal Rate of Return (‘IRR’). The multiple of invested capital returned on exit is used as the key indicator, because of the effect that large multiples have on overall fund performance. Although it is not time weighted as a mathematical calculation, the assumption in using a multiple return of capital is that an exit has been achieved within a three to five year timescale. IRR, by contrast, is a mathematically time weighted measure of return on an investment. Technically defined as ‘the discount rate which, when applied to a series of cash flows, produces a net present value of zero’, it can be viewed more simply as the annual rate at which an investment grows in value. Its extreme sensitivity to time can make it misleading. For example, a D100 million investment which exits after 12 months with proceeds of D160 million will produce a spectacular IRR of 60 per cent per annum, but in absolute terms a D60 million gain may not make a significant overall impact on a buyout investor’s portfolio. A D100 million investment which produces a steadier return of 30 per cent per annum over three years will have generated a more significant return of D120 million. The highly time-sensitive nature of the IRR tool can also have important consequences for management; we shall review these later in this module. Forecast returns are used as an investment structuring tool to gauge whether or not they meet an investment fund’s targets. The forecast return is based primarily on an exit assumption - an estimate of the likely timing and value of an exit. This assumes the sale of the company at an enterprise value arrived at by applying a multiple to its forecast earnings - EBITDA - in the year of exit. All outstanding debt is deducted from this and surplus cash added back to produce an equity value - i.e. the net proceeds after repaying all external net debt. These proceeds are then allocated first to repaying the shareholder loan, with the balance divided between investor and management team based on their respective equity percentages. Table 4.5 demonstrates, with exit assumptions for each of years 1 to 4 showing how the enterprise value is allocated between the various lenders and shareholders. This is represented graphically in Chart 4.6:
4.4 The Equity Financing
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Structuring the Buyout
Exit assumptions: Year Enterprise Value (EBITDA x 10) Less: Net Debt (see Table 4.3)
2
3
4
112.7
123.0
135.0
144.8
(67.8)
(65.0)
(61.8)
(57.9)
44.9
58.0
73.3
86.9
The investor’s - and management team’s - forecast returns can be calculated using this data as follows (the table below assumes an exit at the end of Year 3). Investor Cashflows
Equity value Less: Shareholder Loan (initially D34.0m, increasing at 12% per annum through PIK) Ordinary Share Value
Of which: Investor Management
1
(38.1)
(42.6)
(47.8)
(53.5)
6.8
15.4
25.5
33.4
Investment 0
1
2
Realisation 3
Dm Ordinary Shares Shareholder Loan
(0.85) (34.00)
0 0
0 0
21.6 47.8
Total Investor Cashflows
(34.85)
0
0
69.4
Investment 0
1
2
Realisation 3
(0.15)
0
0
3.9
Year
Internal Rate of Return Multiple Returned 85% 15%
5.8 1.0
13.0 2.4
4.5 The Exit Assumption (Note that some columns do not sum to one decimal place due to rounding errors)
21.6 3.9
28.4 5.0
26% 2.0x
Management Cashflows Year Dm Ordinary Shares Internal Rate of Return Multiple Returned
196% 26.0x
4.7 Forecast Returns
The Management Stake ‘You might not think it’s perfect, but if the deal is successful it will be the best investment you ever make and it will make you very wealthy.’
Unless they are already significantly wealthy, team members will be expected to make a contribution to the funding requirement which can only be described as nominal in the overall context of anything but the smallest buyout. The intention is that each individual’s investment is large enough to represent a serious personal commitment. However this commitment should not be so large that it would cause personal financial pressure, which can be damaging to a manager’s effectiveness, especially if the company’s performance (and hence the value of his or her equity) is behind expectations. The equivalent of a year’s salary is often used as a benchmark; the usual starting point for an executive’s contribution will be the total senior team’s salary costs multiplied by his or her proportion of the total management equity stake.
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Hence a more realistic figure for the management contribution to our nominal D100m buyout would be in the D0.5m to D1m range, distributed between three or four key executives (see the ‘Distribution of Management Equity’ section below). Even with the relatively small numbers used in our example, this investment will realistically produce a D4m capital gain within three years. Because of the relatively small size of the investment, there is no correlation whatsoever between the amount contributed and the management’s share of the equity. This will be negotiated separately, with the team’s ability to increase its share governed primarily by: market practice; investor appetite; and the investor’s anticipated return. While reviewing a proposed structure, the management team should look beyond a simplistic focus on its own nominal equity percentage. They know the business better than the investors and bankers, and are in the best position to judge whether the overall structure and relationship is the most appropriate to its needs. There is no point in agreeing to a highly leveraged deal offering the team an additional 10 per cent of the equity if a predictable blip in trading puts the whole affair into the hands of the lenders. More commonly, an investor who has based his proposal on overly optimistic assumptions - leading to a higher equity percentage for the management - may often be less likely ultimately to deliver than his more cautious counterpart.
Ratchets can often appear to act as a convenient bridge between management’s equity expectations, based on their own expectations of performance, and a more cautious investor’s viewpoint. As they are based on highly time-sensitive IRRs, they also provide management with a strong motivation to achieve a timely exit. However, there are drawbacks to using ratchets. They have the effect of further leveraging the management’s stake, with relatively small changes in the timing and value of an exit having significant financial consequences for the team. They can also lead to divisiveness in circumstances that require adoption of a revised business or exit strategy and may need to be renegotiated, especially if, for example, additional finance is required for a major acquisition. The danger is that a management team, highly motivated by a particular equity structure which would see them suffer from a new approach may be blurred by personal interests in their focus on what is best for the business and its backers. Irrespective of these issues, there is no doubt that the use of a ratchet can be a powerful additional motivator for the management team. The extra equity it offers can represent a major prize for the team and help to cement the congruence of objectives.
Distribution of management equity ‘It is the currency that you use to get super-performance - it is one of the most important issues for the buyout team.’ ‘We did the management share split, between three of us who made up the team, in about 20 minutes. The investor told us what he thought was appropriate, and explained why.’
Management ratchets The management ratchet is an arrangement whereby the management’s percentage of the equity will be increased - usually in the range of 5% to 10% provided certain targets are met. In exchange for this, the team will have to accept a lower starting point, so for example they might be offered a fixed 20% participation or a ratchet in the range 15%-25%. With an emphasis on achieving an exit within the agreed timetable, modern practice is to link ratchet targets to the achievement of a target IRR and a minimum multiple return for the investor. Earlier approaches - typically achievement of profit or debt repayment targets - proved to be flawed, based as they were on measures that do not necessarily reflect long term value creation, and introduced further potential for conflict between investor and management team.
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Ownership of management equity is, of course, the driver of significant wealth creation and, in the light of this, investors will take a detailed interest in which members of the team receive management shares. There is a delicate balance between spreading the shares widely enough to align motivation throughout the team, and concentrating them in the hands of individuals whose performance is critical. Typically, investors will focus their performance expectations on two, three or four individuals, whilst management often feel that equity should be distributed more broadly, perhaps driven by a perception of the need to sell the buyout internally or to reward their colleagues. Experience (as witnessed by a variety of buyout chief executives who say that given another chance they would hold equity more tightly) shows that the
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investor approach has merit. The pressure on senior board members of a buyout company is unrelenting, and it is to those who bear the responsibility for delivering performance and exit that the bulk of the rewards should be delivered. However the use of an enlightened share option scheme, which will deliver relatively significant amounts of cash throughout the company on an exit, is a valuable tool in sharing motivation and will invariably be supported by investors.
Transaction fees Fees equating to some five to seven per cent are typical in the buyout market. They will include: corporate finance advisory fees; debt arrangement fees; private equity arrangement fees; legal expenses; and due diligence expenses. In addition, the investors and debt providers will charge monitoring fees during the life of their investment. This level of fees will often come as an unpleasant surprise, but it should be remembered that: although the private equity arrangement fee does represent an additional return to investors, they will often incur significant professional advisory and due diligence fees in the pursuit of a buyout opportunity which are written off should the transaction not complete. Equity arrangement fees on completed transactions will to some extent be used to offset these abort costs; the management team will have little, or no, exposure to expenses should the buyout not complete. It is not uncommon for a private equity investor to underwrite the management team’s legal expenses once the transaction is well advanced and the investor is in an exclusive arrangement with the team; and debt arrangement fees are factored into the overall levels of return a lender wishes to see when pricing a loan package.
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Structuring the Buyout
Investment Documents The legal documentation surrounding a buyout is complex, voluminous and detailed, and it is essential that the management team’s legal advisers are both experienced in the buyout arena and familiar with current market practice. Because of this need for detailed, transaction and jurisdiction specific legal advice, this guide will not review the contractual aspects of buyouts. We will, however, outline the key principles that govern the contractual relationship between investor and management. (There will of course be separate documentation addressing the contractual relationship with the debt providers, and an agreement covering the acquisition itself, both of which are beyond the scope of this manual.) The relationship between the management and investor is enshrined in the Investment Agreement (the principal document that describes the arrangements between investor, company and management), the directors’ Service Agreements, and the company’s Articles of Association. These documents encompass: investment agreement warranties; warranties from the vendor; compulsory share transfers; drag along / tag along rights; summary dismissal; corporate governance; and investor consent.
Investment agreement warranties The management team will be required to sign warranties which, in essence, state that: the business plan has been honestly prepared and is believed to be reasonable and realistic; and the due diligence reports are reasonable and realistic. There are three key points to understand about these warranties. The first is that they are a series of statements about facts at a given point in time - the completion date of the buyout - and are not intended to be a guarantee of future performance. The second is that they are concerned with verification of
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Structuring the Buyout
information on which the investment decision has been taken. The investor will not look to them as a source of recourse against loss in value - unless the management team has deliberately or negligently provided false or misleading information - and the managers’ liabilities will be capped, albeit at a level which is painful enough to ensure that they are taken seriously. The third, and perhaps most important point from the investor’s perspective, is that they will encourage the management team to think carefully about what is being warranted and force disclosures - statements of fact provided by the team during the legal process. The investor cannot subsequently sue the team under the warranties in relation to any such facts that were revealed during the disclosure process, so that this stage represents the team’s last chance to air any dirty washing.
Warranties from the vendor Although we don’t discuss the Acquisition Agreement (also often called the Sale and Purchase Agreement, or ‘SPA’) here, the topic of warranties from the vendor, which would be contained in the SPA, is relevant. Whilst lenders and investors in a buyout will require warranties, they may often be prepared to accept these from the management team only, as part of the Shareholders’ Agreement. This can provide the buyout proposer with a competitive negotiating advantage over a sale to a strategic or corporate acquirer, which will invariably insist on full vendor warranties and is quite likely to claim under them if possible. However, the stronger the warranties are in the SPA the less onerous will be the same warranties given by management in the Shareholders’ Agreement.
Compulsory share transfers The driving principle is that share ownership in a buyout is restricted to active, contributing members of the management team. Management shareholders are not permitted to sell their shares to anybody else except as part of an agreed exit (transfers to family members or trusts for tax planning purposes may sometimes be permitted) and anybody leaving the team before an exit is achieved may be forced to sell. The price at which a departing team member
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will sell their shares is governed by the ‘good leaver / bad leaver’ provisions in the company’s Articles. If required to sell, a ‘good leaver’ will typically be able to sell some or all of his shares at a fair market valuation, whereas a ‘bad leaver’ will receive no more than the original purchase price (or a market valuation if that is lower). It is rare for the ‘good leaver’ provisions to apply; they will only cover circumstances such as pre-agreed retirement and departure by death or disability. All other departures, whether voluntary or forced, may generally be viewed as ‘bad leavers’ so that only those members of the team who stay the entire course through to exit will share in the value created by the buyout. This extreme position is often tempered in practice by the adoption of vesting provisions, based on time served with the company, and there is sometimes scope for a technically ‘bad leaver’ who in fact has made a strong contribution to negotiate less draconian treatment. When reviewing these provisions, it is important that the management team views its position as shareholders. A departing team member will probably need to be replaced, and equity will need to be made available for the replacement; this can only come from the leaver if the rest of the team are not to have their holdings diluted. In addition to this practical issue, there is a broader matter of principle; the objective of management shareholdings is to bind team and investor together through to a successful exit, and to reward premature leavers will fundamentally weaken adherence to this principle.
Drag along / tag along rights The purpose of these provisions is to ensure that the entire share capital of the company can be delivered to an acquirer at exit. Hence ‘drag along’ rights compel other shareholders to sell if the investor sells. Fair treatment of the management team is ensured by provisions that the sale has to be a bona fide arms length transaction and that the same terms are offered to all equity holders. The other side of the coin, the ‘tag along’ provisions, protect minority shareholders by enabling them to sell at the same time and on the same terms as the investor, or in cases where the investor itself is a minority shareholder to protect it being locked in or being made an offer at a lower value.
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Summary dismissal The Investment and Service Agreements will contain provisions whereby members of the management team can be summarily dismissed if they wilfully or consistently breach the terms of those agreements or, in some cases, if the company is in breach of its senior debt covenants. These provisions protect not only the investor but also the remaining members of the team, allowing as they do the ability to make a clean break.
Corporate governance The Investment Agreement will contain certain governance procedures for the business. These include the investor’s rights to board representation and ability to appoint non-executive directors and a Chairman. The level and content of management reporting are also stipulated. Both of these issues are reviewed in detail in Module 6. The formation of Audit and Remuneration Committees is laid out in the Investment Agreement and Articles. The Remuneration Committee will comprise the Investor Directors, the Chairman and may also include the CEO. The Committee’s consent will be required when setting the executive directors’ initial salary and bonus levels, and for all subsequent amendments.
Investor consent The Investment Agreement will also include a list of matters that require investor consent. These are major strategic decisions, such as: annual budgets and business plans; capital expenditure above a certain level; appointment or dismissal of directors and senior employees; acquisition or disposal of subsidiaries; and significant changes to operating plans. In addition to the investment documentation, there will of course be voluminous documents relating to debt terms, Sale and Purchase Agreement, service agreements, statutory declarations and due diligence, all of which must be executed simultaneously at exchange or completion. These documents will be bound into a ‘Bible’, running to many hundreds of pages, following completion.
