Management Buyout

A management buyout (MBO) is a transaction in which the managers of a business acquire it from its current owners. The managers seldom have the means to pay the full price, so they are usually backed by a private equity firm, which provides most of the equity and arranges debt secured on the business. After the deal, the managers hold a significant minority of the shares and continue to run the company.

Buyouts arise in several situations: a founder or family sells on retirement; a group disposes of a subsidiary or division that no longer fits its strategy; a listed company is taken private; or a business is bought out of insolvency. The management buyout is one type of buyout transaction and normally takes the form of a leveraged buyout. Where the buyers are outside managers the deal is a management buy-in.

The purchase is made through one or more new holding companies. The investors and managers subscribe for shares in the top company, lenders advance loans to a company lower in the chain, and the combined funds are used to buy the target. Financing typically comprises the following.

• Senior debt from banks or a private credit fund, repayable from the company's cash flows and ranking first, as senior secured debt.
• Subordinated debt, such as mezzanine financing, carrying a higher return.
• Institutional equity, mostly in the form of preference shares or loan notes with a fixed yield, held by the investor.
• Ordinary shares, split between the investor and the management team.
• Deferred consideration or vendor loans, where the seller agrees to wait for part of the price.

Because the investor's money is concentrated in fixed-yield instruments, the ordinary shares are inexpensive, and managers can obtain a meaningful percentage for a modest outlay. This arrangement is known as sweet equity. If the company's value grows after debt is repaid, the gain accrues disproportionately to the ordinary shares.

The relationship is governed by an investment agreement and the company's articles. The investor receives board seats, information rights and vetoes over major decisions. Managers give warranties about the business and the plan, and accept restrictions on competing. Leaver provisions set the price at which a departing manager must sell shares: a good leaver, such as one who retires or is dismissed without cause, generally receives fair value, while a bad leaver receives the lower of cost and fair value. Drag-along rights allow the investor to require managers to sell on an exit, and tag-along rights allow managers to join a sale by the investor.

A buyout places managers on both sides of the transaction. As directors or employees they owe duties to the current owners to obtain the best price; as buyers they benefit from a low one, and they know more about the business than anyone else. Sellers manage this by appointing independent directors or advisers to run the sale, by controlling managers' contact with bidders and by seeking competing offers.

In public companies the rules are stricter. In the United Kingdom, the Takeover Code requires that information given to a management-backed bidder be made available to other genuine bidders, and that the target's independent advisers give a view on management incentive arrangements, which may need shareholder approval. In the United States, going-private transactions involving affiliates carry additional disclosure obligations under securities rules, and courts scrutinise the fairness of the process. Public-to-private deals in the UK are often carried out by scheme of arrangement or takeover offer.

Managers typically approach the owner or respond to the owner's decision to sell, then select a financial backer, sometimes with the help of advisers. The investor carries out due diligence, though usually with the benefit of the managers' inside knowledge, and negotiates the sale agreement. The seller gives fewer warranties than in a sale to an outsider, on the basis that the buyers already know the business; in practice managers often give warranties to the investor instead. Price is commonly fixed by a locked-box mechanism or adjusted through completion accounts.

Supporters argue that buyouts improve performance: managers who own shares and operate under the discipline of debt and an active investor focus on cash generation and long-term value, free of the pressures of a parent company or the stock market. Continuity of leadership also reduces disruption for staff and customers.

The risks stem mainly from borrowing. High debt leaves a company vulnerable to a downturn or a rise in interest rates, and failures of heavily leveraged buyouts have led to job losses and creditor losses. Critics also point to the possibility that insiders buy a company for less than it is worth, to cuts in investment made to service debt, and to repeated sales between financial owners that add borrowing each time. Exits take place through a trade sale, a secondary buyout, a flotation or, increasingly, a transfer to a continuation vehicle managed by the same investor.