Management Buy-Out: How a Lender Reads the Funding

A buy-out happens when an owner wants out and the obvious buyers are already in the building: a founder with no successor in the family, or a group selling a division it no longer wants. The managers know the customers, the staff and the weak spots. A lender values that, because the most common way an acquisition goes wrong is that the buyer did not understand what it bought.

Three things move on the day of completion. The founder who held the key supplier relationship or did the selling is gone, unless the deal keeps them on for a handover. The managers stop being employees with a salary and become owners with personal debt and a stake they cannot easily sell. And the business, or the new company that buys it, takes on borrowing it did not have, to pay a price set by what the seller would accept rather than what the business can carry.

Managers rarely have the price. The usual structure is a new holding company that the managers own, which borrows and buys the shares of the operating business. The money comes in layers: the managers' own equity contribution, senior debt from a bank sized on the business's earnings and cash flow, a vendor loan from the seller where the gap needs it, and, in larger or tighter deals, outside equity from a private investor or a private equity fund. When an outside fund leads and the managers take a minority, the deal looks more like sponsor-backed lending than a management buy-out.

The bank lends to the holding company, but the cash and the assets sit in the business below it. Getting the business to guarantee the loan and give security over its own assets is financial assistance, and each market treats it differently. New Zealand and Australian company law permit it through procedures in the companies legislation: a board process built round a solvency test in New Zealand, and in Australia shareholder approval where the assistance would otherwise materially prejudice the company, its shareholders or its creditors. In the UK the restriction now reaches only the acquisition of shares in a public company (assistance by it or any of its subsidiaries) and assistance by a public company towards the purchase of shares in its private holding company, so most private-company buy-outs are outside it, though the directors still have to be satisfied the guarantee is in the company's interest and the distribution rules still apply. The financial assistance page works the procedure.

A distributor of truck and trailer tyres, constructed for this page like every figure in it, is sold by its retiring founder to three managers for US$14.0m, with US$0.6m of costs. EBITDA is US$2.8m after the cost of a sales manager hired to do the founder's job. The proposed funding:

Of the managers' US$1.2m, US$0.9m is borrowed against their homes, and they plan to service it from dividends on their ordinary shares; the investor's preference shares accrue their return and take no cash until exit. The bank's own cover is 2.0 ÷ 1.49 = 1.34 times, but that is not what the business faces: a dividend and the vendor's interest come out of the same US$2.0m, and a fall of 7.5% in that cash, US$0.15m, would leave nothing after all three. The managers need the dividend as much as the bank needs its principal, which is the pressure a lender reads.

The file goes back with two changes. The vendor's interest accrues for the first two years and is paid only when the bank's agreement allows it. Dividends are permitted only when the business meets a distribution test in the facility agreement. The managers' household budgets now depend on the business beating its plan, and they know it before they sign. The levels here are the example's, not a market norm.

DEFINED IN ONE PARAGRAPH → · EQUITY CONTRIBUTION → · VENDOR FINANCE →

A management buy-in is the same structure with outsiders: a manager or team from elsewhere buys the business and replaces the people running it. The lender loses the strongest point of a buy-out, that the buyers know what they are buying, and reads the incoming team's record in a similar business instead. A deal that combines the two, with some existing managers staying and an outside chief executive arriving, sits between them. A sale to a private equity fund that keeps the management team is also called a buy-out, but the fund is the owner, and the lender reads the fund's equity and its record.

In the UK, a sale to an employee ownership trust is another route by which a founder hands a business to the people who run it, under its own tax rules. The lender's questions are close to a buy-out's: who funds the price, and how much of it is paid later out of the business's cash.

A buy-out file turns on four readings. The first is the handover: whether the founder stays for a period, and whether the customers and suppliers who dealt with the founder have met the managers as owners. The second is key-person risk, which moves from the founder to a team of two or three who cannot all be replaced at once. The third is the order of payment: the vendor loan behind the bank under a subordination deed, and distributions to the managers limited by a test the bank sets. The fourth is the managers' own position: what they have borrowed, against what, and whether a lender asks for personal guarantees on top.

FINANCIAL ASSISTANCE → · HOW BANKS ASSESS MANAGEMENT →