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5 Due Diligence The Management Role Types of Due Diligence Reporting Vendor Due Diligence
Introduction Today’s buyout market is characterised by a constant pressure to find new ways to add value, and the due diligence process has evolved so that it is now making an increasingly important contribution to this objective. In a traditional sense, due diligence could be seen as an exercise in verification, or validation; the process of subjecting the facts, assumptions and statements on which an investment decision is based to careful scrutiny. Whilst this is still a central requirement, it is combined in modern practice with the use of a thorough, impartial review of the company’s operations, markets, management, financial performance and strategy to identify areas in which efficiencies can be improved, plans accelerated and new growth opportunities identified. The due diligence exercise, far from being a hurdle of box ticking to be climbed between agreeing a deal and completing it, has become a central part of the buyout approach to value creation. Coupled with the greater expectations of the due diligence process has come an increased urgency. In a market where high quality assets are the
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subjects of fiercely competitive bidding, speed and certainty of completion is an important part of a buyout proposal. The process has been adapted in two ways to meet this time pressure. The first is that it starts much earlier; there is a great deal that can be done, especially in terms of appraising markets, without exclusivity or access to confidential information. Early research, either by the buyout firm’s executives with previous experience of the sector in question, or externally hired expertise, contributes not only to the final due diligence reports but also to shaping the valuation of the target. The second shift is an increased focus on directly relevant, rather than generalised, due diligence. This focus will be sharpened by identifying, at the outset, the key commercial issues (as we discussed in Module 3), using these as a guide to direct the emphasis of due diligence work. This Module looks first at the management role and in particular at the importance for the team of embracing, and playing an active leading part in, the entire process. We then address each of the key due diligence disciplines, before concluding with a summary of the creative and contributory, as well as the fact checking, aspects of due diligence practice in the buyout market.
Due Diligence
beyond the immediate points being discussed to get a sense of the team’s strength, its ability to explain, analyse and communicate, its willingness to share and its openness to new ideas. The underlying principle is that a strong, robust team will reveal and explain everything, discuss issues with the investor and its advisers as equals, and be receptive to new ideas and approaches. The team that obfuscates where it feels exposed, attempts to disguise its shortcomings and rejects external input is less likely to succeed. This opportunity for the investor to get to know the team in more depth, by working with them and developing in depth views on practical issues, also works in reverse, as the team can use the process to deepen its understanding of the investor’s executives. How quickly do they grasp the nuances of the business, do they demonstrate sound commercial judgement, do they take a balanced line between conflicting views and keep issues in perspective? Effort devoted to building understanding at this early stage will repay itself many times over the life of the partnership.
Types of Due Diligence The Management Role First time buyout teams are almost invariably astonished at the complexity, scope and especially the sheer volume of work entailed in the due diligence exercise. Although the investor is responsible for specifying, directing and analysing the output from the process, management’s role is clearly crucial, and the team must configure themselves to cope with the demands that will be made on them. But beyond this, the team’s approach and attitude will have a profound effect on its relationship with the investors and even on whether the buyout completes or not. The goal that unifies investor and management team - the creation of shareholder value - gives the due diligence process its underlying logic. The results will shape both the legal documentation and the framework of the Value Enhancement Plan (see Module 6). During this process every aspect of the team’s - and the company’s performance will be exposed to minute examination by a swarm of unfamiliar advisers and consultants. Inevitably, they will expose mistakes, suggest alternative approaches and produce unexpected analyses. The investor will watch management’s behaviour closely as these issues emerge, looking
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The key aspects of due diligence are as follows: financial; commercial; operational; management; environmental; technical/product; regulatory and legal; pensions; insurance; and tax.
Financial due diligence The specialist due diligence (or ‘Transaction Support’) practice of an accountancy firm will invariably be commissioned to provide a financial due diligence report. In most cases, the vendor will have commissioned a financial due diligence report before starting the sales process (see the Vendor Due
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Diligence section at the end of this Module) and this will form the starting point for the investor and its advisers. With the focus on due diligence as an active contributor to value, the brief to the accountants will focus on key commercial issues and judgements and will entail the active participation of the management team. Typical areas to be covered may include: brief history and description of the business (this may also discuss the value added process that we look at further in operational due diligence); review of the target company’s historical financial performance. The key objective of this should be to highlight key trends in the financial track record which can be benchmarked against the market or competitors, and which can be compared to the key assumptions in a business plan; review of the target company’s historical working capital movements and cash flows; balance sheet review, which will include a detailed review of assets and liabilities; review of management’s financial projections. This will identify the key assumptions within the projections and compare those assumptions to identified historical trends, current circumstances or known or likely future events. The review should aim to highlight the major performance risks within the forecasts as well as unaccounted for opportunities, and will encompass sensitivity analyses in the light of these; review of the internal management systems. Although this may encompass a variety of different business systems, including financial, IT, production, purchasing and marketing procedures, its particular focus will usually be on the financial reporting mechanism; review of the employment issues in the organisation. These may include staffing levels and turnover, redundancy liabilities, pension arrangements and liabilities and labour relations issues; review of the company’s tax compliance status (both corporation and indirect taxes) and a review of the taxation implications of the proposed transaction structure; and assessment of the post transaction funding position of the company and a comparison of projected financial performance against available facilities and banking covenants. The report will not normally include any general opinions or assurances about a company, as these are beyond the scope of financial due diligence. A critical 82
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point here is that the investors - and debt providers, who will also rely on it will have the right to sue the reporting accountants for damages arising from a negligent or misleading report. The natural caution and conservatism that this engenders is in contrast to the more robust approach taken by, for example, the commercial due diligence advisers who do not face this potential liability. It should be noted that financial due diligence is not an audit, and the outcome of the process will depend to an extent on the quality of the audited information which represents its starting point.
Data gathering The detailed data gathering process, together with the evaluation of that data, can take many weeks - or even months - depending on the complexity of the target company and the quality of the information received. The sources of information available to the financial due diligence team will vary from deal to deal. The primary sources will usually be detailed management accounts, interviews with company management, historical budgets and the target company business plan. Other sources of information may include: board minutes; customer, supplier and employment contracts; market reports; production plans; tax returns; policy manuals; property leases; audit letters; and legal correspondence files. Many of these topics will have been addressed in a Vendor Due Diligence report (discussed later in this Module), and supplementary and more detailed information will be provided through a data room.
The data room A key element of the due diligence process is the establishment of a data room - increasingly web based rather than a physical location - designed to make all relevant information available as required without disrupting the day to day running of the company. The data room has evolved as a response to the need to:
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keep the due diligence data collection process separate from the company’s day to day operations; maintain confidentiality; allow equal access to information for all relevant parties; and control the flow of information. The biggest drawback to the use of a data room from the investor or bidder’s point of view is the initial reliance on whatever the vendor or their advisers choose to put in it. The process will invariably allow for additional questions and requests for further information. These will usually be compiled into summary question and answer lists - all bidders will see all questions from whatever source together with the answers - which slows the process down and allows in some cases for obfuscatory answers. Originally the data room was a discrete, physical location, with boxes and racks of files and hard copy documents. Bidders would be allowed access on a rota basis, and because of the often large amounts of data provided, due diligence in physical data rooms could take weeks. The data room is now more likely to be an on line facility (an Electronic Data Room or EDR) with all documents stored digitally, and access is allowed at varying levels controlled by passwords. The EDR has a number of advantages: it allows all bidders simultaneous access to whichever documents they are authorised to view, from any location at any time. This is especially relevant with cross border transactions, significantly cutting down on travel time; although initial set up costs are higher than a physical room, it will generally provide overall savings, as there is no need for physical supervision or to duplicate multiple documents; bidders have greater flexibility in the time they spend looking at documents (although this does run the risk of incurring higher advisory fees); and the vendor has greater control of the information provided, and more importantly can in most cases keep track of who is looking at what. This will often provide clues about which issues the bidder(s) find particularly important, generally giving the vendor an early warning and potentially a negotiating advantage. Management teams should keep a record of information released to the due diligence team. This will aid the review process and avoid misunderstandings
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over data sources, and also provides a basis for management disclosures against warranties in the legal documentation. They should also ensure that as far as possible the information that is released is complete and final, particularly the financial projections. A continuing review of successive iterations of the business plan is nearly always the surest way to rack up professional fees and absorb huge rafts of management time. The result of the data gathering exercise will be huge quantities of information. The real skill of the due diligence team lies not in the collation of this information but in its analysis, evaluation and interpretation. It is through these processes that key trends and issues should be identified and conclusions drawn for communication to the investors.
Commercial due diligence ‘The accountants describe the business and focus on reviewing internal systems, looking at the company’s financial history, examining the balance sheet and checking the internal consistency of the projections. But we also want the external assumptions tested, and to get another viewpoint. That’s why we commission commercial due diligence.’
If the financial due diligence exercise can be viewed as primarily internal to the company, with its focus on reported numbers, systems and consistency, then the commercial or market report is its external counterpart. Financial projections - and in particular, their revenue lines - owe a large part of their credibility to a series of assumptions about the market environment and the company’s positioning and ability to perform within that environment. Commercial due diligence is designed in part to test these assumptions, but has also evolved to become a significant contributor to value creation. The process will incorporate a high level, strategic review of upside opportunities and, in conjunction with the operational due diligence review (discussed below) and will form the basis for developing the Value Enhancement Plan which is reviewed in Module 6. By definition, the commercial appraisal will be more subjective and more difficult to define than the tightly focused financial exercise, although they will cross refer to and rely upon one another and in some areas such as business description it could be either that covers the point. This is not to say that the buyout market has failed to develop disciplines and an experience-led approach to commercial due diligence - it has, and we shall look at the results
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of this shortly - but that the methods by which assumptions are tested vary widely both between different investors and from deal to deal within private equity firms.
Scope A typical commercial due diligence report will incorporate: analysis of market size; review of market growth prospects; assessment of key trends in the market; review of the business’s competitive position and market share, including threats to this market position and ability to increase market share; interviews with key customers to assess their perception of the business and its effectiveness (the timing of this is often very sensitive); benchmarking of the business against its competitors; analysis of supply chain in the industry including impact on the business of any recent/expected changes to this supply chain; review of pricing trends in the industry (historic and forecast); key strengths, weaknesses, opportunities and threats, including the threat of new market entrants and the threat of product substitution; the effectiveness of the company’s sales force; historical impact of a recession on the business; the potential for growth by acquisition; and review of potential exit opportunities. This list is not exhaustive, as the commercial due diligence will always be tailored according to the specific nature of the business involved. Certain areas may also be covered by more expert consultants (eg, technical consultants may be appointed to review the plants, assess the threat of product substitution, etc).
Advisers Commercial due diligence can be undertaken by: private equity firms’ in-house staff; specialist, dedicated commercial due diligence advisers, who can be either independent firms or departments of large accountancy practices;
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management consultancies; and credible individuals, often former senior directors with extensive knowledge of, and contacts within, specific markets. The choice between using external specialist advisers or in-house executives will be driven by resourcing issues, access to specific market expertise and the investor’s own policies. In practice, the major part of the commercial due diligence will be outsourced, both because the investor will not have the in-house resources to complete it in time, and because third parties, such as debt providers, will want to see the results of an independent review. A common feature is the use of freelance individuals who will often have recently operated at board level in a major company in a directly relevant market. These advisers are valuable because of their practical knowledge of the market and their own network of contacts. Investors can appreciate the fast responses and ‘quick and dirty’ reports they tend to produce, although they will lack the resources to undertake a review on the scale demanded by a buyout of significant size. Every investor will have a small database of contacts (which will often also provide a source of non-executive director candidates) whose input it may seek, on a formal or informal basis, whilst reviewing a transaction. It is also common to commission more than one due diligence report, hence exploiting the particular strengths of different advisers.
Operational due diligence Operational due diligence complements the commercial review outlined above, with both combining to give an overall picture of the potential to enhance performance following the buyout. Whilst commercial due diligence will provide guidance on achievable revenues and gross margins from the market perspective, the operational review looks for scope to enhance both margins and asset efficiency by implementing internal improvements. The review will also identify bottlenecks and critical factors in the company’s processes. The outcome from this part of the process will usually be prescriptive, providing a road map for improvements and identifying the Key Performance Indicators which will form the basis for monitoring performance (see Module 6).
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The ‘outside in’ look at operations starts with a review of the value adding processes and will focus on: costs; efficiency; use of capital assets; and cash and working capital management. The review will be informed by plant visits and tours, meetings with senior operational management and benchmarking of EBITDA performance against that achieved by competitors. The objective is both to identify scope for improvements and what needs to be put in place to achieve them. This may require the introduction of external expertise - for example to address shortcomings in IT systems or to effect more cost effective outsourcing of certain functions - and the investor will work with the management team to identify and introduce this support. Opportunities for clear, quick gains will be factored into revised forecasts, which may provide scope for more flexibility at late stages in the price negotiations. Longer term potential for improvements will contribute to the Value Enhancement Plan (or full potential plan) which is discussed in Module 6.
Management due diligence The investor’s key objective is to assess the management team’s ability to deliver the plan that has been agreed with investors (see Module 6). Appraisal of the team starts on the day the proposal is raised and essentially does not stop until an exit is achieved: forming and constantly updating a well-founded view of the team is a core element of the investor’s responsibilities. However the investor will not be satisfied with his own impressions and during due diligence will dig more deeply. With the objective of developing an informed and balanced appreciation of the team’s strengths, capabilities and shortcomings, the investor will: explore each team member’s CV in depth, reviewing the reasons, events and thinking behind each career step. He will be looking for consistency, clear reasons for changes in direction, evidence of commitment and unequivocal demonstration that the individual’s career history and experience equips him for his role in the team;
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take references. This will go far beyond telephoning a handful of people suggested by each team members as referees. Using their own contact networks, investors will seek to identify former colleagues, customers, clients, advisers, lenders and associates of each individual and develop as broad and well informed a picture as possible; in some cases, use psychometric appraisal specialists, or occupational psychologists, to contribute an independent, analytical viewpoint. By its nature this input tends to focus on style, ability to relate to colleagues and motivational issues, rather than competence, and is regarded by some investors as highly relevant, although views vary; and elicit feedback from all other advisers, and in particular those involved in due diligence. Although this may not be a formal component of a briefing, views on the team will invariably be sought, albeit informally and off the record from the reporting accountants and the commercial due diligence providers. Any areas of specific concern arising from this process will be investigated further, on some occasions without the team being aware of it. A check for county court judgements, criminal records, bankruptcy applications and related issues will be undertaken as a matter of course. It is a waste of time for team members to attempt to disguise or remove past failures or negative episodes - an issue which is raised up front can be discussed constructively, whilst the same piece of history emerging unexpectedly from the due diligence process can cause fatal damage to the investor’s view of the team.
