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Are You Management Buyout Material?

Five questions to ask yourself before you take the plunge.
Craig Schneider, CFO.com | US
February 15, 2001

It looks like the climate is improving for management buyouts.

In the past couple of weeks alone, Xerox Corp. reportedly has met with at least three leveraged buyout (LBO) firms to discuss the disposal of certain assets as it attempts to raise as much as $4 billion to reduce its debt load.

And Halliburton Co. sold its Dresser Equipment Group subsidiary for about $1.55 billion in cash and assumed debt to a group that includes First Reserve Corp., Odyssey Investment Partners and Dresser senior management.

Many pros now expect the Federal Reserve's one percentage point rate cut in January to loosen credit and help jumpstart buyout activity.

"As this economy cools down, more and more companies are evaluating internal operations, and I think we're going to see more and more offerings of operating units that they want to dispose of," says Michael Weiss, chairman of the corporate practice group for Pittsburgh- based Doepken, Keevican, and Weiss.

"I suspect over the next 12 to 18 months there's going to be a loosening of credit," he adds. "We expect as a result to see an increase in leveraged buyout activity and management buyouts."

Last year, buyout firms participated in 283 deals worth approximately $39 billion worth of controlled transactions (the firm acquiring at least 50 percent of the company), according to Buyouts, a New York City-based newsletter. That's a big drop from the $63 billion in deals during the prior year.

And the "moribund debt markets" were cited as the "big sticking point" for LBOs in CFO Magazine's November article, Private Dreams.

Is the environment for buyouts finally changing? To a degree, yes.

Thanks to the Federal Reserve's full basis-point rate cut, the junk bond market is coming back to life -- albeit with a faint pulse.

On the other hand, some experts are arguing that senior bank debt remains pretty scarce and uncertainty over the economy's prospects still makes it a difficult environment to engineer buyouts.

Certainly, the private equity sector has the dough to back management that wants to do an MBO. There's about $200 billion in private equity on the sidelines, estimates Greg Peterson, partner at PricewaterhouseCoopers' private equity transaction services.

Typically, MBOs work best for companies in non-cyclical businesses with plenty of cash-flow-rich operations and a pint-sized p/e ratio. If subsidiaries are being spun off as an MBO, they are typically non-core assets of the parent, as is the case with Dresser and Halliburton.

"Over half the companies in the S&P are trading off their all-time highs for over 12 months," says Scott Sperling, managing director at Thomas H. Lee Co., the Boston-based buyout firm that led the management buyout at Snapple, which resulted in more than $100 million in personal gains for each of the beverage company's founders. "And that makes for an interesting base of opportunity for a firm like ours."

Sperling says the firm focuses on buying out middle-market growth companies in the range of $500 million to $6 billion of enterprise value that are growing faster than the GDP and have good management teams.

As the Snapple deal starkly showed, top executives can reap huge gains from participating in MBOs.

In the Dresser deal, participating management is getting 5 percent to 10 percent of the diluted equity.

In a typical MBO, the company is taken private and built up over a 3-5- year period. Then, it is sold, taken public, or recapitalized, often resulting in a big payday for the company's top management and the buyout principals as well as limited partners of the buyout firm's fund, if there is one.

But not every management team has what it takes to participate in an MBO. "You have to run the operation pretty lean and mean," says PwC's Peterson. "If there are costs there that are discretionary, you typically have to take them out. Other management teams might struggle with the change in the culture that may prevail as a result."

If you are considering an MBO, here are five questions to consider before you proceed:

Your investment partners are not going to stand for any soft spots. "Be prepared when the auditors come out that you have everything laid out," advises Bill Decker, CFO at Westomont, Ill.-based Sysix Technologies. "A lot of my work was dealing with the auditors and their accountants and a lot of the due diligence." Last month, Decker, along with CEO John Sheaffer, led a management buyout and corporate restructuring of the $30 million e-business software provider.

In addition, management that has experience managing debt in the public markets has an advantage.

"There were a lot of times that we weren't sure the buyout was going to happen," says Sheaffer, adding that he and Decker approached about 40 different organizations to become an investment partner. "Eventually, you come down to a few investors and you either come together or fall apart in the details."

"Traditionally, you would have to do your going private deal at a minimum of a 30-to-40 percent premium to the 30-to-60 day trailing average of the stock price," says Rick Rickertsen, COO of Thayer Capital Partners, a Washington, D.C.-based private equity investment firm.


The equity sponsors are generally going to look for an internal rate of return of at least 25 percent, he adds.

The terms were very attractive for Chris Randles, chairman and CEO of MathSoft Engineering & Education Inc., who completed his management buyout on January 23. "If you put the equity investment and pool of options together, the management share would amount to about one-third of the stock of the company over a four-year period," he says.

Other than needing it to be efficient to manage debt, companies need capital to fund, say, acquisitions and plant expansion. The debt-to- equity ratio ranges from 1-to-1 to 2-to-1, far more equity than the 10- to-1 and above ratios that were common during the 1980s.

"We're looking to make money," says Sysix's Sheaffer. "The mindset at a lot of companies in the dot-com space was to have an exit strategy instead of a business plan. We're a 13-year old company in a growth mode."

MathSoft's Randles took a unusual, albeit backwards, route in his management-led buyout last month by signing with financial backers before presenting a funded offer to the parent company.

"It's kind of like getting all the mortgage financing in place prior to making an offer to buy a house," Randles says. While the commitment would have been inconvenient for either party to back out, it gave them a sense of each other before officially starting their relationship. He adds, "It was kind of a courting period."




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