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Management buy-outs - a marriage of inconvenience?

The management team is absolutely critical to the success or failure of a management buy-out, argues Andrew Rothery of GS Private Equity in this question-and-answer session. Rothery discusses the difficulties involved in evaluating the management team and the crucial factors needed for a management team to be successful in partnership with a private equity firm.

Up until recently Australian management has largely resisted following in the footsteps of their US and European counterparts participation in Management Buy Outs (“MBO's”).  However, over the last few months we have seen an increased level of interest with the bid for Ansett by a management syndicate, the completed MBO's of Edwards Dunlop Paper, Automotive Components Group (formerly the automotive components distribution business of Pacific Dunlop) and Bradken, and the recent announcement that a private equity firm had been selected as the preferred bidder for the Pacific Brands division of Pacific Dunlop.  

Many managers are often excited by the prospect of owning a piece of their own business. MBO's are seen as a means of stepping off the corporate treadmill and taking the reins of your own fortunes.  However, in the rush for what many see as guaranteed riches, both financiers and managers alike continually focus on “doing the deal”. Consequently, although the evaluation of the management team is often touted as the critical component in any MBO due diligence process, there is still a bias towards the arguably easier financial and operational aspects of a transaction.  As a result all too often stakeholders do not really understand who they are walking down the aisle with!

EZI: Andrew, when the wheels fall of an MBO deal what would you say is the principal reason?

Andrew Rothery: Business specific issues aside, it's the compression of timeframes in MBO's, which tend to cause the greatest problems. When we take on a transaction we try to layout our objectives as clearly and succinctly as possible.  As venture capitalists we are not into making investments with infinite time horizons.  We have a defined investment horizon, typically four to five years, after which we expect to have an exit.  Within that timeframe we also look to achieve internal rates of return in the order of 25 per cent pa.  Our ability to exit is a function of the management team's ability to implement key strategies within the desired timeframe. If performance falters exit becomes less likely and, consequently, the tension around the Board table starts to increase.

EZI: Obviously everybody goes into these deals with the best intentions and a great deal of optimism.  But, clearly the extent to which you can mitigate the possibility of the management team under-performing the more likely the MBO will succeed.  Typically what steps do you take to ensure that you have a management team that can perform to your expectations?

Andrew Rothery: The evaluation of the management team is a critical component of the due diligence investigations, if not the most critical component.  We look at the track records of the team and the individual team members.  We spend as much time as we can with the team, probing as much as we can.  This is done formally - in meetings and in writing - and informally - we try to ‘break bread' with the individuals and to really understand what makes them tick. And we do whatever reference checking we can.  Unlike some of our colleagues in the venture capital industry, we don't go as far as getting psychological profiles of the managers prepared.

EZI: What more do you think could be done to ensure that you have a management team with the “right stuff”?

Andrew Rothery: We are starting to use firms like EZI to help us in the management evaluation process.  After all, organisations like your own do evaluations of managers day in, day out.  To be frank, we don't have the skills to drill down as deep as you do, and often we just don't have the time.  The work which is done for us in this regard doesn't supplant what we do ourselves, but it is extremely complementary.  It really helps us to triangulate issues with the management team.

  Just as importantly, using an EZI in this process gives us a flying start if we need to source a replacement manager or to plug a hole in the management team.  The search firm's resulting familiarity with the business, the existing team and the skills sought saves much time and ensures that there is a clear understanding of the recruitment task.

EZI: On most occasions venture capitalists fund the incumbent corporate executive team. Is it often a case of “fish out of water”?  It would appear that the challenges faced by management in an MBO are significantly different from a corporate environment. What would you say are the major issues facing the management team?

Andrew Rothery: I think there are three major issues.  First, for many teams the MBO represents the first time they have flown solo - without the support of the corporate centre.  We find some managers just can't survive without the support of a big head office infrastructure.  Second, managers of bought out businesses are subject to the shareholders' exit imperative.  They need to do all that needs to be done to get the business exit-ready within, say, three to four years, often with the associated pressures flowing from a highly leveraged balance sheet.  Third, they need to understand that cash really is king and act accordingly.

EZI: What implications does this have for the definition of critical managerial competencies?

Andrew Rothery: Executives within an MBO team must be able to demonstrate a strong track record of managing to plan, or at least remaining in control of situations. That means that they have to be able to hit their revenue and profit targets consistently.  If there are good reasons why the path towards the targets selected at the beginning of a period is no longer an appropriate path to take, they need to have the nous and flexibility to find and switch to another path. Financial competence is also very important.  We have found that most Australian managers are good at managing their profit and loss accounts.  Those managers that can also manage a balance sheet are a rarer breed. MBOs are all about leverage. Managing the working capital position is one aspect of managing the balance sheet. Fixed asset turn is another. If the management team is not cognisant of  the need to manage the balance sheet as well as the P&L then they will likely be destroying value in the deal.

EZI: It would appear that your priorities are focussed on medium term objectives and that the longer term strategic direction and growth are secondary considerations. Is this correct?

