Management buy outs
Mike Wright and Andrew Burrows
From highly leveraged transactions involving listed companies in the US in the early 1980s, buy outs have become an international phenomenon. In Europe, the UK, France, and the Netherlands in particular have seen considerable buy out activity. Buy outs were an important feature of the privatization of state assets during the transition from communism to the market in Central and Eastern Europe, while the need for major restructuring in Japan and Korea has given an impetus to buy outs in the Far East.
Definitions
Management buy outs (MBOs) involve the acquisition by incumbent management of the business where they are employed, with the purchase price being mainly met by a private equity/venture capital firm providing significant amounts of equity and/or banks providing debt. Management buy ins (MBIs) are a similar form of trans action, but differ in that the entrepreneurs leading the transaction come from outside the company. A hybrid buy in/management buy out (BIMBO) combines the benefits of existing internal management and the contribution of external entrepreneurs; these transactions have developed to address the shortcomings of pure MBIs, where asymmetric information problems faced by outsiders contributed to significantly higher failure rates than for MBOs.
Leveraged buy outs (LBOs) are typically led by specialist financiers whose executives take direct equity holdings in the acquired corporation, but with the vast majority of the funding for the purchase being in the form of debt. Incumbent management may play a marginal role in putting the transaction together and in equity holding and may even be replaced. If the managers are heavily involved, the transaction may be termed a leveraged management buy out (LMBO). Similar to LBOs, investor buy outs (IBOs) have developed where private equity groups initiate and lead the transaction, but with the degree of leverage being substantially less. Other variants include MEBOs, where management and employees both provide equity. The initial buy out transaction may be used as a platform for further acquisitions, a so called buy and build or leveraged build up strategy. Such deals are typically aimed at consolidating fragmented industries.
Conceptual Issues
Traditionally, buy outs have been viewed as in volving enterprises in mature cash generative industries with few opportunities to invest free cash flow. The stereotypical cases have concerned listed companies where an agency problem exists between diffuse shareholders and management holding little equity in the business. In these cases, efficiency gains were avail able from taking the corporation private and introducing a buy out structure involving in creased equity incentives for management; the pressures of servicing high leverage and active involvement by private equity investors through board membership contributed to the resolution of agency cost problems arising from the separation of ownership and control.
Typically, the purchase price in a buy out is met by a small amount of funds provided by management and the rest a mix of external private equity and bank debt. In smaller transactions, management may obtain a significant majority of the equity. A major problem may be asymmetric information between incumbent management and the private equity provider concerning the current position of the business and its future prospects. This problem may create differences in valuation of the business and hence differing views about the size of each party’s equity stake. The use of convertible and redeemable stock can help resolve this problem by making the size of each party’s equity stake dependent on the outcome of projections. If performance targets are met, the redemption of redeemable shares enables managers to increase their equity stake. If targets are not met, convertible shares become straightforward common stock, thus increasing the stake of the private equity firm and enabling it to achieve its target rate of return. Private equity firms are also likely to insist on various conditions in the share holders’ agreement that constrain management’s behavior and which may give them powers of control under certain conditions. Debt may be provided through various forms of senior debt secured on assets, subordinated (mezza nine) debt linked to cash flow, and in very large transactions high yield and securitized debt. Covenants attached to the provision of debt also involve close monitoring relationships between banks and their buy out clients. Breaches of these covenants are typically an early warning signal of problems, giving time for corrective action to be taken rather than a signal to put a company into bankruptcy proceedings.
Although the taking private of whole listed corporations has involved very high profile transactions, numerically this kind of deal ac counts for a small minority of most buy out markets. Recent evidence also indicates that the rationale for and type of public to private buy outs is changing, to focus more on cases where relatively small corporations face the problems of illiquid markets for their shares and where top managers already have significant equity holdings.
Internationally, the most common sources of buy outs are divestitures from large corporations. Most divestitures are from domestic corporations, but a significant number of trans actions arise as restructuring corporations find it attractive to dispose of overseas divisions that may pose greater control problems than domes tic activities. Divestitures as buy outs tend to involve activities that do not have a trading relationship with the parent company. However, a significant minority of buy outs involve substantial levels of trading with the parent. The attraction of buy outs in these circumstances lies in the ability to adopt more appropriate incentives for managers than is possible within a group structure. For the parent, pressure to perform may be exerted on management through asymmetries of interdependence, where the buy out is more dependent on the parent than vice versa. For the divisional management, the buy out offers the scope to pursue external growth opportunities that were con strained within a group structure. In Japan, pressures to restructure heavily indebted keiretsus are producing an increasing stream of buy outs where management can realize growth opportunities (Wright, Kitamura, and Hoskis son, 2003). Buy outs also offer considerable scope for the privatization of state owned activities, as they introduce important incentive and control mechanisms that are absent under public ownership (Wright et al., 2000).
