In the '80s, managers who bought out their own businesses could land huge windfalls. In a more sober 1996, however, MBOs aren't such easy earners.
Once upon a time there was a divisional manager, an average type of bloke who put in just enough effort to keep out of trouble, and whose division performed accordingly - not disastrously, but not too brilliantly either. This division was a bit of a backwater anyway, not strictly related to the corporation's mainstream business, which is why one day top management decided to dispose of it. Rumours of this impending change gradually seeped into the consciousness of our manager, who felt somewhat unnerved by the thought of new and presumably more demanding bosses. Musing gloomily with his colleagues on this unpleasant prospect, he had a sudden brainwave.
'Why don't we buy out the business ourselves?' he cried, signalling to the barman for another round of drinks. 'We'd get top managers off our backs, and in a few years' time, when we floated, we'd make a fortune.'
Seized with unwonted energy, he and his colleagues swooped into action, convincing top management, appointing advisers, securing finance, mortgaging houses, and then working like billyo in their new company for two years so as to improve performance and thus ratchet up their share of the equity still further. Some of the executives left behind in the original corporation remarked scathingly on the sudden progress of the former division, but our manager was undeterred, pointing (quite accurately) to the sting of envy in their comments. Came the flotation, and the company was valued at twice the buy-out price. Our manager and his team, who owned substantial equity stakes, were multi-millionaires. 'We're rich! We're rich!' he crowed. Then he woke up.
And yes, it had all been a dream - an anachronistic dream of those happy times gone by when managers who happened to be at the right place at the right time could suddenly find themselves benefiting from huge windfalls.
A more sober 1996, however, marks a new era in the rapidly evolving management buy-out (MBO) market, one which makes it much less easy for managers to find a huge crock of gold ready waiting for them on their exit from a buy-out.
Tim Lyle, director of Livingston Guarantee and a specialist adviser in buying and selling UK unquoted companies, outlines the market's latest phase: 'The most noticeable trend in the MBO and venture capital market is towards the bought deal and away from the traditional MBO,' he says. In a bought deal (also known as an investor buy-out, an IBO, or financial purchase), he explains, 'the venture capital firm now acts as principal, buys the target company outright, and offers the management team a much smaller stake. As a result, the venture capitalists can offer the vendor a higher consideration, and still get a good return, because they're hanging on to the equity themselves. The biggest winners are the vendors, who get higher prices. The losers,' concludes Lyle, 'are the management team'.
So farewell, then, to managers' dreams of stumbling upon untold fortune.
Whereas in the old days, our somewhat bumbling divisional manager and his MBO team would have been in a doubly privileged position - buying the division at a lower price than other possible contenders, then receiving a majority stake into the bargain - these days incumbent managers have to participate in a highly competitive auction on equal terms with trade buyers and the venture capital firms. Where they do succeed, their share of the equity is likely to be 10% or less plus a ratchet (an agreed equity increase if targets are met) rather than 25% to 30% plus ratchet, according to Ken Robbie, research fellow at the Centre for Management Buy-out Research (CMBOR).
The new pattern is well-illustrated by the £37 million IBO, led by venture capitalists Charterhouse Development Capital and Advent International, of Zeneca's garden care products in late 1994. The decision to sell the garden care business was taken in late 1993, explains John Wilson, then general manager, now chief executive of the new company, Miracle Garden Care. The garden products business, which had sales of £34 million principally in the UK and Ireland, was no longer a core activity for Zeneca Agrochemicals, a leading player in the global crop protection market, with sales of £1.2 billion. 'The business had not been an investment priority,' Wilson explains. Zeneca identified 16 potentially interested parties - a mix of trade companies and venture capitalists - and, by September, two frontrunners (both deals put together by venture capital firms) had emerged. Zeneca ran these in parallel through further in-depth diligence until in November the Advent International/ Charterhouse bid was granted exclusivity.
There was never any question of a buy-out by management, says Wilson.
However, 'To my surprise, the offer was made conditional on my coming with the business'. Eventually, 5% of the equity was made available (not given away) to management, to be shared between four directors of the new company, two of whom were outside appointees. There was no ratchet attached, but the directors will earn themselves exit bonuses provided the venture capital firms get a 'minimal return' when the company floats or is sold.
The deal is different to the £25 million MBO of the Levington horticulture business from Fisons (finalised in July 1994) which was structured more on the older style of MBO: this split 15% of the equity between three directors, offered ratchets to double that, and made a further 2% available among 14 other staff. While Wilson did raise this possibility with Charterhouse and Advent, it was too late in the process to be considered. He adds, however, that one reason the Levington deal was more advantageous to management was because it was 'more management-driven'. 'They initiated the process themselves, and negotiated their own support from Prudential Venture Managers.' The Miracle Garden Care buy-out, by contrast, was investor-led - and it shows.
