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The Management Buy-Out (MBO) has evolved dramatically from a junk-bond financed spree in the US in the mid 1980s, to the privatisation of state-owned assets during the transition from communism to a market economy in Central and Eastern Europe in the early 1990s and, more recently, in tightly-regulated Chinese SOEs. For incumbent management teams of mid-market private businesses in Asia however, do MBOs represent a more efficient and incentivised way to operate a business, or is it a risky venture best left to veteran takeover
specialists? Structuring is
key
Those interested in undertaking an MBO are recommended to pick up an M&A primer and study the nitty-gritty details theorising the rationales behind them. Our discussion here, however, will focus on one of the most conceptually sound and practical impetus or "trigger" for undertaking a mid-market MBO in Asia: corporate divestitures or, more precisely, the spinning-off of non-core business divisions of multinational corporations. The benefit of this type of transaction is by its very nature double-edged. The parent company has the most qualified and knowledgeable buyer in-house for a business division, and at the same time can successfully divest this subsidiary without divulging any information to competitors. The management team takes on the extra risk and return as business owners, and gains a level of strategic and management liberty which enables them to carry out more aggressive growth measures than were possible before. The new owners are also likely to exercise aggressive cost-slashing measures by tackling excessive administrative costs inherited from the "top-heavy" parent. Some of these costs may include legal, audit or global insurance policies that can be renegotiated and purchased at a much lower cost from sources outside the parent
firm.
With sound intentions from both parties of a potential MBO transaction, a well-structured deal is critical to its success. When brainstorming different strategies for putting your deal in place, try to consider the following principles:
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Be over-engineered -
More often than not, management teams are unable to, or simply not willing to, put up the capital for the purchase price of an
MBO. Working with a reputable private equity group has proven fortuitous to the conclusions of some recent large scale MBO transactions, (e.g. $325 million public-to-private MBO of Pokka Corp. in Japan with Avantage Partners and CITIC Provident Management; $104 million MBO of Onesource Group with Archer Capital etc.), but these same groups are usually unwilling or unable to invest in mid-market (US$5m to US$50m) transactions. For these smaller transactions, securing a financial sponsor might not be as straightforward due to mismatches in the transaction size, industry-focus or other investment criteria of potential investors. As many management teams do not wish to give up equity control to a third-party, a typical MBO structure often ends up being highly-leveraged, thereby severely escalating the financial risk of the business. This type of operational environment might not be unfamiliar for leveraged turnaround specialists, however, for management teams in mid-market Asian business, running a business motivated by a fear of not generating sufficient cash to pay debt servicing costs is rather intimidating. Management teams are strongly recommended to leave an adequate margin of safety by extending the loan amortisation period or giving up more equity control in exchange for less debt. A detailed scenario analysis should be carried out to evaluate the
post-MBO operational environment. The cost-cutting plan should be in place and its impact taken into account in the analysis. Management teams should revisit the competitive strategies of the business and examine its viability with a leveraged capital structure and no "parental support". Consider how your own competitors might use the lack of a corporate parent against your business in their marketing campaigns.
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Be legally well-versed -
The management should not underestimate the benefits of obtaining early legal advice on the structure of the deal and their liabilities following its successful conclusion, particularly where they are giving personal security to lenders. Good legal and financial advisors can help minimise the wide scope of the security, undertakings and covenants normally sought by lenders and private equity groups. Individual members of the management team may also wish to take advice on their rights under any shareholder arrangements put in place as part of the deal.
Complex legal issues can arise in
MBOs. If, as is usually the case, there is a debt component to the financing structure for the buyout, the lenders will typically want to take security and up-stream guarantees from the target group. For targets in Hong Kong, such deals need to address the prohibition on the granting of "financial assistance". As a general guideline, legal restrictions (having as their objective the maintenance of a company's capital for the protection of its creditors) prohibit a Hong Kong company from providing financial assistance (including among other things, loans, guarantees or security) for the acquisition of its or its parent's shares, or the reduction or discharge of the liability of any person incurred for the purpose of such an acquisition. With skilled financial and legal advisors, managements of private company targets can often avail themselves of a procedure to obtain exemption from the prohibition and meet the demands of lenders for such
security.
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"Financial assistance issues should be considered early for deals involving commonwealth jurisdictions, as they may impact on the structure of any debt financing and, if not addressed in a timely manner, can delay the completion of
deals."
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James Griffiths, Consultant with Cheng Wong Lam & Partners.
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Be creative -
Structuring the financing for a mid-market MBO can be a highly creative process. For smaller deals, management teams usually rely on simple senior debt which requires personal guarantees and the pledging of personal assets (such as a principal residence). Mid-sized deals would use private equity and debt, where private equity may demand a straight equity tranche plus an equity kicker of the mezzanine variety (warrants, options, convertible preference shares etc). In most cases, a separate "working capital
tranche" would be set up in which the company's account receivables, inventories and equipment would be used as collateral for working capital loans from banks.
An often overlooked source of financing actually comes from the seller itself. This is particularly true in the case of corporate divestitures from multinational conglomerates. Provided that both parties have sound motivations for carrying out an
MBO, some level of financing should be available directly from the seller. This "vendor financing" may be partially guaranteed by the buyers, and often carries below-market interest rates. A full share charge, which involves an ongoing claim over the equity of the company until the loan is repaid, is also common for such a loan. Apart from purchase price financing, a buyer might obtain other concessions from the seller such as the extension of supplier or buyer agreements from the parent company at a favourable rate, letters of comfort extended from the parent for working capital facilities etc. There is usually little harm in asking, so be creative and ask for as much support as you
need.
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Conclusion
A successfully implemented MBO plan can be a mutually rewarding proposition for both the buyer and seller. Like any M&A transactions, good intentions and a strong willingness must be in place from both parties before a deal should even be discussed. A management team involved in an MBO needs to diligently spend time and effort with its advisors to develop a thorough plan which comprises of as much detail as possible with respect to the structure of the transaction, pricing, financing, post-closing cost-cutting measures and competitive strategies of the business going forward. We suggest that management teams planning to initiate an MBO get early advice on the feasibility of the deal and on their obligations of confidentiality. Going unprepared to a corporate parent regarding an MBO can be a quick way to lose one's
job. The successful closing of an MBO is a major milestone on its own. However, the toughest work remains in the hands of the new business owners who must pull things together in order to be handsomely rewarded for the new level of risk being
undertaken.
kenneth.liu@gthk.com.hk
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