Environmental Where the business’s activities give rise to the environmental impacts - or the dangers of them - the investor will commission a report to identify the risks associated with these impacts, both historically and in the future, and the costs associated with any clean up. The outcome of this report may well affect the price for the business, or lead to the inclusion of specific indemnities from the vendor in the sale and purchase agreement. Environmental due diligence can be costly, and the presence of severe contamination issues may well dissuade an investor from pursuing a transaction.
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Technical / product When a significant part of the plan rests on a business’s technical outperformance of, or product superiority over, its competition then investors may commission a report focused on this aspect. Typical issues might include: likely longevity of a current technical advantage; production reliability; capacity to cope with forecast volume increases; potential for product development; and product conformance in targeted new markets.
Regulatory and legal The investor will be seeking: a definitive understanding of the regulatory environment, if appropriate, within which the business operates, the impact of this on its day-to-day operation and the likelihood of - and consequences of - any changes in regulation; confirmation that the business is not in breach of regulatory requirements; the terms of major contractual arrangements, and the impact of these on future trading; the causes, status and likely outcome of any material litigation in which the business is involved; any areas which give rise to the potential for future litigation; ownership of all relevant tangible and intangible assets, including intellectual property such as patents, trademarks, copyrights and licences; and employment liabilities, disputes or contractual shortcomings.
Pensions Pension liabilities are an issue of potentially serious concern. The combination of a legacy of final salary related schemes, longer life expectancy, a history of pension contribution holidays taken during periods of strong investment performance and the subsequent widespread fall in share prices has resulted in widespread underfunding of pension schemes. The sweeping powers of the regulators to impose corrective measures - in some jurisdictions this includes
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the ability to pierce the corporate veil and require shareholders to provide additional funds - mean that a substantial shortfall in provisions for pension obligations will give rise to the need for, at the least, revisions to the acquisition terms of the buyout target. Due diligence will therefore need to ascertain that the fund and the ongoing contributions are adequate to meet the planned benefits following the buyout.
Insurance A detailed review of risk and insurance coverage will be required. This may identify shortcomings in the coverage which will need to be rectified, cost assumptions which need to be revised and the need for new cover specifically relating to the company’s new status following the buyout. An example of the latter will be the need to obtain ‘Key Man’ policies for the senior members of the management team. It may also be possible to obtain insurance to cover some of the commercial risks identified in the due diligence process.
Tax The tax aspect of due diligence is two-fold. First is the confirmation that the buyout company’s stated tax liabilities are accurate. Second is the use of the output from this exercise as the basis for the detailed negotiation of the tax deed documentation, which sets out what liabilities and risks are retained by the vendor.
Reporting The end product of the due diligence process depends on the scope established at the outset, but it will naturally encompass a series of reports. These may be short issue based reports accompanied by oral presentations, but a large transaction will demand voluminous, detailed reports, each accompanied by an executive summary. Whichever route is adopted, it is important that the management team is involved in the reporting process and has the opportunity to review the findings of the due diligence teams before they are presented to the potential investors and lenders. This review will in most cases take place on a continuous basis throughout the due diligence exercise.
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Due Diligence
The purpose of the management review of findings and any draft report is two-fold: it should identify any factual errors or inconsistencies known to management within the report; and it allows management to present contrasting opinions, iron out ambiguities and misrepresentations, and give examples of upsides and opportunities not already reflected in the report. At the end of the management review process the advisers will normally ask the management team to write to them confirming that: they have read the report; the facts as stated in the report are materially accurate; and they are not aware of any matters relevant to the scope which have excluded.
Conclusion The use of due diligence as a positive contribution to value creation, and the shared ownership of the process between management and investors which naturally arises from this has been one of the major developments in buyout practice in recent years. It is at this stage in the process that the team and the investor start to work together to build on the basic premise of the buyout, using input from specialist advisers and the benefits of a fresh, impartial view to find new ways to accelerate growth and enhance performance. The partnership starts to become real as these plans are built, and the foundations are laid for the post completion relationship, which is the topic covered in Module 6.
Writing this letter frequently causes management teams concern as they feel they are being asked to warrant the advisers’ work. In fact, the principal purpose of the letter is not to provide comfort to the investors but is a procedure established by the investigating accountants that allows them to demonstrate that they have conducted their own work with due care and attention. In most cases, however, the potential investors will ask the management team directly to warrant the facts contained in all due diligence reports. This is a separate issue and should be approached in the same way as negotiating any other warranty.
Vendor Due Diligence The preparation of a Vendor Due Diligence (‘VDD’) report, before or at the start of the sales process, is now widespread practice. This report is designed to speed up the sales process, to entice more buyers by making more information readily available and, in many cases, to help the vendor identify and rectify any weaknesses in the company that may damage its value, and to help them write the Information Memorandum. Useful though the VDD report is, it has limitations. In some cases it will only cover financial, accounting and legal aspects, and hence will be incomplete. Where a commercial aspect is included, investors will generally view it with some scepticism as the brief will have been prepared by a party who wish to show the company in the best possible light.
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6 Making the Partnership Work Investor Involvement Budgets, Plans and Value Enhancement Communicating and Reporting Board Structure and Composition How the Board Functions Underperformance
Introduction This Module looks at life after completing the buyout, exploring the realities of managing a private equity backed company and, in particular, how the partnership between management team and investor works in practice. ‘The business had been structured to deliver results - and it had to deliver them. If you lose credibility as a management team in the private equity environment you are dead.’
By the time the buyout completes, the management team and investors will have developed an understanding of each other, of the key business issues and of what needs to be done to make the buyout work. The due diligence exercise, described in Module 5, demands the full engagement and commitment of the management team, not only in helping investors understand the business but in paving the way to developing a plan to maximise value creation (see Budgets, Plans and Value Enhancement later in this Module). This process will have laid the foundations of the open, constructive partnership that characterises a successful buyout.
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Although the investors will have played a highly participative role in helping develop the plan, ultimately it is management who must deliver it, and hence they must take complete ownership of it - and responsibility for it - irrespective of who contributed what. The investors are reliant on the management team for this, and the demands of putting plans into practice mean that the period immediately following completion can often be the most challenging - and sometimes tense - of the entire buyout cycle. The key for management at this stage is to use its understanding of the private equity approach to anticipate the investor’s needs and priorities; the team needs to be on the front foot when it comes to adjusting to a new form of partnership and making it work.
Investor Involvement One of the issues invariably raised by first time buyout teams is the extent to which the investor will become involved in the operational management of the company. Most teams will naturally prefer to run the business without the new owners - or a management consultancy - watching over their shoulders and questioning their every move. For his part the investor is not interested in close involvement for its own sake. It will certainly not back a management team it judges incapable of managing the company in the operational sense but with the high levels of pricing and leverage in recent years will want to ensure that: every opportunity to enhance value is identified and pursued; and sufficient resources and expertise are deployed to maximise value enhancement, as quickly as is realistically possible. Hence the level of investor involvement will be a function of the aggressiveness of the growth plan following the buyout (and by extension, the extent of fundamental changes that need to be made to implement it).
Budgets, Plans and Value Enhancement As we saw in Module 4, the projected levels of profit and cash generation produced by a budget agreed between management and investor - are the key drivers in setting both the price that can be paid for the company and the way in which the acquisition is financed. Hence this budget forms, in effect, the basis of a contract - it sets out what management undertake to deliver.
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However in most cases it represents only the starting point, and not the entirety, of the value creation exercise. The due diligence process, explored in Module 5, will have been focused not simply on verification of facts and assumptions but also on identifying further opportunities to create value. These opportunities may range from something as relatively straightforward as streamlining a supply chain to major strategic initiatives such as moving production to a low cost country or addressing a new market. After completion of the due diligence process the management team, with input and support from the investor and advisers, will be invited to develop a detailed plan to exploit this additional potential. This plan will, of course, identify not only a series of actions, and the likely consequences for profit and cash (a 30 - 40% improvement over budget is not unusual) but also the additional resources required to implement it. The exercise is painstaking and highly involved. The process will in most cases entail setting up a steering committee; this is a sub committee of the board that sets the agenda for change, decides on the metrics to be applied and the resources required and takes overall responsibility for delivery of the plan. This committee will normally report progress to the board. The day to day work, including developing the detailed action plan, will be carried out by a programme office, led by a senior executive who reports to the steering committee. This is the time intensive part of the exercise, and potentially the most confrontational. The investor may or may not sit on the steering committee, but will want to make sure that all is progressing properly. Often an external, neutral individual - such as a non-executive - will sit on the committee. Investors and management may, having developed the Value Enhancement Plan, decide to implement it in full, in part, or not at all, but the key benefits of the exercise are: it offers scope to provide a contingency - a buffer - against any underperformance against the budget; even if not, or only partially, implemented, it can still add value by making the company more attractive to a subsequent buyer; it adds to the rigours of the overall forecasting and planning process, often making the budget itself more robust; and it - or rather the discussions around its implementation - will make clear to the management team the extent of additional resources available to them.
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Where the decision is made to execute a value enhancement plan, reporting will be centred on key performance indicators, which will be distinct from the budget numbers and relate directly to key business issues and crucial metrics.
CASE STUDIES
Different approaches to value enhancement: Two case studies from Scandinavia The key principles outlined in this Module will apply, in general terms, to all buyouts. However, the way that they are implemented will vary widely, as these case studies, of the Unifeeder and Logstor buyouts, demonstrate.
Unifeeder Unifeeder is a leading logistics company that transports containers from the large European container hubs at Hamburg, Bremerhaven and Rotterdam to over 25 regional ports across the Nordic Region, the Baltic States and Russia. It also operates a door-to-door, short sea container transport business. The company achieved sales of ca D400 million in 2007 and is headquartered in Aarhus, Denmark. It has 200 employees and subsidiaries in Norway, Sweden, Finland, Germany and the Netherlands and a presence through agents in the UK, Belgium, Estonia, Latvia, Lithuania and Russia. The 2007 buyout of Unifeeder by Montagu, from the family owners who had managed it for three decades, was the trigger for a total overhaul of the company’s approach to strategy and operations. Jesper Kristensen, CEO, said: ‘It was clear that the opportunity lay in a shift in thinking about shareholder value and development. The main challenge at first was making people aware of the need for change. Everybody had been to some extent conditioned by the way the company had been run; it was very conservative, backward looking and risk averse.’
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The company’s new board, with a blend of internal and external directors, some with direct transportation/logistics expertise and others with a more general perspective, together with Montagu’s in-house post transaction team, led the change with the development of a 100 day plan and a series of initiatives designed to engage the 40 most senior people in the new approach. The 100 day plan consisted of 10-12 work streams organised under three key areas: the main feeder business (transhipment of containers for the major deep sea operators): new strategic approach, anticipating changes in the market and positioning the business better to meet client demands, the door-to-door, short sea transportation business: new strategy for growth, and the operational side of the Company (chartering and managing transport and logistics resources): significant scope for greater efficiencies and closer integration.
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cooling networks, oil and gas pipelines, marine and industrial applications and solar power systems. In 2007, the company recorded sales of D300 million and EBITDA in excess of D40 million. It is headquartered in Løgstør, Denmark and has 1,350 employees in eight European production facilities and eleven sales offices. In addition, the company has distributors in 28 countries and joint ventures in Dubai, China and Korea. The company sells its products in markets where rising energy prices and environmental concerns are increasing the importance of efficient, energy-saving products and transport. Before the company’s 2006 secondary buyout it had been owned by a group of financial investors, and its management team had a clear and independent focus on value creation. They were also familiar with, and equipped to meet, the demands of investor reporting and managing bank relationships. Preben Tolstrup, CEO, said ‘Montagu’s value to us was as much in their interpersonal and people skills as in their financial strengths. They looked at us, and our plans, very carefully and
Boston Consulting Group conducted a strategic review while Montagu’s post transaction team helped implement the plan and monitor progress, under a Programme Office headed jointly by an internal Unifeeder senior manager and a Montagu representative. The results from the three streams of work were integrated and implemented between December 2007 and March 2008, with excellent results. Jesper Kristensen commented: ‘50% of the value was in the improvements we made, but just as important was the change in attitude and learning about how the process works. Now we know how to do it. Montagu made two major contributions - their support was conditional upon us carrying out this process rigorously and the senior management bought into this completely; and secondly they facilitated the process by introducing us to a completely new range of tools, expertise and techniques we were not aware of.’
bought into them.’
The board includes two external non-executives who both have strong industry expertise from previous senior management roles in various manufacturing businesses and two Montagu representatives. Peter Dahlberg, Director at Montagu, said: ‘These two cases are very different, and show the importance of tailoring our role to what is required. Unifeeder, as a primary buyout from its founders, had been run successfully on the owners’ gut instincts, with little use of KPI’s and cross divisional communication and with the management below the founders being of the opinion that there was a resistance to their suggestions for improvement. It needed a ‘big bang’ of cultural transformation. Jesper and his team saw this need clearly, and we worked very closely with them to implement it.’ ‘Logstor, on the other hand, was already actively working with fulfilling its
Logstor Logstor is the world’s leading manufacturer of pre-insulated pipe systems for transportation of gases and liquids in district heating and
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ambitious strategic plan and the team was successfully pursuing value creation initiatives independently. Whilst we did increase the focus on what we believed were the key value creation levers, our main contribution, by contrast, was on financial matters, the medium to long-term growth strategy and value realisation.’
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The management perspective
Communicating and Reporting
Private equity investors are well aware that successful management teams are characterised by a robust independence, and a natural inclination to want to make their own decisions with as little outside interference as possible. They will often have honed the art of managing their bosses in the corporate environment to achieve this freedom of action, and will inevitably be tempted to apply this skill to their new bosses - the investors - after the buyout. Investors are not naïve; they will see when this is happening and, provided results are being delivered, may to some extent acquiesce to it. However:
Communication between investor and management in a successful buyout company will be an effective blend of informal exchanges and a formal reporting regime. Each is of equal importance; whilst formal reports are of course essential, and can perhaps be seen as a mechanism for protecting value and monitoring performance against plan, the informal exchange of ideas and insights can:
‘If you keep people in the dark, you’d better deliver’
if problems do arise, an under-informed investor is less likely to view management in a favourable light; and the investor may well have access to resources the management is not aware of, so that opportunities or solutions may be missed. From the management’s viewpoint, the answer to achieving the right balance lies in choosing the right investing partner at the very outset, one whose credibility and commercial acumen encourages openness and sharing rather than distance.