Family businesses facing succession problems also provide a major source of buy out opportunities, especially in European countries where industry is dominated by large numbers of private businesses. Buy outs can be attractive to founders as they maintain the independence of the firm as well as potential tax advantages in some countries. Buy outs of family businesses are often viewed as avoiding the agency problems involved in buy outs of listed firms or divisions. However, important asymmetries of information may exist in favor of either the vendor or the incumbent management. These information asymmetries may be influenced by the extent of involvement of the vendors in the running of the business before the buy out, their intentions regarding future involvement, as well as the negotiating stance adopted; that is, whether it is cooperative, competitive, coordinative, or command oriented (Howorth, Westhead, and Wright, 2004). The interplay of these factors influences whether the transfer process is successful and whether the price paid is deemed, ex post, to have been a fair one.
Management in buy outs may not merely respond to greater incentives. Rather, managers may have an entrepreneurial mindset that enables them to perceive entrepreneurial oppor 180 management buy outstunities but which cannot be realized within the existing ownership and control structure (Wright et al., 2000; Wright, Hoskisson, and Busenitz, 2001). Bureaucratic control systems may make it difficult for management in divisions to convince the head office of the attractiveness of potential opportunities in new markets where there is little concrete information.
Performance
Most studies of post buy out performance changes have concerned the short period after the transaction and generally identify substantial improvements in profitability two or three years after the buy out compared to cash flow and productivity measures one year prior to buy out (Jensen, 1993). Improved working capital management and productivity are important sources of improved performance. Evidence indicates that at the plant level, buy outs under perform comparable non buy outs in terms of total factor productivity before buy out, but significantly outperform them following the change in ownership. Productivity improvements are often associated with substantial downsizing of the enterprises concerned, with subsequent re employment being at below comparable industry levels.
Improvements in performance may also be down, based on innovative behavior by management teams. Significant increases in new product development as well as more effective use of R&D expenditures are found to occur post buy out, especially in smaller venture backed trans actions, which the entrepreneurs concerned believe would not otherwise have happened (Wright, Thompson, and Robbie, 1992; Zahra, 1995).
Exits
Buy outs have sometimes been argued to be short lived, highly leveraged transactions led by leveraged buy out associations that are little more than a disguised form of asset stripping. Evidence shows that buy outs have a heterogeneous life cycle: some last a short time, while others retain the buy out form for considerable periods. While about half of larger buy outs are sold or floated on a stock market within four years, the majority last well above seven years. Larger transactions are found to change their ownership form again significantly sooner than smaller buy outs.
The principal factors influencing the longevity of a buy out relate to the objectives and needs of the parties involved – owner managers, financiers, and the company itself (Wright et al., 1994). The extent and form of exit from buy outs and buy ins are also influenced at least to some degree by the cyclical nature of stock and takeover market conditions. When these exit routes are problematical, yet financiers with limited life closed end funds need to realize their gains, new forms of exit may be sought. An important option in these conditions is the secondary buy out or buy in, involving a sale from one private equity firm to another. In such circumstances, the incoming private equity firm needs to be convinced that the reasons for sale are genuine and that it can identify prospects for further upside gains.
Future Research
Buy outs have become a more common feature of the economic landscape, both in multiple sectors and countries where they are found. Al though buy outs have become an international phenomenon, quantitative research across countries in particular is limited. Increasing practitioner attention is turning towards entrepreneurial aspects of buy outs, as generating gains purely from downsizing becomes more difficult to achieve. From an academic point of view, greater interest in entrepreneurial concerns is emerging as the limitations of agency based theories in explaining the wide scope of buy outs become recognized.
Bibliography
Howorth, C., Westhead, P., and Wright, M. (2004). Information asymmetry and opportunism: A study of management buy-outs and buy-ins. Journal of Business Venturing, forthcoming.
Jensen, M. C. (1993). The modern industrial revolution, exit, and the failure of internal control systems. Journal of Finance, 48: 831 80.
Wright, M., Hoskisson, R. E., and Busenitz, L. W. (2001). Firm rebirth: Buyouts as facilitators of strategic growth and entrepreneurship. Academy of Management Executive, 15 (1): 111 25.
Wright, M., Hoskisson, R. E., Busenitz, L. W., and Dial, J. (2000). Entrepreneurial growth through privatizamanagement tion: The upside of management buyouts. Academy of Management Review, 25: 591 601.
Wright, M., Kitamura, M., and Hoskisson, R. E. (2003). Management buy-outs and restructuring Japanese corporations. Long Range Planning, 36 (4): 355 74.
Wright, M., Robbie, K., Thompson, S., and Starkey, K. (1994). Longevity and the life cycle of management buy-outs. Strategic Management Journal, 15: 215 28.
Wright, M., Thompson, S., and Robbie, K. (1992). Venture capital and management-led leveraged buy-outs: The European perspective. Journal of Business Venturing, 7: 47 71.
Zahra, S. A. (1995). Corporate entrepreneurship and financial performance: The case of management leveraged buyouts. Journal of Business Venturing, 10: 225 47.