There's no shortage of reasons for believing that the current surge in management buy-outs is sustainable.
Management buy-outs are booming again. Private equity houses have coffers full of funds to invest, vendors are winning full prices for their companies, and managers are eager for the financial rewards that can result from taking a stake in their businesses. Last year saw the management buy-out (MBO) industry break new records. Figures compiled by Nottingham University's Centre for Management Buy-out Research (CMBOR) reveal that in 1997 there were 430 MBOs with a total value of £4.4 billion, plus 230 management buy-ins (MBIs) valued at £6.0 billion. Combined, those 660 deals were worth £10.4 billion, an increase by value of one-third on a year earlier. Buy-out and buy-in deals now make up nearly 10% of mergers and acquisitions (M&A) activity by value, and over 20% by number of deals. The figures underline the view that the MBO is here to stay.
MBOs boomed in the go-go economy of the late '80s, then fell away sharply between 1990 and 1995.
David Thorp, managing director of Ivory & Sime Baronsmead, can take particular pride in the growth of MBOs. In July 1977, Thorp produced a research paper for 3i analysing 300 investments made over the preceding 10 years. Around 260 of the deals were start-ups, of which one-third had gone bust. But of the other 40, only two had failed. When Thorp looked more closely at this group he found they consisted of MBOs and MBIs, though those terms had not then been coined. Thorp recalls the discovery: 'I said, "Here is a market opportunity. These things are risky on the face of it, but they work very well."'
Much has changed since those days and the market has now become far more sophisticated, covering a range of different deal types. But there are still plenty of the classic MBOs, where an existing management team buys a business, playing a pivotal role in the deal with backing from a private equity specialist. But there are also MBIs, where an outsider joins the management team and takes an equity stake.
And apart from the hybrid BIMBO (buy-in management buy-out), there is also another, new type of deal that has recently grown in importance - the institutional buy-out (IBO). Here the private equity backer drives the deal, offering selected managers a stake in the business, but generally involving them in the sale negotiations at a later stage in the deal.
Sales to institutional buyers are often conducted by auction and are becoming popular with vendors as they tend to get a higher price. The importance of IBOs is reflected in CMBOR's figures, which include IBOs in the totals, and which show the average deal size increasing to £15.7million last year from £12.2 million in 1996. 'The fact that the average deal size is going up reflects the fact that more of these auctions are going on and financial buyers are winning,' says Graeme White, head of private equity at Barclays. 'You have to accept, if it's an auction, you are probably going to pay a full price.'
Purchasers are only prepared to pay the 'full price' because MBO funds have performed extremely well in the past. The British Venture Capital Association's (BVCA) 1996 performance measurement survey of independent venture capital funds shows that MBOs provide profitable investments.
Latest data show that MBO funds outperformed all the FTSE indices and other asset classes held by UK pension funds.
The success of MBO investments has attracted increasing sums from pension and insurance companies. As Martin Kitcatt, head of private equity at Arthur Andersen, says: 'The success of private equity over the years has generated further success. The coffers of CVC Candover, CINVen and 3i have been filling up with cash.' Candover, for example, recently formed a £850 million fund aimed at larger buy-outs and buy-ins in this country and continental Europe. 'In the last five to six years, MBOs have been highly profitable. On the back of that success large funds have been raised and they are looking for larger deals,' says Colin Buffin, joint managing director of Candover Investments.
But what are the underlying factors behind the recent boom in buy-outs?
Macro-economic factors have played their part in the MBO success story.
Low inflation combined with low interest rates and a reasonably healthy economy has stimulated plenty of M&A activity. 'From a venture capitalist's point of view, low interest rates mean we can gear our investments with debt on advantageous terms,' says director of CVC Capital Partners Rob Lucas. 'The stable economy gives us confidence and allows us to pay higher prices.'
Those high prices are also linked to the buoyant stock market. Vendors of private companies base the price they seek on the price-earnings (P/E) ratio achieved by public companies in their sector. 'In the past, private sector deals have tended to occur at a slight discount,' says Mark Owen, a director of Granville Private Equity Managers. 'But now we are often finding that the P/E ratios we are paying for private companies are similar to those of public companies.' This has a double impact - not only are more private company owners tempted to sell up, but venture capitalists are more willing to consider buying a public company and taking it private.