Working with consultants As the buyout progresses, the extent to which private equity firms encourage the use of consultants will become increasingly clear. Nowadays all the major consulting firms have significant practices built to serve the private equity market. In some cases, this approach to bringing in external resource will continue after the acquisition, especially where the opportunity to accelerate change raises specific tasks that the management team consider it best to contract out. Useful though consultants can be, they are not part of the risk and reward sharing partnership between investor and management. The investor will expect the management team to maintain control and to keep the consultants’ contributions in perspective.
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identify new opportunities to create value; increase the pace at which decisions are taken; ensure that unworkable ideas are nipped in the bud; and help cement the relationship between all the shareholders with common objectives. The formal reporting regime will be agreed with the investor before completion and - provided all is going well - will be built around a monthly accounting and reporting cycle, supplemented by an interface with the more immediate and KPI focused reporting from the steering committee. In most cases management accounts will be produced by the end of the second week following each month-end, in good time for a board meeting during the third week of the month. The accounts will be produced in a format agreed with the investor and will typically entail: profit and loss accounts, with budget and prior year comparisons. These will normally be produced in summary form, presenting key data on a single overview page, supported with detailed breakdowns by subsidiary, division, country or product line as appropriate; cash flow summary and a rolling 12-month cash forecast; capex summary, again with analysis of any significant changes from budget (although these overruns will generally need to have been agreed with the investor under the terms of the shareholder agreement); and analysis of performance against bank covenants, and the implications for this performance of any revisions in trading and cash forecasts. These statistics will be supported by a brief narrative summary, generally from the Chief Executive with input from other executive directors, and a separate report from the Finance Director. Whilst management accounts are by
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definition historic, these narrative reports will need to be forward looking, reflecting the imperative to anticipate problems, changes and opportunities. Key items will be: issues not reflected in the numbers; and evidence, whether from leading indicators, customer feedback, competitor activity or any other source of market intelligence, that the assumptions on which the business plan was based may be changing. ‘Even the best investments rarely go to plan, and we are not frightened of that.’
The primary mechanism through which both the performance review and the adaptation of strategy to a changing world are conducted is the monthly board meeting, usually supplemented by less frequent strategy, exit planning and annual budget reviews. Before investigating the way in which a buyout company’s board works, we need to review its composition.
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board, or executive committee, which will usually be larger and include representatives from all departments. Only those issues with major performance or strategic implications arising at the operating level will be raised with the main board.
The Chief Executive The focus of executive responsibility lies, of course, on the Chief Executive or Managing Director who, as well as running the company, will be expected to: deliver a demanding and aggressive plan; maintain a constructive dialogue with the non-executive directors and investors; and deal with the stakeholder issues that arise from the company’s newly independent status.
Non-executive directors
Board Structure and Composition The board of a private equity backed company operates in a different way from its equivalents in either publicly quoted or closely controlled private companies, reflecting the closeness of the relationship between the executive management and the investors. In addition to its conventional role as the authority for taking major decisions and setting strategy, the board is also in this context the major interface between investors and management. This additional function is reflected in its composition, with executive directors supplemented by external non-executives appointed by the investor.
Executive directors The two key executive members of the board will always be the Chief Executive and the Finance Director. Dependent on the size of the company and the nature of its business, these will often be supplemented by directors with responsibilities for sales and marketing, operations or production. However it is an important distinction that this board - which may be referred to as the main board, or holding company board - will not concern itself with day-to-day operational issues, responsibility for which will be devolved to an operating
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The investor will appoint at least two non-executive directors (more in the case of a large, syndicated investment). The individuals selected will include executives of the private equity firm that made the investment, and often independent businessmen or women known to the investor. This will be chosen for their knowledge of the sector, experience of the type of transaction, their understanding of investor requirements and, in some cases, because they have a specific skill set (for example M&A experience) which is lacking in the executive team. However, beyond specific skillsets, non-executives are primarily appointed on the basis of their ability to see, and contribute to, the big picture. The four key aspects of their role are: representing the investor; acting as a sounding board for the executives, mentoring them and bringing a broader range of experience to bear in assessing the implications of board decisions; appraising the executive team; and taking responsibility for specific board committees
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Representing the investor
Board committees
At least some of the non-executives will understand the investor’s objectives, priorities and concerns, interpreting these for the management team and guiding the team through them. The emphasis here is the investor’s concern to keep the team focused on delivery, followed by a smooth and timely exit. In this context it is important to point out that the partnership ethos that drives relations between management and investor does not mean that the team does not have a ‘boss’; in a sense it does. The relationship differs from the clear cut reporting line between a group subsidiary CEO and its parent company, or the various ways that shareholders can force changes in the management of quoted companies, but ultimately the investor will have the authority to make major changes in the interests of shareholders or the company as a whole.
Corporate governance is carried out through board committees, which will to a large extent be influenced by the investor. The investor’s involvement in a buyout company means that many of the governance functions, which are designed to protect passive shareholders, do not function as they would in a quoted company. For example, although salary discussions will be undertaken through a remuneration committee, the investor - via its director who will chair it - will have a direct influence on their outcome. An audit committee will be established, and ad hoc committees or teams created for specific projects - an acquisition, for example - will see the involvement of non-executives with appropriate experience to contribute.
Sounding board
The chairman ‘We’ll usually appoint a chairman, but you have to be careful: sometimes they can create a barrier between us and management.’
‘The private equity people know a little about a lot of things. They bring a different perspective.’
The capacity of non-executives to contribute to growth is based on their: broader experience; ability to advise on issues unfamiliar to the management team; different perspective and objective viewpoint. A key investor director skill here is the ability to spot opportunities - and problems - early; and wide network of contacts - they will invariably know ‘a man who can’.
Appraising the executive team ‘We are there to observe management and to continue to test the theory that they are
‘The VCs brought a chairman in, who had experience in a sector very close to ours. He was a great help, and gave me the confidence to take the company forward.’
The investor will not always appoint a chairman, but where they do the cornerstone of his contribution is his relationship with the Chief Executive. The chairman will often have successfully completed and exited from a buyout himself, or at the very least will have extensive experience of operating as an independent chief executive and working with private equity investors. This will equip him to act as a sounding board, and in many cases a mentor, for the Chief Executive. Investors will place a significant degree of responsibility for the investment’s performance on the CEO’s shoulders, and he in turn will seek to enable and guide the chief executive in achieving that performance.
as good as we think they are.’
The prime role of the non-executives here is to identify the potential for improvement and to enable the team to move faster and operate more effectively. A large part of this role is conducted outside the board room, and the non-executive who simply turns up for monthly board meetings is a creature of the past in the buyout environment. Regular attendance at ad hoc meetings to address specific issues, and a steady flow of e-mail and telephone exchanges, represent the minimum investment of time expected of an effective non-executive director.
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How the Board Functions The board is primarily a vehicle for strategic decision making, not a detailed and certainly not an uncontrolled debating forum; the effective chairman will ensure that discussion, whilst open and free ranging, is disciplined, constructive and relevant. It is important that the executives do not treat board meeting as presentations to the investors. This approach manifests itself in decisions being taken by the management in what they regard as ‘real’ board
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meetings with the investor or non-executive directors not present. A refinement to the approach is for the team to have agreed a party line in terms of explanations for variances in performance, with a rationale based not on reality but on what they think the investor is most likely to accept or respond most positively to. ‘It doesn’t take a rocket scientist to spot when a board meeting is rigged. It leads to a stand off between management and investor and is completely dysfunctional.’
An experienced investor will quickly identify that something is amiss when all members of the executive team present a united front on matters which by their nature demand an open discussion and will generate different viewpoints, or when the list of points for or against a particular decision has clearly been assembled with a view to taking the investor where management has decided it wants to go.
Employee issues ‘The buyout was in some respects a bit like having a major medical operation. It left us healthier but there were some immediate side effects which could have caused us major damage if they weren’t dealt with properly.’
Stakeholder issues are a key item in board agendas, and the most significant side effect of a buyout for the company’s stakeholders - primarily its employees, customers and suppliers - is uncertainty. ‘The staff were very excited that we were going to be independent, they were delighted that we were buying the business, but not so positive when they realised that only three of us and a financial institution would be owning it.’
Even before completion, staff not involved in the buyout discussions will not fail to notice that major ownership and strategic changes are afoot, and with management generally forbidden to enlighten them (and for a large part of the process themselves uncertain of what the final outcome will be) the rumour mill will inevitably fill the vacuum. Concerns about financial viability, lay-offs and redundancies, no longer having the perceived security of being part of a larger group, envy of the financial rewards accruing to the buyout team and nervousness of the unfamiliar will all arise and are unlikely, in the short term, to lead to a more harmonious or productive workforce. In most cases, therefore, the management team’s first objective after completion of a buyout is to tell the employees what has happened and what
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the implications are. Any cut backs, closures and redundancies need to be implemented quickly and cleanly, with a sense of both security and sound planning for the future conveyed to staff. The issue of share options for employees, typically through an employee share option plan (ESOP), will often arise during buyout negotiations. The effectiveness of this tool as a motivational device is the subject of extensive debate and is not a specific buyout issue except to the extent that doing a buyout raises it as a possibility. Private equity investors will generally be open to the suggestion of an ESOP, provided there is clear evidence that it will add value, but the allocation of shares to it will in many cases need to come from the management team’s stake.
Underperformance ‘If the company is underperforming, then the equity is under water immediately.’
The danger in a buyout built on leverage is that a relatively small degree of underperformance can have a disproportionately damaging effect on the value of the equity. Investors, with a clear focus on protecting this value, will act swiftly if they see it under threat and will, if they gauge it to be necessary, take matters into their own hands. ‘We want to back management teams who have enough confidence in their ability to warn us well in advance if they see problems coming.’
The answer for the management lies in anticipation, identifying problems before they are reflected in management accounts, and discussing practical solutions with the investor. To insist that performance issues are temporary aberrations which do not need to be addressed is to store up greater problems for the future and runs a very high risk of permanently destroying credibility. Despite the need to review these issues with the investor, the answers will lie with the executive directors, who will be gauged by the success of the measures they take. Should performance fail quickly to show signs of improvement, the investor will bring extra resources to bear in order to identify the causes, ranging from other members of the private equity firm’s staff to external advisers. Although management will be involved in this process, they will be targets for analysis as much as contributors to the debate and will not be made privy to all the feedback.
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If events have reached the stage at which the ability to meet debt covenants appears to be under threat then the lenders will take a more active interest. Provided that they are satisfied with the plan to bring performance back on track, the investor will in most cases be able to negotiate a revised set of covenants, often at the expense of an increase in the interest margin and a fee. A key investor role here is to create a breathing space, so that they and the management can remedy the underperformance without distracting interference from the debt providers. All of this places additional pressure on the team, who are not only having to deal with difficult trading issues but doing so against a backdrop of decreasing investor confidence in their performance. Investors will be more forgiving when it is clear that significant external issues - a change in the economic climate, competitor activity or new demand profiles, for example - invalidate the assumptions on which the forecast was made. These changes rarely happen without warning and the management’s and investor’s - ability to look forward and absorb the implications of changing markets is critical to success. Provided that the need for a new approach is identified and discussed before it has a serious effect on trading results, management can expect investors to take a constructive approach and work with them to develop a revised strategy and plan.
The debt spiral The worst case - the armageddon scenario - will arise in the unusual, but not inconceivable, situation where the lenders have lost faith in management and the investor’s ability to turn things around, triggering the debt spiral. The start of this spiral will be the appointment by the lenders of an accountancy firm, usually the company’s auditors, to produce an independent report. This is the point at which management and investor face the risk of losing control, as the accountants run up costs when cash is already tight, comb through the company with an agenda over which management have no influence - but which will take up management time - and come to a set of conclusions whose primary focus is to protect the banks’ position. The key point here is that the buyout management team is in the front line; a failure to deliver will result not in an awkward discussion with a boss but with ruthless, although rational, actions by the banks.
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CASE STUDY
Maplin Electronics No plan ever emerges intact from exposure to the real world, and sometimes events can take a drastic turn for the worse. When this happens the quality of the management team, the insight of the investor and the strength of their relationship can be severely tested. The Maplin case study is an example of how a forward looking management team retained the support of an investor through very testing times, and how both sides of the partnership contributed to recovery. Maplin is a multi-channel retailer operating a fast-growing chain of High Street and out-of-town retail stores, a mail-order catalogue and expanding internet business. Its product range comprises an extensive number of electronic components and accessories, in the broad categories of sound and vision, computer products and hobbies and electronics. With 153 stores, more than 13,000 stock keeping units and a constantly changing product range, Maplin presents some demanding logistical management challenges. In September 2004, Maplin was the subject of a secondary buyout by Montagu at a price of £244m. This buyout itself helped to sow the seeds of problems which were to emerge soon after completion. The first of these was that the process itself was slow and tortuous, distracting the management team for many months as they made presentation after presentation to competing private equity houses determined to woo them. This was compounded by a management restructuring, which saw former Chief Executive Dr Keith Pacey move into the chairman role and a series of promotions at board level under him. With all the executive directors moving into new roles, an untested management structure was put under pressure by an aggressive growth plan. Finally, the team members each received large payouts at completion, which only added to the distraction. Keith Pacey: ‘We took our eye off the ball during the secondary buyout, and when the cash arrived (management’s share of the sale proceeds), we really took our eye off the ball.’
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It became clear, in the hectic trading period running up to December 2004, that issues around inventory selection, stock management and inadequate web site infrastructure were damaging performance. The reporting structure alerted Montagu to the problem but the team, led by a chairman embarrassed by such rapid shortcomings in performance, had already identified the causes and was developing a plan to turn them around. ‘This is a management problem and management will fix it.’ The fact that the team spotted the issues early, and raised them openly with the investor, had a significant impact on Montagu’s approach to rectifying them. Montagu: ‘By early 2005, performance was falling sharply behind plan, and we asked ourselves three questions: ‘Is the business model sound?’ Answer - yes, it was a solid business in a strong niche market; ‘Do we have faith in the management?’ Answer - yes, but the team needs strengthening and restructuring; and ‘What are we doing wrong?’ The issues were internal -
7 Making it Pay The Management Perspective Exit Methods Secondary Buyouts Trade Sales IPO’s Recapitalisations Ten Golden Rules for Buyout Teams
operational and logistical - and could be addressed. Once they were, improvements came through very quickly.
