Critical Success Factors For Buy-Outs

Table of content

Executive Summary

1. Introduction

2. Literature Review
2.1 Definition and Background of individual Buy-Out forms
2.1.1 Management Buy-Out (MBO)
2.1.2 Management Buy-In (MBI)
2.1.3 Leveraged Buy-Out (LBO)
2.1.4 Buy-In-Management-Buy-Out (BIMBO)
2.1.5 Employee-Buy-Out (EBO)
2.2 The Buy-Out Market in the UK and Europe
2.3 Buy-Out Investments in Germany

3. Structure and Substantial Elements of a Buy-Out
3.1 The Process of a Buy-Out Transaction
3.2 Elements of the Financing Structure

4. Critical Success Factors
4.1 Checklist for Success
4.1.1 Most Important Success Factors for the Management
4.1.2 Most Important Success Factors for the Financial Investor
4.2 Key Success Factors
4.2.1 Well-balanced and Experienced Management Team
4.2.2 Balanced Financing of the Buy-Out
4.2.3 Agreement in Negotiations and Aims
4.2.4 Equity Participation of the Management

5. Conclusions and Outlook

Bibliography

Appendix

6. Case Study Analysis: Management Buy-Out
6.1. Starting Position
6.1.1. Company Profile: VITALIS Ltd
6.1.2. Equity Situation
6.1.3. The Management Team
6.2. The Buy-Out Transaction
6.2.1. Selling and Delisting
6.2.2. Selection of Investors
6.3 Determination of Purchase Price
6.3.1. Evaluation via Capital Market
6.3.2. Discounted Cash Flow approach (DCF)
6.3.3. EV/EBIT Multiple
6.4. Transaction Structure
6.4.1. Foundation of “Single Purpose Company”
6.4.2. Share-Deal

7. Areas of Application for Buy-Outs
7.1 Entrepreneurship, Start-ups and Exit Strategies
7.2 Succession Planning in Medium-sized and Family Businesses

Executive Summary

This dissertation calls attention to critical success factors for Buy-Outs and reveals why they are currently one of the most interesting financing forms. Subsequently, the main objective is the testing of theoretical arguments from the literature review in practice. For this purpose the case study analysis (see appendix) for the Management Buy-Out of VITALIS Ltd. was developed. As a result “the checklist for success” combines both theoretical (literature review) and practical (case study analysis) success factors for Buy-Outs.

At first different Buy-Out forms were analysed. Thereby Management Buy-Out (MBO) and Leveraged Buy-Out (LBO) proved as the most used types due to the fact that the internal management possesses comprehensive knowledge and understanding of the business model. In contrast a Management Buy-In (MBI) carries much higher risk and is applied predominantly with medium-sized and family businesses. However all Buy-Out forms have in common an advanced financial structure risk and the need of financial investors.

The development of the Buy-Out market in the UK as well as in Europe showed extensive growth. In 2005 the transaction volume in the European Buy-Out market exceeded for the first time the sum of 100 billion . In Germany the record number of 82 Buy-Out transactions was executed. Most important reason for this was a strongly increased number of small and medium-sized businesses as well as sales of family businesses.

After an overview of the relevant Buy-Out market was attained, the complete Buy-Out process and its financing structure were analysed. The Buy-Out process can be subdivided into five stages and takes approximately between six and nine months. Especially the participation model, Due Diligence and the final contractual agreement are crucial for the success of the transaction. Apart from the classical bank credit equity capital of the management, venture capital and Mezzanine financing structures are most used.

Furthermore it was discovered that companies after Buy-Out and owner changes develop better on the average than comparable companies without Buy-Outs. The reason for this outperformance can be seen in an acceleration of market entry, faster implementation of distribution networks and the acquisition of already existing know-how and brand image. For medium-sized and family businesses the finding of the right successor for future leadership of a business displays more and more a critical success factor. Their probability of survival is affected considerably by success regulations. The financial investor can not only bring in capital but also valuable know-how by means of advisers and network contacts.

