Buyout Basics

Table of Contents

1 Introduction
1.1 Relevance of the subject
1.2 Outline of the work

2 Description of a buyout
2.1 Definition
2.2 Types of buyouts
2.2.1 MBO
2.2.2 MBI
2.2.3 BIMBO
2.2.4 OBO
2.2.5 EBO
2.2.6 IBO
2.3 Motivations for buyouts
2.3.1 Succession problems
2.3.2 Spin-off
2.3.3 Turnaround
2.3.4 Going-private
2.3.5 Privatisation

3 Financing of a buyout
3.1 Leveraging
3.1.1 Definition
3.1.2 Preconditions of the company
3.1.3 Financial instruments
3.1.4 Structure
3.1.5 Covenants
3.2 Exit strategies
3.2.1 IPO
3.2.2 Trade sale
3.2.3 Secondary sale
3.2.4 Buyback
3.2.5 Liquidation

4 Factors for value creation
4.1 Framework for value generation in buyouts
4.2 Levers of value capturing: financial arbitrage
4.3 Levers of value creation
4.3.1 Primary Levers
4.3.2 Secondary Levers
5 Conclusion
5.1 Critical assessment
5.2 Outlook

List of Figures

Fig. 1 European buyout characteristics

Fig. 2 Buyouts in the life cycle of a company

Fig. 3 Overview of buyout types

Fig. 4 Exit channels chosen by BVK members (2005)

List of Tables

Table 1 Structure of a buyout

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1 Introduction

1.1 Relevance of the subject

Originally developed in the USA, buyouts as a way of company acquisition gained more and more importance in Europe during the last years. They have not only experienced a growth in number but also in value as can be seen in Fig. ¹. “The overall value of buyouts completed during the second quarter of 2006 rose to an unprecedented level, reaching €38,9 bn.”1 Significant for the second quarter 2006 “was the increase in the number of large deals”.² There have been “six buyouts worth more than €1.65bn and 40 deals worth between €160m and €1.65bn”.³

illustration not visible in this excerpt

Fig. 1 European buyout characteristics⁴

Concerning the number of buyouts in Europe one can clearly identify the United Kingdom (UK) as the largest market being followed by France and Germany. 46 of the total 162 buyouts in the second quarter 2006 have been concluded here.⁵ Nearly the same picture can be observed by looking at the value of the deals.

The UK can by far register the highest value of buyouts with France being second. The Nordic regions and Germany are following with approximately the same amount.⁶ With the rising number of buyouts and especially of large deals that topic will probably become more and more important in the future.

1.2 Outline of the work

This work tries to give an overview of the characteristics and types of a buyout, the financing and exit strategies as well as the influence on the value of the respective company.

Chapter 2 describes the basics of a buyout, starting with a definition of the term ‘buyout’ and the possible buyout constructions. Thereupon follows a listing of the different buyout types and a short explanation of those. The chapter closes with a description of the most common motivations for buyouts.

Chapter 3 treats the financial aspect of a buyout. It is subdivided into two sections. The first one explains leveraging, the financing technique used in most buyouts. A short description of the leverage effect and its application in buyouts is given being followed by a listing of preconditions that a business has to fulfil to be suitable for a buyout. Thereafter the financial instruments and their structuring in a buyout are explained. The paragraph concludes with a short listing of covenants usually included in financial buyout contracts. The second section specifies the different exit strategies for the financial intermediaries.

Chapter 4 gives a short overview of the different factors of value creation in buyouts. This is done by describing a framework to categorise the possible aspects and then by mentioning and classifying those ones.

Finally the conclusion gives a short summary with a crititcal assessment of value creation in buyouts. It closes with a future outlook.

2 Description of a buyout

2.1 Definition

In corporate finance buyouts belong to the area of mergers and acquisitions (M&A). The term ‘buyout’ generally describes the acquisition of a business or a part of it. Additional specifications like ‘leveraged’, ‘management’ or ‘owners’ provide information about the method of financing, the cause of the transaction or about the acquirer of the company.⁷ Often a clear classification of the type of buyout is not possible as two or more specifications exist. A management buyout for example can additionally be a leveraged buyout and is therefore called leveraged management buyout (LMBO).