The turnaround plan was developed jointly between the management team and Montagu. With a reshuffle of senior roles, some additional finance director resources and increased emphasis on supply chain management, trading performance was improved before any bank covenants were breached or lending facilities fully utilised. Montagu: ‘The debt providers were very supportive, we were able to concentrate on the business without being distracted by extensive conversations with them.’
One major distraction, however, was the press. Maplin is a well known high street name, recognised by a large proportion of the population, and one journalist in particular pounced on rumours of problems. Montagu: ‘The press reported the wrong facts, exaggerating the scale of the issues which
Introduction This module covers the final phase of the buyout cycle, the value realisation or exit stage. We first explore the management perspective, looking at key issues for the team in terms of their relationship with the investor, their own objectives and their alignment with the investor’s objectives. The section also raises key issues in connection with timing the exit and developing an exit strategy. This is followed by an overview of the four primary routes to an exit, focusing on the management and investor considerations for each. We conclude the module - and the book - with Ten Golden Rules for Buyout Teams.
certainly didn’t help with employee morale and confidence.’
The outcome of the turnaround exercise was a speedy recovery, achieved because the team identified the issues early, openly addressed them with the investor and worked in partnership to resolve them. With a temporarily suspended store opening programme resumed, and a new plan to exploit the business’s full potential being developed within a strong - and stress tested - partnership between investor and management team, the business is on track for a successful outcome. 110
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The Management Perspective The development and execution of a value realisation strategy will have a significant impact on the overall success of the buyout. Hard won increases in value can be squandered if conflicts or confusion are allowed to enter the process, while additional value will be captured by well judged timing and a clear sighted positioning in the eyes of the best buyer. BUYOUTS - A GUIDE FOR THE MANAGEMENT TEAM
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Although the conclusion of the process will see management and investors part company, its success relies upon maintaining a close and open partnership all the way up to completion. The investor is reliant here on the management team, for whom it has provided support, financial backing and the potential to make a life changing capital gain, to deliver the final part of its commitment in return - a smooth and value maximising exit. This means that the team is contractually obliged to: promote and actively pursue the most attractive exit route; not hijack the exit process, or use it to pursue their own objectives at the investor’s expense; and be prepared to provide warranties to the new acquirer on the understanding that the investor will not. As each side of the partnership tends naturally to look to its own interests - to the investor, the level of return, and to the management team not only its own personal gains but also the future of its members - the exit process introduces a new range of potential conflicts. These conflicting interests, should they arise, need to be managed by taking a transparent approach and by mutual acknowledgement of, and respect for, each party’s objectives. In extreme, and very rare, situations where the team is clearly pursuing its own interests at the investor’s expense, the investor may be forced to exercise his ultimate sanction, which is to use his contractual rights to dismiss all or some of its members (see the Compulsory Share Transfers in Module 4). It is highly unusual for an investor to do this because in most cases it raises the risk of value destruction, delays the exit, introduces all the complications associated with recruiting a new team and - an important issue - damages the investor’s reputation in the market. The investor’s reluctance to change a management team, and the immense difficulties associated with doing so, highlight the extent to which he relies on the team to perform and to deliver on its side of the bargain we outlined in the paragraphs above.
Management’s views on the exit ‘Management sometimes find it psychologically difficult to move towards exiting. They’ve put a great deal of effort into doing the buyout, they have built up a partnership with us, and they can be reluctant to move on.’ ‘We had to commit to run the company for three more years - the investors got out immediately.’
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Module 2 demonstrated how a management team can influence a sale process, primarily by identifying and supporting a preferred bidder and, where it is required, by adding a credible buyout offer to the list of the vendor’s options. The situation at the other end of the buyout cycle is different in some respects: the imperative to find an exit, the team’s commitment to support that process and the joint development of a strategy to achieve it reflect a clearer sharing of rewards, objectives and priorities. In most cases, this means in practice that the management team will from the start have a much greater influence in selecting the exit route than a corporate owner would allow, recognising their key, central role in the process. An exit for the investor by no means implies an exit for the company’s management - in fact the majority of cases see the team continue their involvement in running the business, albeit in a fundamentally restructured way. The management team’s own objectives are therefore a constituent part of the development of an exit strategy. These personal objectives - influenced also by age, succession planning and possibly retirement plans - will typically fall into one of three broad categories: the crystallisation of the largest possible personal gain, with career development and employment consequences taking a distinctly secondary place. A trade sale (see below for more about specific exit routes) may be the most attractive option for a team taking this view, as it will typically yield the best immediate return in terms of cash and/or tradable quoted shares of the acquirer. It will also usually enable the management team, at least after a pre-agreed time period, to leave and pursue new interests; a return to a major corporate career, with the strengths of broadened experience, enhanced credibility and financial independence that come from having completed a successful buyout. Again this is most likely to favour a trade sale, although the executives will have a greater personal interest during negotiations in their own position and role within the acquirer; and regarding the buyout as simply a transitional stage in the growth of an independent business, an interim source of funding on the road to building a major, commercial enterprise. The team with these ambitions, or whose continuing presence is essential to the company’s ability to perform, will seek routes that offer the buyout investors the return they seek whilst leaving themselves with the same, or an enhanced, equity position and with a lower priority on their own immediate cash returns. These routes will entail a stock market flotation (IPO), a secondary buyout or a recapitalisation. BUYOUTS - A GUIDE FOR THE MANAGEMENT TEAM
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The value of private equity experience ‘By the time it came to selling the company, we knew exactly what we were doing, and the shared understanding between us and the investors was there; we could talk in shorthand to them by then.’
The buyout company and its management team will in most cases be better equipped to plan and execute an effective value realisation exercise than at the time of the original acquisition process because: management and investors will share the exit objective, and the team’s rewards for achieving it will be clearly defined through the equity structure. This is in distinct contrast to the team’s uncertain position in a sale by a corporate owner; the company itself will have already, relatively recently, been through an extensive due diligence process. Subsequently its performance will have been closely scrutinised by investors and it will have developed or adopted accounting and management information systems that meet their demands. The information presented to potential buyers or analysts will stand up to detailed verification and the potential for deal breaking surprises is minimised; and management will be used to presenting its performance and strategic thinking to external scrutiny, to dealing with professional advisers, anticipating the questions and thorough processes of financially focused analysts, and differentiating between those who understand their operations and those who do not.
Timing the exit Timing is a critical element in achieving a successful exit. The ideal is to match strong trading performance by the company with a market hungry for acquisitions or IPOs, but the limited life of private equity funds (see Module 2) places pressure on this timing and management and investors will work towards value enhancement and realisation over, typically, a three year period. The use of a management ratchet, which increases the team’s equity holding based on the investor achieving a targeted minimum internal rate of return, provides an incentive not to delay the exit because IRR is highly time sensitive.
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The most compelling argument for an early exit comes when the opportunity arises to realise tomorrow’s value today, usually driven by a strategic acquirer offering a price which generates the anticipated multiple of funds that the private equity investor anticipated at the time of making the investment. Many management teams will see the opportunity to bank a significant - life changing - capital sum, and take it in preference to the uncertainties associated with a longer term plan. For their part the investors will normally support this, favouring a clear and satisfactory cash to cash result over more challenging, and possibly capital demanding, expansion plans.
Developing the exit strategy The exit strategy will be agreed - in some degree of detail at least - during the original buyout discussions, and will be an important factor in the investor’s decision to proceed. These early exit discussions will, in addition to identifying potential routes, help to clarify and develop the investor’s understanding of the management’s motivations and objectives in respect of the exit. Constant review and update of this strategy will be a key element of the partnership phase, with regular discussions focused specifically on its development. The key factors are the: company’s performance, prospects and strategic market position; state of its markets; overall levels of acquisition activity and pricing in the sector; specific opportunities for synergistic deals; quoted stock market’s appetite for new issues; private equity market’s appetite for secondary buyouts; and availability of debt for re-leveraging.
Exit Methods As we briefly introduced in Module 1, there are four major routes by which a successful exit can be achieved: secondary buyout; trade sale; stock market flotation (IPO); and recapitalisation (which represents a partial exit).
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Secondary buyouts and trade sales have in recent years been the most important routes; more than half of D500m and larger buyouts exited through secondaries, whilst trade sales are the single most prevalent type of exit for companies below this level (see Chart 7.1). The achievement of rapid performance improvements, discussed above and in earlier Modules, have combined with greater availability of debt finance in recent years, to produce two major trends: Holding periods, especially for large deals, have reduced, as investors seek to capitalise on early increases in value (although indications are that these are beginning to lengthen again due to the condition of financial markets).
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The use of recapitalisations has increased, as companies with better and more stable performance established following a buyout gain access to cheaper and larger quantities of debt, allowing refinancing of the original buyout debt (although this trend has reversed at the time of writing, again due to market conditions).
Secondary buyouts Secondary buyouts have grown markedly in importance in recent years, because of: the growing importance of buyouts in the M&A market overall and the greater availability of capital for larger buyouts, as we reviewed in Module 1; the wider base of private equity backed companies that have already completed a primary buyout; the availability of debt to support relatively high valuations; the willingness of financial (private equity) buyers to outbid strategic buyers where the potential for value creation can be clearly identified; the realisation on the part of management teams that a secondary offers them the potential both to realise a capital gain and to continue running and creating more value from - their company; an increasingly specialised and segmented private equity market; a company that has grown too large for a particular fund will represent an attractive new investment for a larger fund; and fewer natural or credible corporate acquirers. The issues surrounding secondary buyouts were aired in Module 2; these are recapped and expanded upon here.
Exiting investor considerations
Source: Montagu Private Equity
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The potential for conflict between management team and investor is perhaps greater with a secondary than with any other type of exit. The team is now both buyer and seller and will directly face the consequences of overpayment or over ambitious projections. Although the team will take out some cash, the incoming investor will want to ensure that the significant part of their future wealth is tied to performance following the secondary buyout. However the exiting investor will have its own perceptions of the company’s value, and of course is well equipped to form a view of what represents a viable
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value range for the new investor. Conflict will arise when management’s preferred bidder is not offering the highest price, or when management think the highest bid is in fact too high. In practice, the investor will have to accept that the highest practicable bid will be the best bid that management can support - unless the acquiring investor is prepared to override and if necessary replace the management team. There is no reason why the trade sale route or the secondary buyout approach need to be mutually exclusive. An investor can invite bids from target acquirers in both categories, much as a corporate vendor will often do in an auction. The benefits of selling to a financial buyer which we identified in Module 2 also apply: the secondary buyout can be a faster, lower cost route with the added bonus that vendor and acquirer will speak the same language.
Incoming investor considerations The management team which has demonstrated its ability to work with private equity firms, and to manage high levels of debt, will generally be attractive to potential investors in a secondary buyout. The company’s track record will often be more visible than is the case when buying from a corporate vendor, and the due diligence process should be more straightforward. However the initial buyout will have seen the benefits of greater management motivation, repositioning, earnings enhancement, working capital and capital expenditure rationalisation and immediate growth opportunities; with all the ‘low hanging fruit’ having been picked and digested, further value creation in a secondary is generally a greater challenge.
Management team considerations The single biggest issue for management in a secondary - even beyond price, future equity percentages and their cash take out - is their continuing motivation. They will have to go through the process all over again, proving themselves and building another relationship, but often with more demanding targets and with the distraction of having banked some personal wealth. For some teams this is simply not an issue; many executives prefer the private equity backed environment to any other and are keen to repeat the experience. This enthusiasm can be refreshed as the team is restructured - it is not uncommon to see a round of promotions and recasting of the equity split - but this brings its own challenges and to some extent can weaken the argument that the new investor is backing a proven team. 118
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Trade sales ‘We received two or three approaches to buy the company. Montagu told us to sell if the price was high enough, but when we got offers at the target price we still thought we could do better by identifying our own buyer. We did, and got a price 15% higher than the target.’
Investor considerations The art of positioning a company so that it has maximum strategic value to a clearly identified universe of potential acquirers is a core private equity skill. Even when different exit routes are used, the investor will always, from the very start of the appraisal process, identify where strategic interest will lie and work with management to maximise it. Sales to trade buyers have long been the most common exit route (albeit recently overtaken by secondary buyouts for the very largest deals, as mentioned above) and are, with few exceptions, the starting point for developing an exit strategy. The primary attractions of the trade sale are: the potential to benefit from synergies with the acquirer; reducing dependence on a narrow customer base; reducing volatility by becoming part of a larger portfolio; and the prospect of a cash exit for senior management who wish to retire.
Management considerations The biggest issue for the management team in a trade sale is naturally the relinquishing of its independence - or even its job. Whilst for some the prospect of a return or a move into corporate life - and perhaps the opportunity to advance rapidly through an acquirer’s senior management structure - holds appeal, there are attractions to a strategic sale even for those who abhor the idea. These are: crystallisation of a life changing capital gain; freedom to pursue other opportunities, either immediately or after a negotiated hand over period; and the achievement of a clear, and irrefutable, business landmark.
IPO’s (Stock market flotation) The essential point in pursuing an IPO, as opposed to a trade sale, is that floating the company does not represent an exit for the management team, BUYOUTS - A GUIDE FOR THE MANAGEMENT TEAM
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who are swapping one set of investor demands for a different one. It is the natural course for a strong, ambitious team committed to continuing the growth of their company. The buyout investor will favour an exit through an IPO where this clearly offers a better return than would be available through a trade sale.
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private equity firm. A robust business, a management team which can gain analysts’ confidence and clear prospects for growth, all of which will stand out clearly from the summary page of a prospectus, are a sine qua non for a successful IPO.
Management considerations The factors that govern a company’s ability to achieve quoted status are: the stock market’s appetite for new issues; the size of the company; the business’s viability as a quoted company (which will include its track record in the public market if it was originally quoted before the buyout); and management’s ability and willingness to operate in the public arena.
Stock market appetite Quoted markets are highly cyclical, with their ability to absorb new issues - and the type of companies that interest quoted investors - varying with time. For example, the pendulum has swung over the last decade towards greater interest in larger companies - typically a market capitalisation of £250m or more. Timing is a critical issue and a depressed stock market will make the IPO route unviable. The management team determined to take the company public may find it difficult to persuade investors to wait for a recovery whose timing is uncertain, and hence will need to find another route through which to meet their undertakings to deliver an exit. Within this generalisation about demand for new issues, a more detailed consideration is that different sectors go in and out of favour, as has been amply demonstrated in recent years. Varying degrees of enthusiasm for different levels of risk/return profile on the part of quoted investors mean that the timing issues outlined above will have different implications from sector to sector.