In the main part the critical success factors for management and financial investor resulting in the “checklist for success” were summarised theoretically and practically:

Theoretically according to a recent study the largest risks (why MBOs are failing) are high outside financing of the deal, unrealistic relation of equity to debt capital for the financing of the purchase price and an inexperienced management.

Practically the key success factors for the MBO of VITALIS Ltd. included an experienced management team, a business with solid cash flow generation and agreement in negotiations and aims as well as a balanced financing structure.

In the case study analysis of VITALIS Ltd. the quality of the management with the right mix of management skills proved as the most crucial factor. The management team of VITALIS Ltd. included various skills and provided a track record in the business. Moreover a balanced financing structure appeared as fundamental important both to the short-term and long-term success of the Buy-Out. As a result a “win-win scenario” between financial investor and management could be achieved. Hence, it could be ensured that a realistic purchase price was paid.

A complementary agreement between the different parties on the outcome appeared also as highly relevant. In this context it was important to have detailed discussions about the future governance of the company before signing the contract.

Finally the equity participation of the management proved as critical for success due to the fact that it outlined the equity structure for the transaction. In the case of VITALIS Ltd. the equity participation of the management was with 40% relatively high.

Last but not least it is advisable that participating investors and former owners are clearly focused on the right timing of their exit strategy.

1. Introduction

It is a desire of many managers to lead a company not on behalf of others, but as an independent manager and owner. A Buy-Out can make this possible. It is usually an exciting, once-in-a-lifetime opportunity for managers to own a significant stake in their business. Thereby they can work as entrepreneurs on own risk and make substantial decisions personally. However it can also be a major distraction, because managers must resolve many important issues regarding the structure of the transaction and the raising of funds, while attending to the normal running of the business.

The main objective of this work is to obtain a comprehensive overview of theoretical (literature review) and practical (case study analysis) success factors for Buy-Outs. In the first part different Buy-Out forms are defined and distinguished from each other regarding their special features. Afterwards the recent development of Buy-Out financings in the UK and in Europe is analysed, whereby the main focus is on the German market. The second part is concerned with the structure and substantial elements of a Buy-Out. Here the process and the elements of the financing structure as well as the involved persons and their motives are highlighted.

The third and main part summarises the critical success factors for management and financial investor using a “checklist for success”. Hereupon the results from the case study analysis of VITALIS Ltd. are presented containing the four key success factors for their Management Buy-Out. In the appendix the informative case study for the Management BuyOut of VITALIS Ltd. is included entirely.

2. Literature Review

A literature review has been done to identify the recent development for Buy-Outs. At first an extensive amount of literature research about different types of Buy-Outs was conducted. Especially the Centre For Management Buy-Out Research (CMBOR) and the German Venture Capital Association (BVK) were most helpful in getting the newest information about the Buy-Out market as well as the different stages of the transaction process. Additionally, different journals about Private Equity and Venture Capital have been reviewed.

However, first of all it is necessary to define different Buy-Out forms and provide some additional background information about their special features.

2.1 Definition and Background of individual Buy-Out forms

2.1.1 Management Buy-Out (MBO)

A Management Buy-Out (MBO) is the takeover of the whole or a part of a company by the existing management. The former owners are quasi "bought out". The acquisition of the shares and the financing of the purchase price take place usually in co-operation with financial investors. Among these rank venture capital companies, which publish investment funds, in those banks, insurance companies or foundations participate. The moneys of these Buy-Out funds are then invested in the participation in companies. The investment companies aim at annual average interest charges of the funds of 20 to 35% and a transfer of the company (“exit”) at the end of the holding period. (Constantin/Rau, 2002)

The advantage of a MBO consists in the comprehensive knowledge and the understanding of the business model by the internal management. On the other hand this is very rarely in the position to acquire the necessary money by itself or to secure classical bank credits. Therefore it is necessary to look for an investor both with the necessary capital and with industry expertise assessment and/or support in the management. MBOs are usually not only applied within medium-sized enterprises but also play an increasing role within the decartelization of large concerns and the separation of uninteresting business segments.

