Dave Harries

Neil, What is a Management Buy Out and how does it work.

Neil Ackroyd

Well, a Management Buy Out is a type of mechanism by which a management team, somebody who runs a business, can be offered the opportunity to pay a sometimes quite substantial for the business that they are running, from the third party shareholders who might be a PLC or maybe an owner manager in a situation where they don’t really have any money. They have been employees all their lives and they come along and raise funding from Venture Capitalists and bankers to buy that business and ultimately grow it and make money themselves.

It works through some fairly simple financial engineering in such a way that the Venture Capitalists can make an exciting return and the Management can make life changing sums of money.
The best way to describe this is just to take you through an example of how a deal would be structured and how it would be funded.

So if we were talking about a £25m transaction, which is kind of a reasonable standard, mid market transaction but it works for deals that are a tenth the size or deals that are 10 or 20 times the size. Typically speaking, you would have a slug of senior debt at the top of the deal so this is money that is raised from a banker organisation so the type that you will see interviews on RBS, Lloyds etc and they might do this through a Term Loan, which is a loan which is paid back over a term ie 5,6,7 years and is unsecured or more likely these days there is some partial part of asset back lending (ABL) so they may have a mortgage on a property that is owned by the company or invoice discounting facility so they may get financing from the debtor book of the business or something like that. But this is just absolutely just debt.

The next bit of the business is similar to that. It is still quite like debt but it is provided by the private equity player. They come in and are interested in the equity of the business but the bulk of their money on a transaction is put in as debt. So typically on your £25m transaction you would have half your debt in Senior Debt and half of it in loan stock from the Venture Capitalist. Then baring in mind that there are fees to come out of the deal, that leaves an element of the deal that is the equity. But on a £25m deal, the equity would be a much smaller proportion. I have used £0,5m as the equity but there are calculations and it varies on each deal. Again for simplicity, I have said that the Venture Capitalists will get 50% of the equity for half of the £0.5m equity band and the management will get 50% of the equity for their half of the £0.5m equity band. So you have funded the whole transaction but most of it has come from the bank and the VC but you can see that the management still own half of the business behind all the debt.

Dave Harries

So it is a bit like buying a house and getting a 100% mortgage.

Neil Ackroyd

It is very much like that. If you think back to the property boom, which everyone can understand, people bought houses and got very high mortgages and as the property price went up then of course they made a huge amount of money so on a £200k house they may have put down a £10k deposit and then it goes up in value by 50% and they have turned that 10% into £110k and the gearing on a Management Buy Out is very similar. So you can see that a lot of the risk is being taken by the funders and a lot of the reward is going to the management.

Now how does that play out. If we roll this forward 3 years to an exit – and people generally go into a Management Buy Out deals so the business will get better and perform better so we are making an assumption that the business has grown and maybe got twice as big or 50% as big and more attractive so we are selling the business for £50m. We are assuming that the Term Loan has been partially paid off so whereas it started at £13m, you’ve paid the interest of on it and its now £6m. So you can see when we sell the business for £50m and that is the proceeds. First thing that you pay back is the senior debt, you then pay off the VC loan stock and then you end up in this case with around about £31m to split up between the management and the venture capitalists. So the Venture Capitalists get £15.5m and the management team get £15.5m which means that over the course of the transaction the Venture Capitalist has more than doubled its money and in two to three years which is the kind of return they are looking to get. So they have got their £13m back and they have got £15.5m in equity. Whereas the management team have had a much more exciting experience in terms of they have put a £0.25m and they have turned it into £15.5m in this example and given that they are the ones that are key to delivering that growth in value then the venture capitalists are happy that the management team are incentivised and are going to have life-changing money and the venture capitalists are going to make a return much higher than a normal investment or a lower risk stock market investment.