Viability as a quoted company Many of the issues we identified in Module 2, as factors which make a company a viable buyout target, are relevant here. However quoted investors will not be able to devote the resources, or have the ability to make decisions entailing the exploitation of specific opportunities, to the degree achievable by the
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In one sense, life under private equity ownership, especially with multiple debt providers who will demand detailed management presentations and who will often sell the debt to unfamiliar investors, will prepare the team well for the quoted arena. However the demands upon, and public scrutiny of, a quoted company’s performance from investors - who will demonstrate a fraction of the detailed understanding that can be expected from a private equity investor - will mean that only those teams with well-founded ambitions to operate in the public arena will be attracted to floating the company. A brief review of the benefits and drawbacks of listing as a quoted company will put these issues in perspective. Benefits: no dominant shareholder, and no pressure to provide an exit in the conventional sense; strong, lightly geared balance sheet; access to a broader shareholder and capital base. The desire to continue growth and the need to raise capital is the prime motivation behind most IPOs. Less than ten per cent of institutional equity investment is held in unquoted companies, the rest is in public markets, reflecting these markets’ overwhelming importance as sources of capital; prestige and external perception. By obtaining a quote, a company demonstrates to the world at large that it has passed a rigorous series or due diligence investigations and checks, and has satisfied the regulatory authorities that its financial health, management quality and trading prospects are sound. Quoted companies will often be perceived by employees, suppliers and customers as being sounder than their privately owned competitors. The greater availability of information helps with reassurance in this respect. The press also takes more interest in quoted companies - as its readers can buy their shares - providing further support for marketing and PR activities;
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the ability to use shares to acquire other companies; and employees can be motivated by the issue of share options which have a clear open market value. Drawbacks: onerous pre-IPO disclosure and due diligence requirements. Although the buyout team will be used to the process, stock exchange demands are more formalised and offer less scope for the tailored negotiations which will be familiar from the private equity experience. This regulatory aspect is an additional burden on management; ongoing disclosure and reporting requirements. No longer will the team be able to make an informal phone call to the investor if a major contract is lost or an acquisition opportunity emerges. Disclosure requirements are highly circumscribed and driven more by the overall imperative to maintain an orderly market than the particular commercial needs of an individual company. The release of information must be carefully controlled and it will be subject to a level of - often partially informed - analysis which adds additional pressure to decision making; the risk that a planned IPO might have to be aborted at a late stage, due to short term trading problems or adverse market conditions; the potential for commercial damage which arises from having to make public disclosures; exposure to market conditions. A company’s share price, and hence its public credibility and its ability to raise capital or make acquisitions, is a function not only of its own performance but of market sentiment as a whole. This has been demonstrated to excess in recent years; although the shareholder base can be broad, non executives and advisers sometimes feel pressured into seizing control from the executive board; and the increased profile of the directors, who will be exposing both their performance and personal wealth to public scrutiny (although the reporting code being adopted for larger UK buyouts following the Walker report, discussed in Module 1, will demand significantly higher levels of disclosure for these companies, narrowing the gap between quoted and private in this respect).
Investor considerations The investor will develop his own view, informed by access to specialist advice, as to the viability of an IPO as an exit route. In the face of a management team
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which makes a convincing argument for flotation, and when independent research confirms its viability, concerns will focus on the: potential for a cleaner exit and higher price via different route; cost, both in terms of management distraction and the very considerable fee levels entailed in pursuing an IPO process which market changes might force to abort. Related to this is the potential opportunity cost associated with pursuing an IPO to the exclusion of other routes; extent to which the investor will not be able to sell his shareholding for cash at the IPO, but be forced to retain a holding whose value will then be at the mercy of both market conditions and a management performance over which he will now have little influence; and reputational damage if a publicly trailed IPO is withdrawn at a late stage or if a company performs poorly following the flotation. Despite these issues, the IPO route can offer some clear attractions, particularly with a company demonstrating strong growth prospects where there is little or no prospect for a trade sale. The Dignity Funeral Services case study, in Module 1, provides a clear example of how this can work.
Recapitalisations This term covers a range of variations on the central theme of raising new debt, on better terms than were available for the original buyout. At one extreme, this may simply mean refinancing part of the original debt structure either at a lower cost or because repayment is becoming imminent - whilst at the other sufficient new debt may be available to refinance the original private equity investment, enabling the investor to recoup at least the cost of his original investment or even to realise an element of profit. In this latter case the management team may receive a cash dividend, representing its share of the profit realised. Thus at the first stage it will represent only a partial exit. The essence of recapitalisation is that the buyout company has proven its ability to operate independently and to maintain strong levels of profit and cash generation. An outline scheme for raising further debt will have been developed at this stage and put into practice as soon as the independent track record is sufficiently established for it to become viable. However it is an expensive and complex process and there needs to be a compelling reason to pursue it, and of course the debt markets’ liquidity will be the prime factor in this decision.
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Management considerations Key issues for the management team with a recapitalisation are: can they run the business without the new financial structure encroaching on them? do they get any cash out? does it help achieve exit based ratchet targets? and is there potential for relaxing the terms of the debt covenants? Where the refinancing is achieved through the issue of publicly traded bonds, the proceeds will be greater than can be raised through conventional buyout debt. However, management will also have to endure the rigorous analysis of one or more ratings agencies (a process which the Dignity Funeral Services team, in the case we reviewed in Module 1, described as more challenging than the buyout itself). However this route has compensating benefits. Beyond allowing the team to bank, irrevocably, a share of the early value creation, it represents a clear step towards greater independence. The process demonstrates the company’s ability to raise finance from the public, as opposed to private, markets. The disciplines associated with this environment will greatly assist in preparing the company for an IPO if that is the preferred route (as it was for Dignity) and will give the company greater public visibility which further increases the potential for a value maximising complete exit.
Investor considerations When debt markets permit - as they did for the two years up to the middle of 2007, for example - investors will be keen to take advantage of the ability to refinance with debt at lower cost and greater EBITDA multiples, producing a more efficient capital structure. At the more modest end of the range, this may simply mean repricing debt on better terms, whilst at the other extreme a new debt package may permit payment of a dividend which sees the return of at least the cost of their investment and a boost to their IRR performance. However the overriding concern will be to ensure that a refinancing should not hamper the company’s growth prospects; it is, after all, value creation that drives the major part of an investor’s return. Similarly, a recapitalisation does not by any means rule out further support for the company (indeed the need for further resources may trigger the recapitalisation). If, for example there is a good case to be made for providing further equity to finance an attractive
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acquisition then the door should be open. The flexibility this implies in the use of financing structures - using debt when stable cashflows (and debt markets) allow, and equity finance where the scope for value creation justifies the risk perfectly reflects the advantages of tailored financing which are inherent in the buyout approach.
Summary: Ten Golden Rules for Buyout Teams A successful exit brings the buyout cycle to a close and, naturally, this book to a conclusion. The scale and complexity of a large buyout can submerge the participants in a sea of detail and it is essential that these are seen in the context of the broader picture. To help with this we have summarised the lessons from the book in the form of 10 key rules: 1. A successful buyout is a win-win. The vendor has sold for a good price to a deserving management who are then in a position to prosper. 2. Although the rewards are considerable, so are the risks. Think like an investor. Be objective and don’t overpay. 3. Identify major issues at the outset. Develop a clear, sound post buyout strategy. 4 Make sure you can deliver on the numbers - particularly cash generation. 5. Ensure the management team is complete, experienced and shares the same motivation. 6. Take a leading, active and participatory role in the process - don’t get carried along. 7. Choose your investor and advisers carefully. You are setting out on a journey with them. You cannot know what is around some of the corners nor can they. Make sure that they understand your business and are committed to it and to you. They will want the same in return. 8. Communicate clearly, early and honestly when problems arise. Maintaining trust throughout the relationship is key. 9. Run the business throughout. Somebody on your team must continue to be responsible for the day-to-day. 10. Focus on the exit from day one and exit when the going is good.
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Appendix 1 Directors’ Duties in the UK Introduction In any buyout situation, it is natural that the management team will want to devote time and resources to ensuring the success of their bid. However, it is important that management do not overlook or neglect their duties and obligations as employees and (often) directors of the buyout target. If members of the management team disregard these obligations, a number of consequences follow. Aside from the strict legal position, if the vendor believes there has been a breach of trust, this can seriously damage the personal relationship between the management team and the vendor who may then be less inclined to look favourably on management’s bid. In the case of a demonstrable breach of duty, the vendor may well have grounds to dismiss members of the management team for misconduct. If the target company has suffered loss as a result of the breach, there may also be a claim for damages. Either could be ruinous for the individuals involved, not only financially but also in terms of professional reputation. In practice, the vendor may well not want to take such severe action, but the possibility will significantly strengthen the vendor’s negotiating position.
What Duties Apply? The duties to which the management team are subject depend to a large degree on whether or not the members of the management team are directors of the target company. The duties of a manager who is a director will be more extensive, and more onerous, than the obligations of a manager who is simply an employee of the company without also being a director. All members of the management team, as employees of the target company, are subject to the express provisions of their own employment contracts. As employees, they are also under an implied duty of loyalty to their employer, which means, among other things:
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acting honestly; disclosing all relevant information to the employer (such as the fact that a bidder has made an approach); and respecting the confidentiality of the employer’s commercial and business information. A manager who is a director of the target company is subject to additional duties, most notably the duty to promote the success of the company for the benefit of its members as a whole, and the duty to avoid conflicts of interest.
Conflicts of interest As a matter of law, managers who are directors of the target company have an absolute obligation to avoid a situation where their own interests conflict with those of the target company, or where there is a real likelihood that such a conflict of interests will arise. This duty does not, generally speaking, preclude management from formulating and discussing plans for an MBO among themselves, provided that this is done in the management team’s own time, using their own facilities and resources. However, some care does need to be taken. For example, senior managers would need to be cautious about approaching more junior team members and suggesting that they join the discussions. As soon as the buyout process is underway, a conflict between the interests of management and the interests of the vendor is almost inevitable. Management will be looking to buy the business on the best terms they can negotiate, whereas the vendor will be seeking to sell on the best terms possible and for the highest price. Management will also need to spend time preparing and negotiating the bid, which is likely to distract from their day-today management of the company. Consequently, there is a clear risk that those members of the management team who are directors of the target company will breach their fiduciary duties, giving the vendor a potential right of action. If at all commercially possible, once there is a real likelihood of a management buyout, management should seek the permission of the vendor to take part in the buyout process. If the consent of the vendor is obtained, this will eliminate much of the legal risk, provided that management operate within the boundaries of the consent given. Conflict of interest provisions of the Companies Act 2006 came into force in October 2008. Provided that those directors who are not part of the MBO team
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are sufficient to form a quorum at a board meeting, conflict approval may be given by those independent directors rather than directly by the vendor.
also likely to be in breach of the contractual assurances (or ‘warranties’) that the private equity investor will require from them.
Use of confidential information
Multiple bids
One of the key risk areas for all members of the management team is the use, or misuse, of confidential information relating to the target business. An employee has a legal obligation to keep information relating to the business of their employer confidential, and - for senior employees - this obligation is often extended through the inclusion of comprehensive confidentiality clauses in the employment contract. It should also be borne in mind that documents such as strategic development plans, operations manuals or customer databases belong to the company and, without permission, may not be used by the management team for their own benefit. In order to secure financial backing for a bid, the management team will need to prepare a detailed business plan. However, private equity investors are well aware of the confidentiality issues faced by management and so, in the very early stages of a bid, will expect only an outline plan based on information that is publicly available. Management will then need to seek the consent of the vendor before disclosing a fully developed business plan to the prospective backer. At this stage, the vendor may well seek confidentiality assurances directly from the private equity investor. In the case of an auction sale, the private equity investor will usually have signed a confidentiality agreement with the vendor, and received detailed and confidential information about the target business directly from the vendor, at the stage when management are still excluded from the process. However, even in this situation, management would be wise to seek the vendor’s consent before discussing confidential information with the investor. When disclosing confidential information, management must take care to ensure that all relevant information is disclosed. For those members who are directors of the target company, in particular, this can require a careful balancing act. If information tending to increase the value of the company is not disclosed, the vendor may have an action against the director for making a profit by acquiring the company at a low valuation. Conversely, if information tending to decrease the value of the company is not disclosed, not only will management have overpaid for their own share of the business, but they are
Once it is known that a company is for sale, the vendor will typically receive several competing approaches, either from a number of private equity firms, or from a combination of trade buyers and private equity investors. Where there are multiple bids, management is likely to play some part - whether formal or informal - in determining which bid succeeds. In this event, those members of the management team who are also directors of the target company have a juggling act to perform. Management may well have a personal preference for one bidder over another. For example, management may fear that a trade buyer will bring in its own management team, leaving the existing managers out of a job. Alternatively, a private equity bidder may be offering incentives to management that make its bid particularly attractive. The law requires directors to put such personal considerations to one side when deciding whether or not to assist a particular bidder, and to act only in the best interests of the target company. In a takeover situation, this has traditionally been taken to mean that the directors have an obligation to achieve the best possible price for the vendor. However, the Companies Act 2006 entitles, even requires, directors to take into account factors other than simply price. Section 172 of the Companies Act 2006 imposes on a director an overriding obligation to ‘act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of the members as a whole, and in doing so have regard (amongst other matters) to:
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the likely consequences of any decision in the long term; the interests of the companies employees; the need to foster the company’s business relationships with suppliers, customers and others; the impact of the company’s operations on the community and the environment; the desirability of the company maintaining a reputation for high standards of business conduct; and the need to act fairly as between members of the company.
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Leaving aside personal considerations, directors must carefully weigh up these various factors, and decide whether a bid (or which bid) is likely to promote the success of the company. Relevant factors might include the bidder’s future plans for the business (does the bidder plan to lay off significant numbers of employees, or to source supplies from abroad rather than from a local supplier?), or the bidder’s proposed acquisition structure (is the bid so highly leveraged that it could jeopardise the future of the company as a going concern?). It may, of course, be the case that the bid that is in the best interests of the company is also the bid that is in the best interests of the management team. Provided that the directors of the buyout target evaluate the relevant factors diligently and in good faith, there is nothing to prevent the management team from making a case for their own bid, even if they are not offering the highest price.