2.1.2 Management Buy-In (MBI)

A Management Buy-In (MBI) is to be understood as the takeover of a company by an external management, which "buys in" a company. Here the shares are acquired with the assistance of financial investors as well. However various risks can occur with a MBI, which result from lacking internal knowledge, false estimations (e.g. of the earnings) as well as problems of acceptance in the company itself. In comparison a MBI carries much higher risk than a MBO, because the prospective management team has less familiarity with the business. The MBI is used primarily with small and medium-sized businesses.

Basically the high danger of insolvency due to an advanced financial structure risk and the cohesion of the management can be estimated as critical within both MBOs and MBIs.

The two instruments, MBO and MBI, are used apart from privatisation purposes on the one hand for follow-up regulations with family businesses and on the other hand for the strategic reorientation of strongly diversified companies. Consequently, a concentration on the core competences can be achieved, since strategically irrelevant or business segments with losses can be sold and sorted out. From the view of the management the way into entrepreneurial independence becomes realisable with the help of these instruments.

2.1.3 Leveraged Buy-Out (LBO)

With a Leveraged-Buy-Out (LBO) the far outweighing part of the transaction is financed with debt capital. Thus develop Leverage-effects, which affect to a considerable degree the return on equity. (Kasperzak, 2001) With good earnings the return on equity rises due to the high portion of outside financing.

However bad result situation and substandard increase in value enhancement lead to the “Leverage risk” (Huydts, 1992, 73), since then the costs of debt cannot be covered any longer. The Buy-Out can be characterised as a LBO, if the portion of debt capital amounts to at least 70% of the total financing volume.

In order to be able to pay back these liabilities in many cases the following strategy is used: “Sell off some of the firm’s assets to reduce the debt and then rely on the firm’s free cash flow to pay down the remaining debt”. (Bygrave, 1997, 430)

For this reason it can be recommended to expand the amount of equity after the end of the transaction as fast and as far as possible in order to maximise both the absolute and relative yield. (Boxberg, 1991)

2.1.4 Buy-In-Management-Buy-Out (BIMBO)

The Buy-In-Management-Buy-Out (BIMBO) represents a combination of a MBI (external management) and a MBO (existing management). At the beginning the external management buys shares in a business and continues this together with the former management. With a BIMBO a completion of the internal management (MBO-manager) may take place via an external manager (MBI-manager), who is experienced with integrations. As a result the BIMBO often has clear advantages compared with a pure MBI. (Dunne/Boden, 2000)

A large risk is however that inappropriate external managers are participated in the property of the company and it is extremely difficult to remove them later. In principle a BIMBO tries to connect the advantages of a MBI with those of a MBO and avoid their disadvantages. Due to the weaker development and higher error rate of MBIs compared with MBOs these are more and more replaced by such “hybrid” BIMBOs.

2.1.5 Employee-Buy-Out (EBO)

A further special form for a Buy-Out is the Employee-Buy-Out (EBO). With an EBO, apart from the management, the employees acquire a large portion of the company. This form of business takeover is rather rare in practice, since financial investors and banks support an EBO due to unclear shareholders only in certain cases.

In past times this approach was used primarily for the defence of hostile takeovers. Today an Employee-Buy-Out is applied within cases of reorganisation and insolvency of small and medium-sized businesses.

The subject of the next section is concerned with the recent development of Buy-Out financings in the UK and predominantly in Germany.

2.2 The Buy-Out Market in the UK and Europe

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Illustration 1: Evolution of European Buy-Outs By Number of Deals (EVCA, 2005)

The development of the Buy-Out market in the UK as well as in Europe (see illustration 1) has been watched from September 2005 until April 2006 to identify potential changes. As a consequence examples for Buy-Outs could be examined for the case study analysis. For this purpose please refer to chapter 4 and the case study of VITALIS Ltd. in the appendix.

