Distressed Management Buyout Opportunities
Corporate & Finance Alert
February 3, 2009
The current economic downturn and sea change in the capital markets has indirectly created a contrarian opportunity for entrepreneurially inclined managers of a distressed business to participate in a management buyout of their business (“MBO”). This article will discus these opportunities, the process involved in a MBO and the differences arising in a distressed MBO.
Distressed MBO Opportunities
The past decade of robust M&A activity was characterized by excessive valuations and debt leverage based on future cash flows. This was followed by a tightening of the credit markets, starting in late 2007, and a migration of hedge funds to fill the void left by traditional mezzanine and high yield lenders. The deepening worldwide recession and implosion of institutional capital providers has created stress on many businesses which requires both financial engineering and operational changes notwithstanding viable business plans and strategies. It has been reported that 50% of companies are stressed or in distress from a balance sheet perspective as the result of unsustainable debt levels or depressed industry conditions. As a consequence of these events, many distressed businesses are under severe pressure from their creditors, shareholders, suppliers and customers seeking to protect their conflicting interests. Management’s familiarity with a business and its industry opportunities suggest a MBO is the best alternative to timely preserve the going concern value of a business where a speedy sale of the business has been determined to be the best method to maximize value for all stakeholders.
Many lenders, under pressure from regulators for liquidity and capital reserve compliance, are exerting demands on their distressed borrowers for a liquidity event. Hedge fund lenders, historically impatient sources of funds and under redemption pressures from their own investors, do not have interest in committing additional capital and are interested in exiting distressed portfolio investments. Private equity funds unable to deploy customary debt leverage for acquisitions, have invested their capital by purchasing, at a discount, existing loans from banks to distressed companies with the objective of obtaining “blocking positions” to achieve a exchange of debt for equity and an ultimate liquidity event. This scenario has created opportunities for a MBO of a distressed business where the input and expertise of management is critical to achieving the goal of a quick and cost efficient sale of the business as the liquidity event. Also, M&A valuations based on EBITDA multiples have decreased by a third from the fourth quarter 2007 to the fourth quarter of 2008. As a result, acquisitions will require less leverage and management will be better able to partner with opportunistic investor groups who view management and a MBO as the most secure method to capitalize on these current market conditions.
Typically, a MBO is initiated by a seller to divest a non-core business with limited strategic buyers, as a family estate planning or succession plan or in response to a request of management, in each case where the seller prefers confidentiality or is concerned that exposure of the targeted business to competitors would be damaging. In distressed situations, creditors of the seller or the business to be sold (including holders of debt acquired from institutional lenders) often initiate a MBO on the basis that management is best able to execute a sale quickly with a trade off between the time to close and diminution of value for all stakeholders.
Depending on the degree of stress on the business to be sold, a MBO may be accomplished as a negotiated private sale to management, or a Bankruptcy Code Section 363 or Article 9 UCC sale. These latter two methods of distress sales are discussed elsewhere,1 however, it should be noted that the direct and indirect costs of a distressed bankruptcy sale may substantially reduce the enterprise value of the business and its future prospects. This should, however, be compared with the cash flow benefits of de-leveraging the balance sheet of the acquired business and shielding the business from potential claims and liens.
Regardless of the method of the sale, if a MBO structure is selected, the management team may develop a direct conflict of interest with the seller and other constituencies of the business. Management, like other buyers, wants to pay the lowest price, has access to confidential and non public customer and supplier information of the business not available to other interested buyers, is in a position to control the timing of and financial status of the business and therefore, its ultimate deal value. This conflict typically creates a shift in negotiating strength to management and concern by the seller as to whether it is achieving the “best deal” from its management. Management must be careful to address this concern with caution and “walk a fine line” as a failed deal would likely cause irreparable damage to management’s future employment relationship with the seller.
The typical MBO will proceed to execution in accordance with the following process:
- The management team, usually lead by the CEO, will engage a financial advisor to (i) act as an intermediary with the seller to defuse any perceived conflict issues; (ii) validate the feasibility of the business plan of management, including strategies on customers, supply chain management and labor contracts and the costs of “de-coupling” the business from inter-company support services and overhead charges; (iii) prepare pro forma financial projections and valuations; (iv) negotiate the sale price and terms with the seller; and (v) arrange the equity and debt financing for the deal which in many cases may be provided by the financial advisor.