Keeping the business going Finally, management must also ensure that, amid the buyout activity, they continue to focus sufficiently on the day-to-day running of the business. Senior managers will typically have a ‘time and attention clause’ in their service contracts, requiring them to devote a specified amount of time and energy to the affairs of the buyout target. Those members of the management team who are directors of the company should also be mindful of their statutory obligation to exercise reasonable diligence in the performance of their duties. This should not be an onerous obligation - it is, of course, in the management team’s own interests to ensure that the company they hope to acquire continues to perform.
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Appendix 2 Directors’ Duties in Germany Introduction In a management buyout situation (MBO), the members of the MBO team typically face an obvious conflict of interests - on the one hand they are naturally committed to ensure the success of their acquisition bid, on the other hand they are, as members of the target company’s management, obligated to safeguard the interests of the company and its shareholders. It is important that the members of the management team handle such conflict of interests with utmost care and avoid breaches of their duties as managing directors or employees of the target company. A breach of duty would not only endanger the success of the intended transaction but may also lead to the dismissal of the relevant managers or even expose the management team to claims for damages. The following gives a general overview of the critical duties to be considered by management in an MBO and shows how typically arising conflict of interests may be handled.
Executive Summary Managers are generally obliged to devote their entire time and manpower to the company. Such an obligation may be difficult to sustain, once the intended buy-out demands time and energy of the management team. The management team should always ensure that management and operations of the company are not neglected and that the distraction of the management team from its ordinary duties is kept at the lowest possible level. At a later stage of the process, when the transaction requires more time and energy, it is advisable to seek for an express approval of the respective supervisor (employees) or, with respect to directors, the shareholders or a supervisory board, whichever body is responsible for supervising the directors.
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Managers are strictly obligated to keep confidential all business secrets of the company. Therefore, confidential information should only be made available to external advisors, banks or investors upon signing of a nondisclosure agreement. In order to protect the managers from liability for damages the company may suffer in connection with such disclosures, the MBO team should at least inform other directors about the intended disclosure and have a resolution taken thereon. In an MBO situation the managers, due to their superior knowledge, usually have a fiduciary duty to disclose all relevant information (in particular information which is relevant for the valuation of the company) to the vendors. In the event the managers hide any relevant information (e.g. information about hidden reserves) which would lead to a less favourable deal for the vendors, the latter may have a claim for damages for breach of pre-contractual or contractual fiduciary duties or may even contest or rescind from the agreement. Particular critical conflicts of interests arise where only parts of the company are sold to the MBO team rather than the entire company. The members of the MBO team are then well advised to leave the entire organisation of the transaction as well as the negotiation on the part of the company to the remaining non-conflicted directors and not to take part in resolutions of the board of directors dealing with the MBO transaction. The liability risk of the directors in such situation is considerably higher than in a buy-out of the entire company, as the directors are directly liable for any undue disadvantage the company may suffer in the buy-out.
Regime of Duties The duties which apply to the relevant manager depend on (i) whether such manager is a director or an employee and (ii) whether the target company is a limited liability company (Gesellschaft mit beschränkter Haftung - GmbH) or a stock corporation (Aktiengesellschaft - AG). This memorandum focuses on the duties applying to managers of a GmbH (in general also applicable to a GmbH & Co. KG) as these are the legal forms where MBOs typically occur and touches upon the somewhat more restrictive regime of duties applying in an AG where appropriate. The extensive set of rules which applies in the event of a take-over of a public corporation as governed by the German Take-over Code (WpÜG) is not part of this analysis and is only shortly outlined in a separate section.
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Employees The duties of those members of the MBO team which are employees are mainly governed by their employment contracts and may therefore vary from case to case. In addition, employees have a general duty of loyalty to their employer which - generally speaking - means that they must not act against the interests of the employer. Typical duties relevant in an MBO situation are: the manager’s obligation to devote its entire time and manpower to the company (if provided for in the employment contract, as typically is in the case of executives); the manager’s duty to keep confidential all of the employers trade and business secrets; the managers obligation to avoid that the company suffers any disadvantages or damages; and the managers duty to honestly disclose to the employer information which is relevant to the employment to the extent the employer has a legally protected interest to know such information.
Directors In addition to the duties of employed managers as listed above, directors are, inter alia, obligated to: realise business opportunities for the company; beyond the duty of loyalty of employees, promote the company’s interests (or, as the German Federal Court put it, directors must not act for their own benefit where interests of the company are at stake); strictly devote their entire time and manpower to the company (irrespective of any explicit obligation in their service agreement); and honestly report to the shareholders of a GmbHG, upon their request, about the affairs of the company (Sec. 51a Limited Liability Company Act GmbHG), in the AG the board must regularly report to the supervisory board (Sec. 90 Stock Corporation Act - AktG), while the information right of the shareholders is limited to shareholders’ meetings (Sec. 131 AktG). In a nutshell, due to their position as a corporate body directors have a natural obligation to safeguard the interests of the company which is more comprehensive than the duties of an employee which are limited to the specific tasks of such employee as described in the employment contract.
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Conflict of Interests in an MBO and Resolution In the following we would like to give an overview of the various conflicts of interests which may arise at the different stages of a typical MBO and show how such conflicts may be resolved and a breach of duties be avoided.
Assessment phase As long as discussions on the feasibility of an MBO transaction are limited to the management team itself, the potential for a conflict of interests is relatively low. However, there is a risk, increasing with the progress of the transaction, that the management is distracted from the duty to devote their entire manpower to the company. The management is, therefore, well advised throughout the entire process to ensure that management and operations of the company are not neglected and that the distraction of the management team from its ordinary duties is kept at the lowest possible level. At a later stage of the process, when the transaction requires more time and energy, the managers should seek for an express approval by the respective supervisor (employees) or, with respect to directors, the shareholders meeting or the supervisory board, whichever organ is responsible for supervising the directors. Already in the assessment phase the management team will want to involve external advisors to work out a concept which implies that confidential information (financial data, budgets, strategic planning) must be made available to such advisors. The submission of information to advisors who are subject to professional duties to maintain the confidentiality, such as chartered accountants, tax advisors and lawyers, is generally seen as an acceptable disclosure. However, it is advisable to reveal highly sensitive information only to the extent necessary for the envisaged transaction.
Preparatory phase In order to ensure the financing of the transaction, the MBO team will have to contact banks and/or private equity investors and provide them with adequate information about the target company in order to allow them a reasonable analysis of the feasibility of the transaction. As a first step, however, the management team may want to provide only non-critical information (teaser) about the target company to give a basic impression and to find out which banks or private equity investors might be interested in providing the financing
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for the MBO. As a second step, interested investors will nevertheless expect more detailed information which would necessarily imply the disclosure of confidential information. In any case, the management team should only make available confidential information to banks or investors upon signing of a non-disclosure agreement. Even then, the disclosure of sensitive company information remains problematic, as, arguably, such disclosure is made rather in the interest of the management team than in the company’s interest. In order to protect the managers from a liability for potential damages the company may suffer in connection with such disclosures, the MBO team should at least inform other directors about the intended disclosure and have a resolution taken thereon. Nevertheless, it must still be ensured that the disclosure of confidential information does not conflict with the corporate interests of the company. In a GmbH with a limited circle of shareholders, this would normally be the right moment to inform the shareholders about the envisaged MBO in order to obtain their backing, ideally laid down in a shareholder resolution authorising the directors to investigate into a buy-out. In a GmbH with a large number of shareholders, it may, however, not be sensible to announce the plans for an MBO at an early stage, as such information may irritate business partners and employees of the company. In an AG the decision to disclose information is exclusively vested in the management board. However, if all the members of the management board are part of the MBO team, it may be advisable to involve the supervisory board. The above considerations apply even more if due diligence should be available to a financial investor who is teaming up with the MBO team.
Negotiation phase The typical problem with coming to a balanced deal in an MBO situation is the superior knowledge of the MBO team about the company. Under normal circumstances, a buyer is not obliged to disclose any information about the object of purchase to the vendor. However, in an MBO situation the managers, due to their superior knowledge, usually have a fiduciary duty to disclose all relevant information (in particular information which is relevant for a valuation of the company) to the vendors. In the event the managers hide any relevant information (e.g. information about hidden reserves) which would lead to a less favourable deal for the vendors, the latter may have a claim for damages for
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breach of pre-contractual or contractual fiduciary duties (Sec. 280, 241 (2), 311 (2) German Civil Code - BGB) or may even contest or rescind the agreement (Sec. 123, 142 BGB or Sec. 324, 241 (2), 311 (2) BGB). Although sale and purchase agreements (‘SPAs’) usually provide for an exclusion of most statutory claims, the purchasers would still be liable if members of the management team have intentionally hidden relevant information. The members of the management team should hence be very careful to disclose all relevant knowledge, in particular valuation sensitive information, to the vendors. On the other hand, it should be noted in this context that a liability for breach of representation and warranties in an SPA (if vendors are prepared to grant such warranties) may be excluded to the extent that the members of the management team knew or failed to know due to gross negligence about the breach (Sec. 442 BGB). The purchasers may seek to exclude such exemption from the vendor’s liability. However, this may be difficult to achieve and claims for wilful acts or a wilful deception cannot be excluded. It is therefore even more important in an MBO than in a usual M&A transaction that the management prepares the disclosure schedules of the SPA with utmost care.
Competing bids In most cases, an MBO will be negotiated between the shareholders and the MBO team on an exclusive basis. However, sometimes shareholders may decide to ask for competing offers or enter into an auction process. Such a situation is difficult to handle for directors who are at the same time members of the MBO team due to an obvious conflict of interest. In such a situation shareholders are well advised to either retain full control of the auction process or lay the responsibility of the entire process, as far as possible, in the hands of a neutral person - be it an uninvolved director, the president of a supervisory board or an external advisor. In a GmbH, the shareholders have an extensive right to give directions to the directors and they could therefore instruct the directors to treat all bidders equally and to provide them with the same information (as there is no such neutrality obligation under statutory law). The directors are then obliged to implement such directions. Having said that, in the event of a contravention the directors are normally only liable to the company, not to the shareholders which would typically suffer the damage if the directors prevented a more attractive offer (Sec. 43 GmbHG, Sec. 93 AktG).
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A direct liability vis-à-vis the shareholders only exists in exceptional circumstances, in particular if the directors intentionally caused damage to the shareholders’ assets (Sec. 826 BGB). Therefore, a certain risk remains that a director could be held liable if he prevented a more attractive offer by active manipulation. The situation in an AG is more complicated as the decision to disclose confidential information about the company is exclusively vested in the management board. The shareholders are not entitled to instruct the board to take a certain approach vis-à-vis competing bids. However, it appears that the prevailing view in legal doctrine holds that the board must maintain strict neutrality vis-à-vis competing bids. Again, the directors are liable for damages the company suffers due to a breach of their duties to the company and are only liable to shareholders in exceptional circumstances.
Sales of parts of the Company Particular critical conflicts of interest arise where only parts of the company are sold to the MBO team rather than the entire company. In such case directors which are also members of the MBO team would at the same time represent the vendor (the company) and the purchaser (the MBO team). Such conflict is usually mitigated by the fact that not all of the directors are members of the MBO team. The members of the MBO team are then advised to leave the negotiation on the part of the company to the remaining non-conflicted directors and not to take part in resolution of the board of directors dealing with the MBO transaction. This includes preparatory measures such as carve-outs measures (e.g. a spin-off of the business on sale to a subsidiary). The potential risk to the directors in such situation is considerably higher than in a buy-out of the entire company, as the directors are directly liable for any undue disadvantage the company may suffer in the buy-out. In any case, the directors should seek the consent of the shareholders for the proposed measures. In the rare situation where the entire board of directors is part of the MBO team, the directors should request the shareholders to appoint a new director well in advance of the sale in order to duly represent the company in the preparation of the transaction. In an AG the company must be represented by the supervisory board if the purchaser comprises the members of the management board (Sec. 112 AktG). However, in most buy-out scenarios the
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purchaser will be a company in which also investors other than board members hold an interest and, accordingly, the management board usually remains authorised and obliged to represent the company. When entering into a purchase agreement, members of the MBO team who are at the same time directors of the company are not entitled to sign the contract on behalf of the selling company and at the same time for the purchasing entity (Sec. 181 BGB), unless they are expressly authorised to do so under the articles of association or by shareholders’ resolution (AG: authorisation by articles of association or by the supervisory board if authorised under the articles of association).
Listed Companies An MBO of a listed company is rare in Germany. It should suffice here to mention that a take-over of a listed company is densely regulated by the rules of the German Take-over Code (Wertpapiererwerbs- und Übernahmegesetz - WpÜG). The WpÜG does not provide for specific duties applying in the event that board members participate in a take-over bid. Nevertheless, subject to a number of exceptions, the board is prohibited to take action to prevent a specific offer. According to the majority view, it follows that the board must maintain a strict neutrality vis-à-vis competing bids. Moreover, whenever directors buy shares in the company they must observe the restrictions and obligations relating to insider trading as stipulated in Sec. 14 of the German Securites Trading Act (Wertpapierhandelsgesetz - WpHG) and the obligation to publish information about directors’ dealings as laid down in Sec. 15a WpHG.
Sanctions Breaches of the managers’ duties could entail various sanctions, in particular: managers who are in breach of their duties may be dismissed; managers being mere employees could be held liable by the Company for damages due to a breach of their employment contracts; directors could be held liable by the Company for damages caused by any breach of their corporate duties (Sec. 43 GmbHG, Sec. 93 AktG);
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under certain circumstances, managers may also be held liable for damages caused to shareholders, in particular if such damages have been caused wilfully (Sec. 826 BGB); the purchaser (purchasing entity, guarantors) could be held liable for damages caused by breach of contract or by breach of pre-contractual duties (Sec. 280, 241(2), 311 (2) BGB); under certain circumstances, in particular where the MBO team has unduly concealed relevant information from the vendor, the vendor may be entitled to contest and to rescind the purchase agreement (Sec. 123, 324, 241 (2), 311 (2) BGB); the disclosure of business secrets by directors may also constitute an offence and entail criminal sanctions (imprisonment, fine) (Sec. 85 GmbHG, Sec. 404 AktG); under certain circumstances the concealing of information from the shareholders could even constitute fraud with respective criminal sanctions (imprisonment, fine) (Sec. 263 German Penal Code - StGB); and if directors wilfully cause damages to the company in a buy-out of a part of the company, this may constitute embezzlement (Untreue) with respective criminal sanctions (imprisonment, fine) (Sec. 266 StGB).