A buyout can also be seen as a special form of financing. Regarding the life cycle of the business this means that buyout companies are mostly found in the later stage of corporate financing as can be seen in Fig. 2. The target companies are therefore usually mature and established businesses and are able to provide a positive and stable cash flow and profit.⁸ The importance of this will be discussed in 3.1.2.

illustration not visible in this excerpt

Fig. 2 Buyouts in the life cycle of a company⁹

Regarding the acquisition of a company there exist two possibilities: the asset deal and the share deal. In the course of an asset deal the acquirer purchases all assets and liabilities of the target company. If the purchase price excels the difference of those, the exceeding amount is disclosed as goodwill and can be amortised within the scope of a goodwill amortisation.¹⁰ It is necessary, that all essential items of property are transferred. A share deal describes the purchase of the majority of shares with voting power. Therefore at least 50% of the capital interest have to be acquired. Whereas in an asset deal the ownership of the assets changes, the proprietary circumstances stay unchanged in a share deal. As a goodwill amortisation is not possible in a share deal, buyouts are normally structured as asset deals.¹¹

2.2 Types of buyouts

2.2.1 MBO

A management buyout (MBO) is the acquisition of a company through the existing management. The management team takes over the majority or at least a significant part of the shares of the business and thereby becomes joint owner, either with or without the help of an exterior financial investor. Especially in buyouts with great value the involvement of the management team declines as the managers are personally not able to provide a high share of the large buyout value. It is not clearly fixable how high the involvement of the management in the buyout has to be for the transaction to be characterised as MBO. Corresponding literature¹² mentions a significant participation but does however not agree on an exact percentage of involvement in the transaction.

Managers of a MBO have to fulfil a series of preconditions. The most important ones to mention are “experience and competence, motivation, commitment and drive, range of functional skills, trust and reliability, and vision and judgement”.¹³

The investment of the management again is also an important issue for the involved private equity firm. The personal financial risk of the managers enhances their motivation which is one advantage of the MBO.¹⁴ Other benefits result from the management being acquainted with the business, the market and the company’s products. Additionally employees know and trust their bosses and therefore easily accept them as new owners.¹⁵

2.2.2 MBI

In contrast to the MBO the management buyin (MBI) is characterised by the acquisition of a company through an external management that generally has a similar industry background.¹⁶ Just as with the MBO this can happen with or without the help of a financial investor. It is especially applied to companies with an inefficient existing management. The involvement of an exterior management can bring certain advantages. The new team might observe existing problems from another perspective and bring different approaches as solution. On the other hand it faces various problems such as lacking acceptance from the side of the employees, having insufficient knowledge about the in-company structure and of course being unaware of the product and market situation of the company.

2.2.3 BIMBO

The problems of a MBI described in 2.2.2 can be mitigated by assembling the new team of members from the existing management and of new exterior managers. This type of buyout is called buy-in management buyout (BIMBO).¹⁷ Thereby the advantages of a MBO and a MBI can be combined.

2.2.4 OBO

The term OBO stands for owner buyout. In the course of an OBO the owner transfers shares of the business to an acquiring company that he has a stake in. Thereby the proprietary is motivated to give up control over the buyout business as he is participating in the success of the company anyway through his share in the acquiring company which can be a majority or minority holding. In the case of a minority stake the holder gives up control over the buyout company. The majority holder can realise the current market value of his/her company and still stay majority owner.¹⁸

2.2.5 EBO

In the course of an employee buyout (EBO) the employees take over shares of the company. Possible motivations for an EBO are reorganisations of a company or defense against hostile takeovers.¹⁹ Employees are given a majority of the company’s shares for example in return for “wage, benefit and work rule concessions”.²⁰ The stock can then “be distributed through an employee stock ownership plan (ESOP)”.²¹ An ESOP is an agreement that allows employees to buy shares of the company they work with for a lower price than the market price.²² One disadvantage to mention is the missing managerial experience of employees that can however be mitigated by involving the existing management in the buyout which is then called management and employee buyout (MEBO).

2.2.6 IBO

With the success of the buyout market, very high funds became available to the buyout companies. Out of this possibility the institutional buyout (IBO) developed.²³ “Vendors learnt to take greater control of the buyout process, sometimes to the extent of excluding management from early discussions and dealing directly with potential acquisition funders.”²⁴ The transactions are “created and led by investors, with senior management (either the incumbent team or new directors) motivated by salaries, bonuses and options”.²⁵

illustration not visible in this excerpt

Fig. 3 gives an overview of the different buyout types and their possible combination²⁶.

2.3 Motivations for buyouts

2.3.1 Succession problems

One important source for target buyout companies are family businesses that have succession problems either because they lack a successor or because of him/her being unqualified. Another reason could be missing interest of the heir in the continuation of the familiy business.²⁷ In most cases the sale to a competitor should be excluded. The family wants to maintain the business name and secure ongoing business operations. Additionally employees’ jobs should be protected and supplier and customer relations be obtained.²⁸ A buyout is in most cases a suitable solution to those problems.

