Charles Beelaerts examines some issues for directors who are faced with an offer by management to take over the company. In particular directors must be aware of potential conflicts of interest.
A management buy-out (MBO) is an arrangement whereby the management of a business purchases it from the existing owners. This differs from a management buy-in (MBI) which involves an entirely new management team taking over the company. An MBO is usually financed by private equity investors and debt financiers using a mixture of senior and junior (mezzanine) debt. In some instances it is funded by vendor finance together with bank debt. The term ‘leveraged MBO’ means that the buy-out is weighted more towards debt financing than equity.
MBOs are not as common in Australia as they are in the UK or the US, but they are becoming increasingly popular with the rise of professional private equity funds managing substantial amounts of capital for the investment community. These funds acquire businesses, usually retaining most of the existing management team (although not always the CEO), often with the intention of building the business up for a future public float.
Private equity players have been increasingly active in Australia in the past year and it seems that size is no protection from being on the receiving end of a takeover. For example, Newbridge Capital bought the Myer stores for $1.4 billion earlier this year and Coles Myer itself then became a $17 billion target. Investment criteria of private equity firms in terms of MBOs vary. Most private equity firms look primarily for an efficient management team that has a proven ability to run the business and has interests aligned with those of investors. Other factors include strong cash flows, growth potential, reasonable entry price and reasonable exit prospects in 3-5 years. They also look for companies which will generate sufficient cash flow to service and repay the debt raised when buying the company in the first place.
Basis of an MBO
There are numerous reasons why the owners of a business may wish to sell-off all or a part of it. For example, current owners may decide that a part of their business has become ‘non-core’ and is ripe for an MBO. Secondly, an enterprise may purchase several businesses as part of a takeover and not wish to operate all of them. Thirdly, the current owner(s) may wish to retire. Fourthly, there may be a divergence of interests among owners, and one or more of them may wish to divest their shareholding. Fifthly, the owners of a business may be forced to divest some business assets by the Australian Competition and Consumer Commission (ACCC). Finally, there may be what is referred to as a secondary MBO, whereby the financiers and management team associated with an initial MBO wish to realise some or all of their capital gain and on-sell part of the business.
However, an MBO can also be activated by an unsolicited offer from a private equity fund which may have already gained control of a block of shares from sympathetic shareholders. It is this type of MBO this is becoming an increasing concern for company directors.
Issues for directors
When considering hiving off a business or division, the company’s board of directors must decide on the best way of selling the business. Normally, they will have a sale process implemented with several potential buyers, often with advice provided by an investment bank. An MBO may be the preferred option because it minimises the risk of losing confidential information through leaks, and transfers ownership of the business to those who best understand its intrinsic value. In addition, an MBO may be more palatable to other interests such as customers and unions – particularly if one of the alternatives is that the company is taken over by foreign investors.
Experts contacted for this article agree that an unsolicited offer by management to buy out the existing owners is not unheard of, but it is not that common. For example, Nicholas Humphrey, partner with Deacons specialising in private equity, says that it is usually the case that the vendor will invite management to participate in the buy-out. Otherwise the board would be uncomfortable because of the conflicts of interest that arise – eg board members being at odds with each other because some are with management and some are not. The situation 10 years ago is that if an MBO was formulated by management, the board would be suspicious and it would ask why management would make an unsolicited offer. Now an unsolicited offer is generally not considered with suspicion. Martin Bennett, head of private equity at Minter Ellison agrees and says, “MBOs are led by private equity funds not management. It is rare for management to knock on the door of directors and say that they want to buy a company.”
Irrespective of whether an approach is unsolicited or not, Jeremy Samuel, director with ANZ private equity, says that it should be treated seriously: “MBOs can create an outstanding opportunity for directors to realise value for their shareholders in a cost effective, low risk fashion when executed correctly. It is important for directors to understand their duties and be properly advised for their particular circumstances. Often the approach will be from a private equity firm so directors need to consider the level and nature of access to management which will be critical to the private equity firm’s due diligence.”
Conflicts of interest
There are numerous conflicts of interest that directors need to be aware of in the course of a management buy-out. The most difficult situation is where some directors are part of the management team that wants to buy out existing owners, while others are not and wish to maintain their roles on the board. Andrew Cummins, senior managing director of CVC Asia Pacific, a regional buy-out fund in the Asia Pacific, says that this is a highly sensitive situation with which everyone involved needs to be concerned. For a start there are executive and non-executive directors who have different interests. An independent committee should be formed to evaluate the proposed MBO and the committee’s decision-making has to be kept separate from the various competing interests, and seen to be so.