Directors and Officers Coverage Breaches of a manager’s duties in the context of an MBO will usually only be covered by D&O insurance to a limited extent. Typically, D&O insurance only covers liability the managers incur due to a breach by their corporate duties or duties under their employment contracts. A claim by the company for damages suffered due to a breach of confidentiality under Sec. 43 GmbHG or Sec. 93 AktG, respectively, may, for instance, be covered by the company’s D&O insurance, unless such damages have been caused wilfully. Further limitations may apply with respect to a liability to the company or its shareholders. To the extent the managers act as purchasers or on behalf of a purchasing entity, a liability for breach of their contractual or pre-contractual duties under or in connection with the purchase agreement, would normally not be protected by their D&O insurance as managers of the company.
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Appendix 3 Directors’ Duties in France Introduction The implementation of buyout transactions requires a significant involvement of the target company managers. The latter, in addition, generally have a personal interest in the successful outcome of such transactions or in the choice of one bidder rather than another. These objectives need to be considered in light of the following key duties imposed on managers vis-à-vis the interests of the company they manage1. Indeed, a breach of these duties by the managers of the company may result in civil, and in certain cases even criminal, sanctions. Claims against the managers on these grounds could be initiated by either the company itself, or by its creditors or shareholders (depending on which interests have been affected).
Obligation of Loyalty A duty of loyalty to the interests of the company is imposed by French case law2. Such duty directly derives from the principles of corporate governance defined in the common law countries and is consequently close to the English law concept of ‘fiduciary duty’. In practice, the actions of a manager would be viewed as whether they were in the best interests of a company. Such actions cover various, and sometime contradictory, interests, such as those of the employees of the company, of its creditors and of its shareholders. In the context of a buyout transaction, which by nature involves many different interests, the managers of the target company need to be particularly careful before acting. They ought to consult with the shareholders to ensure that their interests are protected, both during the life of the buy-out and at exit. Naturally, this should not result in acting to the detriment of the other interests involved.
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Conflicts of Interest Managers of a French company are prohibited to favour their own interests to the detriment of the other interests of the company they manage. Such prohibition has both civil and criminal sanctions. However such an obligation does not prevent them from contemplating a buyout of a target company. Particular attention should be paid to the risk of conflict of interests. Managers need, for example, to pay attention to ensure that the buy out process does not prevent them from continuing to run the business of the company ‘en bon père de famille’. They also have to preserve the interests of the shareholders of the company, which in the context of a buy-out may be a particular issue. The interests of the managers being associated with an offer may indeed well be in conflict to the shareholders’ objective of maximising the exit price. If possible, a prior consultation with the shareholders before participating in a buyout is in this respect highly advisable.
Auction Sales At the start of a sale process, several competitive offers from investment funds or industrial competing groups are generally made to the shareholders of the target company. Even if the choice of the successful bidder remains the prerogative of the majority shareholder, this latter will generally allow the management team to play a significant role during the process and at the time of the choice of the offer representing the company’s best development possibilities. In this event, those members of the management team who are also directors of the target company have a juggling act to perform. Management may well have a personal preference for one bidder over another. For example, management may fear that a trade buyer will bring in its own management team, leaving the existing managers out of a job. Alternatively, a private equity bidder may be offering incentives to management that make its bid particularly attractive.
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French law requires managers to put such personal considerations to one side when deciding whether or not to assist a particular bidder, and to act only in the best interests of the target company. During the auction process itself, this implies that the managers of the target company should participate in good faith in the process (i.e. in particular, preparation of the data room material, management presentations, answers to the questions raised by the bidders, etc.), treating all the bidders equally. At the time of the choice of the preferred bidder, the best interests of the company should take more than price into consideration. The management team therefore have to compare the bids through relevant and objective criteria such as the business plan (does the bidder plan to lay off significant numbers of employees, or to source supplies from abroad rather than from a local supplier?), or the contemplated structure of acquisition (is the bid so highly leveraged that it could jeopardise the future of the company as a going concern?). It may, of course, be the case that the bid that is in the best interests of the company is also the bid that is in the best interests of the management team. Provided that the directors of the buyout target evaluate the relevant factors diligently and in good faith, there is nothing to prevent the management team from making a case for their own bid, even if they are not offering the highest price.
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protections of the company’s interests are implemented, such as the execution of complete non-disclosure agreements by attendees of these data rooms or management presentations. In the specific context of acquiring listed companies, the French stock exchange authority guidelines relating to best practice are to be followed by persons participating in data room procedures in connection with a listed entity. Such guidelines state the conditions under which potential bidders may have access to the privileged information regarding the target. Specifically, data room procedures in connection with such transactions can only be set up by a target and its managers if the following conditions are met: data rooms may be set up in the context of significant transactions only; confidentiality undertakings must cover all privileged information; the persons participating to such data rooms must have signed a letter of intent confirming the seriousness of their intent to purchase the relevant shareholding; whether or not the transaction is followed by a public offer, the market must be informed in due course of the existence of the data room and the material information disclosed in the data room that may have a material impact on the price of the company’s shares; and should the data room not be followed by a transaction, any person that has taken knowledge of material privileged information within the framework of the data room may not use this information (e.g. sell its shares of the relevant company) until it has been made public or has lost its significance.
Obligation of Confidentiality All managers of French companies are bound by a statutory obligation of confidentiality. This obligation applies to all professionals of the business community, including not only the managers but also all persons receiving information on a company in the course of its activities (including the shareholders). It covers all information and documents concerning the company, such as strategic plans, customer databases or internal manuals. Where buyout transactions are concerned, this obligation also exists but does not prevent the managers from participating in a deal process. In particular, the communication of confidential information within the framework of the preparation of a data room or the participation in management presentations is permitted, provided that adequate and strong
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1
As a preliminary comment, it should be noted that the following observations and comments focus exclusively on the obligations of the mandataires sociaux of a French company (i.e. those managers not being bound by an employment agreement entered into with the company, such as président, directeur général, membre du conseil d’administration, du directoire ou du conseil de surveillance). Employees are subject to a subordination obligation regarding the company which implies specific obedience obligations and, as a consequence, more limited liabilities in relation to the company and its shareholders.
2
This loyalty duty was formally created by the French Cour de Cassation. Such new managers obligation appeared in a decision dated 27 February 1996 and has been confirmed and widened by another decision dated 24 February 1998.
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Appendix 4 Directors’ Duties in Sweden Introduction In any buyout situation, it is natural that the management team will want to devote time and resources to ensure the success of their bid. However, it is important that the management does not overlook or neglect their duties and obligations as employees and (often) members of the board or managing director of the buyout target. If members of the management team disregard these obligations, a number of consequences follow. Aside from the strict legal position, if the vendor believes there has been a breach of trust, this can seriously damage the personal relationship between the management team and the vendor who may then be less inclined to look favourably on management’s bid. In the case of a demonstrable breach of duty, the vendor may well have grounds to dismiss members of the management team for misconduct. If the target company or a shareholder has suffered loss as a result of the breach, there may also be a claim for damages. Either could be ruinous for the individuals involved, not only financially but also in terms of professional reputation. In practice, the vendor may well not want to take such severe action, but the possibility will significantly strengthen the vendor’s negotiating position.
What Duties Apply? The duties to which the management team are subject depend to a large degree on whether or not the members of the management team also are members of the board or managing director of the target company. The duties will in that case be more extensive, and more onerous, than the obligations of a manager who is simply an employee of the company without also being a member of the board or managing director.
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All members of the management team, as employees of the target company, are subject to the express provisions of their own employment contracts. As employees, they are also under an implied duty of loyalty to their employer, which means, among other things: acting honestly; disclosing all relevant information to the employer (such as the fact that a bidder has made an approach); and respecting the confidentiality of the employer’s commercial and business information. The managing director and, especially, a member of the board of the target company also has a fiduciary towards the company and is therefore subject to additional duties. Such person must act for the benefit of the company and must set any personal agenda aside. Furthermore, members of the board and the managing director have an obligation of confidentiality and must not disclose information which may be of detriment to the company. If the above mentioned obligations are set aside, the person responsible may be liable to compensate the target company and/or its shareholders pursuant to Chapter 29, Section 1 of the Swedish Companies Act for any loss suffered as a result thereof.
Conflicts of interest and loyalty The board of directors of the target company have an obligation to avoid a situation where their own interests conflict with those of the target company, or where there is a real likelihood that such a conflict of interests will arise. Pursuant to Chapter 8, Section 23 of the Swedish Companies Act a member of the board is biased and may not handle, or vote in, a matter concerning an agreement between the member of the board and the company. In a situation where the management is buying the target company, a buyer, who is also a member of the board, may therefore not vote or participate in a board meeting regarding the matter or even handle the matter on behalf of the company. The same is applicable for the managing director pursuant to Chapter 8, Section 34 in the Swedish Companies Act. It can be noted that the board of directors is quorate only where more than one-half of the total number of board members are present. When determining whether the board is quorate, board members who are biased must not be deemed present.
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However, the aforesaid does not, generally speaking, preclude management from formulating and discussing plans for an MBO among themselves, provided that this is done in the management team’s own time, using their own facilities and resources. However, some care does need to be taken. For example, senior managers would need to be cautious about approaching more junior team members and suggesting that they join the discussions. As soon as the buyout process is underway, a conflict between the interests of management and the interests of the vendor is almost inevitable. Management will be looking to buy the business on the best terms they can negotiate, whereas the vendor will be seeking to sell on the best terms possible and for the highest price. Management will also need to spend time preparing and negotiating the bid, which is likely to distract from their day-today management of the company. Consequently, there is a clear risk that those members of the management team who are members of the board or managing director of the target company will breach their fiduciary duties, giving the vendor a potential right of action. If at all commercially possible, once there is a real likelihood of a management buyout, management should seek the permission of the vendor to take part in the buyout process. If the consent of the vendor is obtained, this will eliminate much of the legal risk, provided that management operates within the boundaries of the consent given. Even when the management has obtained consent from the vendor, the management is still under a duty to promote the success of the company for the benefit of its members as a whole and is prohibited from providing shareholders or third parties with undue advantages on the behalf of other shareholders and/or the company. These considerations must at all times guide the management during the buy-out process. Since the members of the management participating in the buyout will have a clear interest in the target company accepting the buy-out offer, conflict of interest and loyalty issues arise with regard to the management’s advice to the shareholders and participation in decisions on the buy-out offer. Accordingly, members of the management participating in the buy-out proposal should - apart from preliminary presentations - not advise the shareholders thereon during the buy-out process. Nor should members of the board participate in formal board decisions on whether to advise the shareholders of the target company to accept the buy-out offer or not.
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Use of confidential information One of the key risk areas for all members of the management team is the use, or misuse, of confidential information relating to the target business. A member of the board and the managing director has an obligation of confidentiality which follows from the obligation to be loyal to the company. The obligation of confidentiality includes information which may be of detriment to the company if it was disclosed. For senior employees the obligation of confidentiality is often extended through the inclusion of comprehensive confidentiality clauses in the employment contract. It should also be borne in mind that documents such as strategic development plans, operations manuals or customer databases belong to the company and, without permission, may not be used by the management team for their own benefit. In order to secure financial backing for a bid, the management team will need to prepare a detailed business plan. However, private equity investors are well aware of the confidentiality issues faced by management and so, in the very early stages of a bid, will expect only an outline plan based on information that is publicly available, such public information may be passed on by the management without breaching the abovementioned duties of confidentiality. Management will then need to seek the consent of the vendor before disclosing a fully developed business plan to the prospective backer. At this stage, the vendor may well seek confidentiality assurances directly from the private equity investor. In the case of an auction sale, the private equity investor will usually have signed a confidentiality agreement with the vendor, and received detailed and confidential information about the target business directly from the vendor, at the stage when management are still excluded from the process. However, even in this situation, management would be wise to seek the vendor’s consent before discussing confidential information with the investor. When disclosing confidential information, management must take care to ensure that all relevant information is disclosed. For those members who are directors of the target company, in particular, this can require a careful balancing act. If information tending to increase the value of the company is not disclosed, the vendor may have an action against the director for making a secret profit by acquiring the company at a low valuation. Conversely, if information tending to decrease the value of the company is not disclosed, not
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only will management have overpaid for their own share of the business, but they are also likely to be in breach of the contractual assurances (or ‘warranties’) that the private equity investor will require from them.
Multiple bids Once it is known that a company is for sale, the vendor will typically receive several competing approaches, either from a number of private equity firms, or from a combination of trade buyers and private equity investors. Where there are multiple bids, management is likely to play some part - whether formal or informal - in determining which bid succeeds. In this event, those members of the management team who are also directors of the target company have a juggling act to perform. Management may well have a personal preference for one bidder over another. For example, management may fear that a trade buyer will bring in its own management team, leaving the existing managers out of a job. Alternatively, a private equity bidder may be offering incentives to management that make its bid particularly attractive. The law requires the board of directors and the managing director to put such personal considerations to one side when deciding whether or not to assist a particular bidder, and to act only in the best interests of the shareholders of the target company. In a takeover situation, the board has under the Swedish Companies Act no obligation to achieve the best possible price for the vendor. However, in the context of takeovers of listed companies, the development in recent years has in practice been that the target board acts in a manner to increase the value of the company and consequently the value for the shareholders. Also, the Swedish Takeover Act (applicable with respect to takeovers of listed companies in Sweden) contains provisions in that direction. It may, of course, be the case that the bid that is in the best interests of the company is also the bid that is in the best interests of the management team. Provided that the board of the buyout target evaluate the relevant factors diligently and in good faith, there is nothing to prevent the management team from making a preliminary case for their own bid. However, as stated above, those of the management team who are members of the board should not participate in the board of director’s formal decision on whether to advise the shareholders of the target company to accept the bid or not.
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Keeping the business going Finally, management must also ensure that, amid the buyout activity, they continue to focus sufficiently on the day-to-day running of the business. Senior managers will typically have a ‘time and attention clause’ in their service contracts, requiring them to devote a specified amount of time and energy to the affairs of the buyout target. Those members of the management team who are members of the board of the company should also be mindful of their statutory obligation to exercise reasonable diligence in the performance of their duties. This should not be an onerous obligation - it is, of course, in the management team’s own interests to ensure that the company they hope to acquire continues to perform.
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