- Execution of a commitment letter between the investor group identified by the financial advisor and the management team detailing (i) the deal price; (ii) terms of the investor group’s capital investment; (iii) the equity and compensation plan for management, including equity and bonus incentives; (iv) the deal timetable for due diligence and closing, including allocation of responsibilities between management and its financial advisor; and (v) responsibility for due diligence, professional and other deal costs. It is not uncommon for the investor group to require the management team to make an equity investment in the deal (“skin in the game”) to confirm their commitment to and confirmation of the economics of the transaction.
- Negotiations with the seller and execution of a letter of intent on the deal terms. This will detail the principal economic terms of the transaction, its timetable to closing, a “no-shop” provision and if possible, a reimbursement obligation on the seller for the management team’s out of pocket expenses and costs if the deal is not closed.
- Performance of due diligence by management’s investment advisor and the investor group and preparation and negotiation of the definitive legal documents to close the deal, including if the sale is of a division or subsidiary, a transition service agreement with the seller to provide information technology, human resources, accounting, insurance and, if applicable, product supply for a period after the closing (a “TSA”). The TSA is often a critical closing document which is driven by management’s knowledge of the business and their ability to quickly lower operating costs by implementing replacement services more efficiently than previously provided by the seller.
- Closing of the financing and the sale which typically takes about six months from initiation of the MBO process. This assumes all regulatory and other third party approvals (consent to assignment of contracts and leases) have been timely prosecuted and obtained.
Differences in Distressed MBO
A distressed MBO process may be initiated by creditors of the business or existing equity or hedge funds investors holding equity positions in the distressed company. Management typically will be the first line of communication if a sale is determined to be in the best interests of these stakeholders. Initiation of the MBO process by these stakeholders often mitigates the conflict issues created when management negotiates with the seller since the MBO process will likely be managed by these stakeholders with a higher probability of a successful closing.
The financial advisor retained by management must be knowledgeable in distressed company transactions, have experience with the interplay of creditor’s rights, bankruptcy and corporate law issues and be able to move swiftly to complete the process. Time is not your friend with a distressed MBO and the price of admission to play in this game is speed and a realistic timetable to close the transaction before various stakeholders take preemptive action to protect their positions or the financial condition of the business deteriorates beyond repair.
Since a seller in a distressed MBO has only one chance to close the transaction, the letter of intent with the seller will usually grant protection to management on deal costs and expenses in exchange for a short (thirty to ninety day) due diligence and document negotiation and closing period. Management’s knowledge of the business, their relationships with creditors, suppliers and customers and understanding of unwanted assets with hidden value, grants an edge to management in negotiating with their investor group the terms of management’s equity incentive plan. Further, active participation by management provides comfort to the investor group in understanding and managing the risk resulting from the urgency and speed necessary to complete the distressed MBO without disruption to the business.
Definitive legal closing documents for a distressed MOB may not contain customary representations, warranties and indemnifications thereby placing more reliance and trust by the investor group on the integrity and disclosures of the management team. The investor group may waive the requirement for management to have “skin in the game” on a recourse basis for their equity stake if management is perceived as making full disclosure on their assessment of the business, its risks and future prospects. This is particularly significant in the risk management assessment of the business where management’s expertise is needed to assess pre-closing litigation risks (intellectual property, product liability, etc.) not retained by the seller, with respect to a TSA which is for a short period of time or where the business is reliant on a small number of key suppliers or customers with strong relationships with management.
Notwithstanding the negative reports on the state of the economy and the financial markets, management of distressed businesses may have the opportunity to build future wealth by initiating and leading a distressed MBO. Although risky and not a game for the faint of heart, a distressed MBO may create the potential for outsized returns in an otherwise distressed situation which may not likely be available again during a manager’s career. A properly planned and executed distressed MBO requires a talented and focused management team working swiftly and in tandem with experienced and knowledgeable professional advisors who are capable of recommending timely and workable solutions to complicated legal, financial and bankruptcy related issues. The objective of the management team and their investor partners in a distressed MOB is to establish a trusting working relationship, move quickly to preserve the value of the target business and deftly navigate the conflicting interests of the various business stakeholders before the music stops. Success in this endeavor provides an otherwise sound business a second opportunity and hope to the management team and their investor partners that they each will be the beneficiaries of the future value of the business resulting from the MBO.
1 For a complete discussion Bankruptcy Code Section 363 or Article 9 UCC sale, see Gibbons Corporate and Finance Alert entitled “Distressed M & A: Bankruptcy Code Section 363 Sales” dated December 23, 2008 and “Distressed M & A: Article 9 Secured Party Sales” dated December 16, 2008.