Ian Knight, partner and head of private equity with KPMG Corporate Finance, identifies differences in the amount of information available to MBO backers and other outside bidders as a potential conflict of interest. For example, he says that the management team’s, ie the MBO team, dealings with other bidders, or their preparation of information for a private equity fund, needs to be exemplary if the best interests of the owners are to be served. Knight also says that where an MBO is unsuccessful, it can lead to a significant cause of friction between management and the board. Reasons for an MBO not proceeding include being outbid by a third party, rejection by shareholders, rejection by the courts, or formal withdrawal. There is also an issue of whether management will be available to continue if a third party bidder is successful.
Both Bennett and Humphrey agree with Cummins that an independent committee is important in handling conflicts of interest. According to Humphrey: “The most basic source of conflict in an MBO is that as a potential purchaser they obviously want to buy the company at the lowest possible price. This runs in direct conflict with their duty as a director or employee of the company to act in the best interests of the company and achieve the highest possible price.”
If a private equity investor is interested in taking over a company or part of a company, they will require information as part of their due diligence and the management team will need board approval to provide it. Some experts argue that the management team should also sign an agreement that they won’t withhold information from third party buyers. According to Bennett: “The seller will be keen to ensure that management plays a straight bat and doesn’t favour one buyer over another, and that they do not withhold information from particular buyers.”
Clearly, there are potential conflicts of interest for management if they are bidding for the company against parties that are outside the company. Therefore, the management team would be wise to seek advice in relation to any conflicts they may have by sitting on the potential buy side of the transaction while they continue to work for the seller/target.
Establishing a fair price
Bennett says that when approached with an MBO proposal: “A board has three choices, entertain the proposal, establish a process to elicit offers from other potentially interested parties, or reject the offer. The deliberations of the board will typically take into account a whole range of issues, including, obviously, the indicative price offered relative to the perceived value of the company, the conditionality of the offer, how the business is performing at the time, its future business plans and strategies, the current value of the company, and its prospective value based on the delivery of those future plans and strategies. Other factors include consideration of commercial sensitivities around disclosing confidential information on the business to a prospective buyer, and whether to commission a valuation.”
Knight says that the assessment of value with an MBO is no different from any other takeover offer. In relation to a public company he adds: “Whilst a scheme of arrangement does not technically require an independent expert’s report (unless the Company’s Act stipulates one due to associated parties) it is common practice to provide one to shareholders.”
The process by which a price is set must be at arm’s length and must be seen to be fair. Samuel says that directors need to consider the alternatives when settling on a price and they may engage independent advisers. Together they will look at future growth prospects, the pricing of similar transactions by way of industry benchmarks, such as earnings multiples, and other previous offers or capital raisings for the business.
In assessing whether a proposal is in the best interests of shareholders, Samuel says the factors will again vary depending on such things as whether a company is family owned or whether its shares are widely held. He says: “For public companies, the focus will be more on shorter-term issues of share price and certainty of process. For example, does a sales process have the requisite degree of certainty? Does it risk competitive information falling into competitors’ hands? Should the directors pay a break fee if they wish to have multiple parties doing due diligence?”
Knight says that the independent expert appointed by a public company must consider the overall commercial effect of the proposed transaction and weigh up the likely advantages and disadvantages to the company’s shareholders. From this, directors can form a view of whether the proposed MBO is in the best interests of shareholders.
Another question is whether a director of the company bought out should remain on the board of the new enterprise. Bennett says that this would be quite unusual and that existing directors would not normally continue to hold their positions. Knight says that if this was predetermined, the director in question would not be viewed as independent. He adds: “This will also depend somewhat on the terms of the transaction, eg if there are any areas that post transaction litigation is capable of occurring, then such an appointment would be imprudent.” Humphrey’s view is that you are either a buyer or a non-buyer and if you are a non-buyer and stay on the board, you will have a conflict of interest because the new team pays your director’s fees. In reality this might not be such an issue as it is quite common for representatives of private equity funds to sit on the new board after a successful MBO – so existing directors might not be asked to continue.
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