Andrew Rothery: On the contrary. To achieve targeted returns the management team must grow the enterprise value of their business. It is simply not enough to maintain the status quo and pay down the debt. To really make these transactions work we need a business with strong cash-flow and good growth prospects. From a management perspective the team must comprise executives who are able to articulate a clear strategic vision and have a demonstrable business development track record.

  People often seem to overlook the fact that the management shareholders and ourselves realise value though an exit - an IPO or sale of the business.  That means that, at exit, we need to present to the world a business to which people will ascribe a price that exceeds the price we paid.  Simply de-gearing the business while we own it will provide some return on our investment; but our investors expect us to be able to do better than simply abitraging the costs of equity and debt.

EZI: It sounds like you want Superman. Certainly more than a corporate General Manager of a business unit. What would you say are the missing elements?

Andrew Rothery: Actually, we don't need Superman ,although I'll take him if he's available!  But there is a base level of competence and energy we do insist on. Obviously there are some very competent business unit managers who have managed business units on a growing, profitable basis.  This has required not just good strategic vision and business development credentials, but also sound financial and operational discipline. Unfortunately life as an MBO executive is a brave new world and it would seem that business unit managers on the whole often lack three distinguishing competencies. First, there needs to be an ability to manage a standalone business unit. As I've already said, once an MBO transaction is completed, the entity can no longer rely on support from the parent. In many respects the MBO executive team must operate in a resource constrained environment compared to what they're used to, from day one. In our experience this is a significant paradigm shift. Second, although the management team will have an equity stake it will often have to manage on the basis of the agendas of one or a few institutional shareholders. No longer will the managers be able to hide behind a corporate veil. They will be very much front and centre. Management of key stakeholders, particularly if the MBO is not performing, can be a demanding and diverting activity for the uninitiated.  Finally, time. From the minute the contract of sale is executed time is of the essence and will continue to be until the exit.  Unlike a business unit manager, the executive of a bought out business cannot afford to step off the critical path as this will likely adversely affect the value of the asset. Strong, consistent, reliable results delivered on time ultimately drive the value of the transaction.

EZI: What sought of things would you expect to see a good MBO management team doing?

Andrew Rothery: From the time the sale and purchase agreement has been executed I would want to see management exhibiting behaviour that reinforces the view that the business is now, at least in part, their business.   I would want to see each of the members of the management team acting like an owner - reviewing the value to be extracted from every dollar spent in the business and constantly evaluating management decisions against the criterion of will this help or hinder a successful exit?

EZI: It would also appear that the challenges facing the Board of Directors is also different from that of a publicly listed company.

Andrew Rothery: Absolutely. Unlike a public company an MBO transaction typically has a smaller number of influential shareholders. Public companies tend to have longer investment time horizons and more capital to absorb cyclical ups and downs. Directors on an MBO Board must still have a strategic focus, but they must also provide appropriate governance realising the relative resource constraints of the business and being aware and sensitive of the views of the shareholders.  In a bought out business the lines dividing the board meeting and a shareholders' meeting are often blurred.

  The non-executive directors must also realise that they might only be there for four or five years.  The board of a bought out business will invariably be reconstructed as part of the exit.

EZI: What then does that say about the required competencies of non-executive directors of MBO transactions?

Andrew Rothery: Without doubt, many public directors bring a wealth of experience to these types of transaction. But, critically, non-executive directors must have experience in managing alliances and small numbers of stakeholder groups in businesses that are independent and resource constrained to achieve set growth and profitability objectives within a defined period of time.

EZI: Perhaps individuals with experience in managing joint ventures or alliances where there are a few significant shareholders would be more appropriate in certain instances.

Andrew Rothery: Quite possibly.

EZI: You have spoken a lot about management and the Board of an MBO. It strikes me, however, that vendor organisations in their haste to dump non-core assets are not contributing to the success of the MBO to the extent that they could. Do you believe there is value in companies contemplating the spin off of non-core assets investing more time in the formation of the executive of the entity? Would this not further aid the sale process and possibly improve the value and quality of the asset?
 
Andrew Rothery: Absolutely. Vendors contemplating selling to venture capitalists like ourselves should be more pro-active in managing the business out of their portfolio and as part of that process they should be calling on their advisers to actively review the calibre of the top management team and identify potential Board members.

EZI: In other words, the vendor could present the market with a readymade MBO?

Andrew Rothery: Exactly.  We've seen a few vendors do just that.  They know that this is a good way to maximise both the probability of completing the sale and the sale price.

EZI: Andrew, thank you for taking the time to talk to me.

GS Private Equity is one of Australia's leading private equity investment houses with $295 million in funds under management and the longest track record of any leveraged buyout manager in Australia.

Andrew Rothery is a pioneer of the MBO market in Australia, an experienced company director, and a management consultant and lawyer by professional background.

GS Private Equity is one of Australia's leading private equity investment houses with $295 million in funds under management and the longest track record of any leveraged buyout manager in Australia. For further information please visit www.gsprivateequity.com.au.

Andrew Rothery is a pioneer of the MBO market in Australia, an experienced company director, and a management consultant and lawyer by professional background.