The Buy-Out market in the UK showed extensive growth for seven years up until 2000, but after 2000 the market value fell. However, in 2005 the total value increased again to £23,5 billion. (CMBOR, 2006)

In the rest of Europe Buy-Outs have become more prominent and the total value of European Buy-Outs has pulled ahead of the UK. In 2005 the transaction volume in the European Buy-Out market exceeded for the first time the sum of 100 billion . (Bridgepoint, 2006) Medium-sized businesses with sales of family businesses dominated the Buy-Out activities 2005 enormously with an increase of 17 per cent. (Handelsblatt, 2006) Germany was Europe's market leader in terms of value reaching 26.9 billion by the end of 2004. (EVCA, 2005)

2.3 Buy-Out Investments in Germany

Clear structural changes since the beginning of the 90’s (see illustration 2) are reflected in three general trends: The early stage segment (Seed and Start-up capital) registered first excessive growth during the high-tech euphoria up to the year 2000, in order to realise thereafter equally strong losses.

In contrast Buy-Out financings dominate the investments with clearly rising portion since the year 2001. With the increase of LBOs after the year 2001 the portion of Buy-Outs at the entire participation market grew at the same time. In 2004 it reached with a portion of 71,3 % of the entire investments a record value. In 2005 from the total investments at a value of 3,039.6 millions the majority with 1,767.9 millions flowed into Buy-Outs. For clarification please refer to illustration 2.

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Illustration 2: Long-term Development of Financing Stages ‘93-‘05 in Germany (BVK, 2006)

The portion of MBIs and above all smaller MBOs decreased slightly at the end of the 90's, but large LBOs increased both in terms of figures and transaction volumes. In 2005 nearly three quarter (approximately 1.5 billion ) of all Buy-Out investments accounted for LBOs,

who gained increasingly in importance since the year 2000. For further details please see illustration 3.

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Illustration 3: Development of Buy-out Investments in Germany in Mio. EUR (BVK, 2006)

Although the investment volume of Buy-Outs declined 2005 in relation to the record year 2004 from 2.686,4 million to 1.767,9 million , their number rose clearly. (BVK, 2006) Most important reason for this was a smaller number of large transactions, which is faced by a strongly increased number of small and medium-sized transactions. This is clarified by the record number of 82 Buy-Out transactions in 2005, after 60 in 2004 and 50 in 2003. (Initiative Europe, 2005) This means an increase of 38% in relation to 2004. Thus it can be characterised as a record year for the private equity market.

In addition transactions between financial investors (Secondary Buy-Outs) received attention currently. Secondary Buy-Outs of companies like Grohe and ATU with a total transaction volume of 2,7 billion in 2004 (Matter, 2005) are ever more preferred by many investors than IPOs as an exit channel.

In international comparison the German Buy-Out market is in the top group behind the established participation markets of the USA and the UK. Thus in the year 2004 European Buy-Outs were equipped with approximately $74 billion debt capital as well as $11 billion Mezzanine capital. (EVCJ, 2004)

After an overview of the relevant Buy-Out market was attained, in the next step financing structure and substantial elements are analysed.

3. Structure and Substantial Elements of a Buy-Out

3.1. The Process of a Buy-Out Transaction

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Illustration 4: Buy-Out Stages (Own graphic)

The first impulse for a Buy-Out usually comes from the former owners. These intend to sell their ownership and evaluate strategies, which make a selling price as attractive as possible for them. Beyond that they try to accomplish the owner change without larger effects on the company and take up discussions with the management in order to develop conceivable scenarios. At the time of the discussions between former owners and management advisors are called in, who support the managers with the search for potential investors, which take over project co-ordination and advise the management with tax-based as well as operational questions. (Smith, 1997)

In the second phase the evaluation of the company via the external advisors takes place as well as a debate about possible participation structures. These structures are determined on the basis of individual preferences of seller and buyer, but however not specified finally. At the same time several financial investors introduce themselves to the management, present their suggestions for a possible structure as well as the range for the purchase price, which appears realistic for them. These financial investors step up again to their banks in order to make a financing of the purchase price possible. Beyond that the banks examine to what extent they can pass on parts of the credit amount, which they want to make available for the Buy-Out, to further banks or the capital market.

After conclusion of the presentations the management and its advisors evaluate in the third stage the individual offers and select a financial investor, with whom they submit the Letter- of-Intent to the former owners for the acquisition of the shares. (Constantin/Rau, 2002)

Now in the fourth phase the examination of the goal company takes place in the context of the Due Diligence.

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