Public companies that go private when purchased by venture capitalists lose the high liquidity in their shares that comes with being a plc. 'But a lot of public companies are looking at taking themselves private because they have some significant restructuring to do and they feel they can do that better out of the public eye,' says Owen. 'The driver is often not the company, but the venture capitalist who can see the value in it.' The management team may also be keen because they will tend to end up with a greater proportion of the company's equity than if it remains a plc.
Corporate restructuring provides a steady source of MBO deals. Industrial giants such as Lonrho, Dalgety, Hanson and BTR have been spinning off non-core subsidiaries. For example, in December the motor distribution business, Dutton-Forshaw Group, completed an MBO from Lonrho. CVC invested £25 million in the deal which resulted from Lonrho's strategy of separating its mining and non-mining interests. 'The conglomerates of the 1980s are being forced to provide much greater shareholder value and that's forcing them to look very carefully at their portfolio and think about divesting themselves of businesses that aren't delivering value,' says Lucas. 'The stock market likes focused businesses. That's forcing a lot of groups to get rid of their non-core activities.'
If anything there is an increase in that other traditional source of MBOs - family companies with a succession problem. 'There is no longer the tradition of the child following in the parents' footsteps,' says Kitcatt. 'It's no longer deemed to be heresy if you want to go off and be a ballet dancer or a truck driver.' The importance of family company sales to the MBO market is suggested by the fact that small deals make up a significant part of the MBO market place. 'Of the 1,060 financings that were done last year by BVCA members, 60% were for £10 million or less,' says Norman Murray, BVCA chairman. 'There were only 20 deals above £100 million.'
Corporate financiers and private equity houses have also played their part in the high number of MBO transactions. Arthur Andersen's private equity team recently analysed the origination of its deal flows. Around 50% of deals were generated by the team itself, another 20% came from another unit in the firm, and the remaining 30% from venture capital houses.
'We do a lot of lunching, eating for Britain,' says Kitcatt. There is also a lot of cold calling and working with quality MBI candidates.
New types of finance are also helping to fuel the MBO market. 'Deals are getting more complicated compared with 10 years ago,' says CMBOR senior research fellow Ken Robbie. 'In the early 1990s a lot of deals just had equity, debt and vendor loan notes. Nowadays for larger deals you get extremely complex structures with several layers of senior debt with different terms.' High-yield bonds are also being used in deals. 'There is a group of international investment banks who are keen to get a high-yield bond market up and running in Europe, and the buy-out market is an obvious one to supply,' says Robbie.
The big question is, will the recent high level of MBO activity continue?
'What drives our business? It's M&A activity,' says Nigel McConnell, a director of Electra Fleming. 'What makes M&As happen? It is business confidence.' In other words, it all depends on the economy. There is no unanimous opinion as to the potential for the economy to overheat and blow the lid off the MBO pot, though optimists appear in the ascendant. Owen believes the UK is enjoying a 'Goldilocks economy'. It's not too hot and not too cold - it's just right,' he says. 'The stock market reflects the general feeling about the economy. It isn't anticipating a downturn.'
'We are riding pretty near the top of the cycle,' warns Robbie. 'A lot of people are concerned that we don't repeat what happened at the end of the '80s, but I think that's unlikely. The overall economic environment has been pretty kind. We are not getting the bankruptcies, the restructuring that happened on the early '90s. Until there is a marked economic and financial deterioration the market will continue to trade at a pretty high level.'
High prices may be a cause for concern if they force an increase in the ratio of debt to equity in deal structures. There are signs that deals have become more highly geared in the last couple of years. 'I have heard around the industry that there has been an increase in the number of deals where banking covenants have been broken,' says Ross Dawkins, a director in BDO Stoy Hayward's private equity unit. 'That's not to say the MBOs have gone seriously wrong, but suggests the financing structures put in place have restricted flexibility.'
