Management Buyout (MBO)
Management buyout transaction is similar to leverage buyout. In Management Buyout the managers buy their company from its owners employing debt.
What is Management Buyout?
Management buyout transaction is similar to leverage buyout. In Management Buyout the managers buy their company from its owners employing debt. The debt typically ranges from 70 to 90% of the deal price. In this case Mangers purchase the asset and business operation they manage. They expect a potential return from the deal. They try to maximize their return by becoming owner of the business than employee. MBO is turned out to be favorable as the company is taken over by existing management team than selling it to outsider.
Risk associated with MBO
MBO is similar to LBO. In MBO external financing is required as managers will not have sufficient fund for complete takeover. MBO is associated with following risk.
Equity holder: As mostly finance by financier there will be restrictive covenants from financial institution point of view. These covenants can interfere in general activities of the new firm.
Debt holders: The debt holders bear the risk of default equated with higher leverage as well, but since they have the most senior claims on the assets of the company, they are likely to realize a partial, if not full, return on their investments, even in bankruptcy.
Return associated with Management Buyout
Managers go for MBO to increase in return. Managers expect high return by acquiring the firm and running it efficiently. As MBO is finance by financier, there is expected return of lender from the deal. A lender provides high leverage with anticipation that firm will fully utilize the potential of the business.
Lender perceived risk is lower than its expected return. Lender perceives that firm will have optimum return from this deal. Lender evaluates investment opportunities with by analyzing expected internal rates of return (IRRs), which measure returns on invested capital. IRRs represent the discount rate at which the net present value of cash flows is zero.
MBO Evaluation:
The evaluation technique in leverage buy out is same as other Mergers and acquisition technique. Discounted cash flow technique is used. There are certain steps involved in MBO evaluation.
Steps involved in Management Buyout:
- Estimation and projection of operating income; basically EBDITA to know the cash flow available for debt repayment.
- Determination capital structure with individual cost of capital.
- Calculation of Internal rate of return of firm
- Based on the above parameter valuation price can be determined.
Issues related to MBO:
- It can create conflict between managers of acquiring firm and the shareholders of the firm. The shareholders benefit will reduce if the deal is very attractive for managers. This gives rise to agency cost. It is the responsibility of board to protect the interest of shareholders and ensure that the deal offers fair value.
- Another issue is the price of the target company’s debt instruments. Debenture holder may demand return at par with ownership as majority of finance is being provided by them.
Management Buyout is applicable and favorable in those cases where owners wanted to retire from the business and managers are capable enough to take over the firm. This deal logically makes sense, as managers know in and out of the business operation of that particular entity.
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