2.3.2 Spin-off

In a spin-off parts of the holding company are split off and transformed into an independent company. Motivations for spin-offs are among others the disposal of financial risk or the need for liquidity. The most important reason however is a reorientation of the company to its core competencies.²⁹ Business sections that can not be defined as core business should be sold.³⁰ High spin-off potential can be found in the areas of purchasing, electronic data processing (EDP), logistics, market research and public relations (PR) as well as in research and development (R&D). One characteristic trait of the spin-off is the independence of the formerly dependent management which is however in the case of high debt essentially limited through the investors.³¹

2.3.3 Turnaround

A turnaround describes the recapitalisation of a company through restructuring measures. Capital is provided by selling business units, for example to the incumbent management. The difference to a spin-off lies in the profitability of the respective unit. If the business unit is profitable one can speak of a spin-off whereas the sale of an unprofitable unit is called turnaround.³² Compared to a liquidation the turnaround as well as the disposal to another participant provides the advantage of avoiding an image loss or having to sell assets below book value.³³

2.3.4 Going-private

In a going-private transaction the management purchases all shares of a publicly quoted company normally with the help of debt and equity investors. The former shareholders are motivated with high bonuses to sell their shares.³⁴ Those transactions are also called “public to private” (P2P) or “take private”.³⁵ Several reasons can be mentioned for going-private. A company could be exposed to a hostile takeover in case it is undervalued at the capital market. If a restructuring is necessary that requires high capital intensity the low market capitalisation makes it difficult to raise further funds. Private equity investors will only be interested in providing financial support after the going-private transaction.³⁶ Further arguments for a delisting of the company are lower financial expenditures through reduced administrative effort³⁷ or a better performance of the business with the support of a private equity investor.³⁸

2.3.5 Privatisation

Privatisation describes the sale of a formerly state owned business to the management and to private investors.³⁹ The goal is to realise profits that otherwise would not have been able to be generated. It is assumed that the company is being controlled and restructured more thoroughly by its new owners (the management and the investors).⁴⁰ Two initial situations can be distinguished. If the business belongs to a market-economy system the goal is to relieve the public budget and raise welfare. In a planned economy privatisations can be used as a tool in implementing the transformation to a market-economy.⁴¹

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¹ Incisive Financial Publishing (2006), p. 6.

² Incisive Financial Publishing (2006), p. 6.

³ Incisive Financial Publishing (2006), p. 6.

⁴ Source: Incisive Financial Publishing (2006), p. 7.

⁵ See Incisive Financial Publishing (2006), p. 9.

⁶ See Incisive Financial Publishing (2006), p. 9.

⁷ See Kitzmann (2005), p. 8.

⁸ See Achleitner (1999), p. 565.

⁹ Based on Kraft (2001), p. 45; Schefczyk (2000), p. 24; Pümpin / Prange (1991), p. 83 ff cited in Achleitner /Fingerle (2003), p. 6.

¹⁰ See Becker (2000), p.67.

¹¹ See Becker (2000), p.67.

¹² See Jakoby (2000), pp. 18 - 19; Becker (2000), p. 58.

¹³ Sharp (2003), p. 19.

¹⁴ See Knetsch et al. (2000), p. 25.

¹⁵ See Knetsch et al. (2000), p. 6.

¹⁶ See Achleitner / Fingerle (2003), p. 8.

¹⁷ See Achleitner / Fingerle (2003), p. 8.

¹⁸ See Becker (2000), p. 11.

¹⁹ See Becker (2000), p. 11.

²⁰ Gilson (2001), p. 457.

²¹ Gilson (2001), p. 457.

²² See Becker (2000), pp. 150 - 151.

²³ See Sharp (2003), p. 4.

²⁴ Sharp (2003), p. 5.

²⁵ Sharp (2003), p. 4.

²⁶ Based on Jakoby (2000), p. 26.

²⁷ See Becker (2000), p. 21.

²⁸ See Becker (2000), p. 21.

²⁹ See Hoffmann / Ramke (1992), p. 40.

³⁰ See Becker (2000), p. 21.

³¹ See Hoffmann / Ramke (1992), p. 28.

³² See Jakoby (2000), pp.42 - 43.

³³ See Jakoby (2000), pp.43 - 44.

³⁴ See Achleitner / Fingerle (2003), p. 10.

³⁵ Sharp (2003), p. 4.

³⁶ See Becker (2000), p. 69.

³⁷ See Becker (2000), p. 69.

³⁸ See Sharp (2003), p. 10.

³⁹ See Achleitner / Fingerle (2003), p. 10.

⁴⁰ See Kitzmann (2005), p. 19.

⁴¹ See Achleitner / Fingerle (2003), p. 10.