Of course, the higher the prices paid for businesses, the harder it is for those businesses to meet their investor's expectations. 'MBO funds have been enormously successful, but there may be people who see a falling off of their returns because they have overpaid,' says Chris Ward, head of private equity at Deloitte & Touche. 'If their returns are depressed, that may have a knock-on effect when it comes to raising more funds.' The BVCA's Murray also sounds a cautionary note. 'This industry has made money in the past by buying in recession and selling when we come out of recession,' he says. 'We are buying now, but it's not a recession.'
If the stock market starts to slip, the prices companies attract will fall and that could make vendors less tempted to sell. However, Owen believes that the weight of money around at the moment would reduce the extent of falling prices. 'Funds have generated very good returns for investors,' he says. 'If prices go down, there may be fewer opportunities, but no less money. The competition will be there from the venture capitalists and prices will be held up a bit by that.' Those funds don't all have to stay in the UK. 'We will see a greater proportion of funds invested in Continental Europe,' says Ward.
It is impossible to predict when the latest surge in MBOs will slow down, but it is clear that these types of deals are very unlikely to disappear.
As Thorp says: 'We have changed the face of how acquisitions are done.
Buying any company is difficult, but if you have a buy-out team that already knows the business, you have a head start.
The buy-out team will know where the skeletons are, and will do something about them.'
WORKPLACE TECHNOLOGIES AN MBO TO DREAM ABOUT
Workplace Technologies, which specialises in designing, installing and maintaining data, voice and video networks, saw its share price rise by 91%
in the four months following its flotation in November of last year.
With turnover for 1997 up 27% to £65.9 million and headline operating profit increasing 45% to £3.7 million, it's an MBO success story for other companies to dream of.
Workplace Technologies emerged out of ICL through a £12 million MBO in October 1995. The MBO involved three key management members - the managing director, finance director and sales and marketing director Andy Bridson. Backers 3i took a 44% stake in the company, and BZW Private Equity (now Barclays Private Equity) 28%. On flotation, when the company raised £7.7 million (net of expenses), both backers sold one-third of their stakes.
Bridson believes much of the MBO team's success was due to assembling its team of advisers early, six months before the deal. 'Even before we took the decision to actually do an MBO we had assembled the team and they were taking us through the process,' he says. Mark Taylor, investment director at Barclays' Reading office, says: 'They were a very able management team.
It's a rapidly growing market and they managed to win opportunities.' He says Barclays has already made a return 'markedly ahead' of the norm for MBOs. 'This was one of the most successful MBOs in terms of the way it performed between buy-out and flotation,' he says.
FOSTERS TRADING COMPANY
THE BUY-OUT THAT LOST OUT
Fosters, the £95 million turnover menswear retailer, went into administration in March. Although the company had money in the bank, it didn't have the facilities needed to support future trading. The move came five and a half years after a management buy-out from Sears in September 1992 and affected all 175 outlets.
The MBO, which had the backing of Hambros' venture capital arm, HEV, and cost a mere £1, was initially successful. 'A lot of people at the time didn't give us a prayer,' says managing director David Carter-Johnson.
'However, when we did the MBO we turned a £12 million loss under Sears into a £2 million profit. That situation continued for three years and we repaid our backers and Sears £5.5 million at that time.' But profitability slipped away in the last 18 months. The £2.1 million profit of 1996 fell to a £1.1 million after-tax loss in 1997.
Carter-Johnson doesn't believe that the MBO had much bearing on the company's subsequent slide into administration, except that having to repay £5.5 million after three years 'wasn't helpful with the profit fall-out that followed'. However, he attributes most of its troubles to the move in the marketplace away from denim towards sportswear and branded goods.
Carter-Johnson is optimistic about the future: 'What we hope will come out of the administration process is a viable and sustainable business.' The directors initially held a 60% stake in the company, which was later diluted to 30%. HEV still has a 40% stake. 'HEV has been very supportive,' says Carter-Johnson. HEV's managing director Graham Lee, who is also a director of Fosters, says: 'We are in the hands of the administrators.
I hope we come out of it with a business intact.'.