Although the trend towards IBOs has so far been most marked in big deals (buy-outs of £100 million plus, although some push the dividing line to £50 million), the Miracle Garden Care example shows that the model is now being applied to smaller buy-outs as well.
Robbie explains the trend by pointing out that MBOs emerged in the early 1980s, as a way of providing venture capitalists with more attractive and less risky returns than start-ups, while corporations divested themselves of unwanted and often underperforming businesses. By the mid-1980s, as competition for deals hotted up between venture capitalists, trade buyers and other providers of private equity, so institutional investors introduced the management buy-in (MBI) as an alternative way of 'adding value to turnaround situations with growth potential'. But it proved not so easy to match entrepreneur to target company, nor to identify and solve the problems of the underperforming business. Tested by the recession of the early 1990s, many MBIs failed - and at a much higher rate, CMBOR research found, than MBOs.
With the end of the recession, the venture capitalist firms have once more been on the look-out for the attractive deal. But a healthier economy has meant fewer receiverships, and therefore fewer buy-out possibilities from that source. Says Mike Stevens, head of MBOs at accountancy firm KPMG: 'The venture capital institutions started to panic that the flow of deals would dry up'. They also soon realised that there was more money to be made from deals they unearthed themselves than from those introduced by intermediaries like the Big Six accountancy firms. So they recruited specialists from industry to provide contacts, help sniff out potential deals and assist in assessing the true value of the target division or company. They also stepped up their (new-style) marketing, making direct approaches to large corporations, identifying non-core businesses, and hoping to deal directly, without going through a formal auction process.
And the fact that returns in the MBO market have been very high since 1990 means that it has been easy to attract investors into venture capital firms so the latter have had money to spend. In 1994, when the venture capital firms went on their last major fund-raising exercise (a five-yearly event), they raked in a record £2.6 billion. It had been a 'boom time' for MBO exits, says Stevens, and then 'venture capital firms could go straight back to their investors, in a virtuous circle'.
The new trends have also been driven from the vendor side, however, explains Robbie. With the increasing emphasis in recent years on corporate governance, divestors in public companies are concerned to maximise shareholder value and achieve the highest price on disposals. This more professional approach to disposals usually involves an auction which invites bids from both trade buyers and investing institutions.
But managers should not despair: the experts agree there is still a chance for incumbent staff to gain big stakes if they initiate the buy-out. Comments Stevens: 'Managers can make a lot of money if they produce the complete deal and are in control; if they offer enough upside post-deal, they can get 30% to 50%, with a kicker'. Yet they should not hope to make the sort of money made in the recent Porterbrook deal (see box), which exists in a world - some might say, dream world - of its own.
A SMALLER PIECE OF THE PIE
Year Average Average
1989 24.8 0.79
1990 31.8 1.04
1991 28.4 1.06
1992 27.8 1.08
1993 18.3 0.36
1994 34.4 1.44
1995 14.6 0.79
1996 15.0 0.18
Source: CMBOR/BZW Private Equity/Deloitte and Touche Corporate Finance
THE GOOD OLD DAYS
Company Date Management Management Cost of
investment stake (%) deal (£m)
Kossett Carpets 1990 £110,000 36 plus further
4% in options 15.6
Denby Pottery 1990 £140,000 63 5.6
Eaton Williams 1990 £700,000 67 11.3
Anglian Windows 1990 £720,000 25 84.0
The Dream MBO
Porterbrook, the envy of all buy-outs
Managers contemplating a buy-out may be inspired by the example of Porterbrook, the privatised rolling stock leasing company. Sold to its management (one of several bidders) in January for £527 million in a traditional MBO deal, Porterbrook was bought by Stagecoach just six months later for £825 million. This landed managing director Sandy Anderson with a cool £36.6 million, while his fellow directors shared a more modest £25 million between them. But Porterbrook, which is currently the subject of an investigation by the House of Commons Public Accounts Committee, is a highly unusual case.
Although the 20% stake allocated to existing managers was surprising in a deal of this size, much more unusual is the astonishing leap in the value placed on the company by its new owners, Stagecoach.
Mike Stevens, head of MBOs at KPMG, commenting on the initial price, remarks that buying a public sector business is bound to be a 'massive unknown quantity', and that therefore most government sales are made at a discount. Had Porterbrook floated, it would have fetched even less, says Stevens.
Peter Longinotti, corporate finance partner at Price Waterhouse in Manchester, has one clear suggestion: that the Government makes the mistake when privatising companies of restructuring the business and selling it at the same time. The result is 'nobody understands what they're buying except the management, who know what's in the business, while external bidders don't, and that leads to a discounted price'. The Government would get a better price, he suggests, if the business were restructured and then sold a year later.