A management buyout (MBO) is a type of business acquisition in which the managers of a company purchase the business from the current owners or parent company. Management buyouts can be structured in a number of ways; however, many transactions use the leveraged buyout model.
Leveraged buyouts are often used because few management teams have the financial resources to buy the target company outright. They need external financing to facilitate the purchase and are often interested in leveraging some of the assets of the target company.
Funding the purchase
The type of funding that is available to purchase the company is based on the size, brand recognition, assets, and cash flow of the company. Larger transactions, such as when a corporation is selling off a division, may be able to use a number of products such as bonds, senior and mezzanine loans, private equity injections, and so on.
Smaller companies or turnaround situations usually have fewer options than their larger or better-established counterparts. However, it is possible to finance the buyout of a small company if the management team is willing to use alternative financing. Such options include:
1. Equity from new management team: Perhaps the most important type of financing comes from the managers who are making the purchase. The management team that is organizing the buyout must contribute some of their own cash and assets to purchase the target company. It is not unusual for managers to raise the funds by selling off certain assets (e.g., stocks) or getting a second mortgage on their home.
The management team’s financial contribution is very important. Funding companies consider it a gauge of how committed the team is to the transaction.
2. Seller financing: One of the most common options to finance a management buyout is for the seller to provide financing (also known as deferred consideration). Usually, the seller creates a note that is amortized over a period of time. This option is an advantage for the management buyout team because sellers are usually more willing than banks to provide the funding.
Additionally, as a condition of financing the transaction, some lenders may insist that a portion of the sale be financed by the seller. This condition provides a measure of confidence to the lenders because it shows that the seller believes that the business will remain a viable concern once the sale is completed.
3. Bank loan: Although often hard to get, a bank loan is an effective way to finance a management buyout. The obvious benefit is that bank loans are cheaper than most other options.
4. The assumption of debt: Part of the acquisition cost can be paid by assuming some or all of the liabilities of the target company.
5. Private equity: In some cases, the management team may be able to secure financing through a private equity firm. However, private equity firms prefer scale and tend to invest in larger transactions. Their investment may consist of buying shares and/or providing additional funding such as loans and asset-based financing.
Keep in mind that the private equity firm may have objectives that differ from those of the management team. Private equity firms usually want a liquidity event after 3 to 6 years. They look to exit the transaction in that time frame, allowing them to realize their gains. Consequently, their funding programs often include stipulations of how the company is to be run and what objectives have to be met.
Remember that the private equity firm is looking to maximize its short-term rate of return – often at the expense of future opportunities. Therefore, management teams must be careful to align themselves with the right funding partners.
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