Leverage Buyouts - Copy

8/4/2019 Leverage Buyouts - Copy

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Leverage Buyouts

Introduction

A leverage buyout (LBO) is the acquisition of a business, typically a mature company,by a financial investor.

The term Leveraged signifies a noteworthy use of debt for financing the transaction.

The purpose of a LBO is to allow an acquirer to make large acquisitions without having to

commit a significant amount of capital. A typical

transaction involves the setup of an acquisition

vehicle that is jointly funded by a financial investor

and management of the target company. Often the

assets of the target company are used as collateral for

the debt. Typically, the debt capital comprises of a

combination of highly structured debt instruments

including repayable bank facilities and / or publicly

or private placed bonds commonly referred to as

high-yield debt.

The term Buyout suggests the gain of control of a

majority of the target companys equity. The target company goes private after a LBO. It is

owned by a partnership of private investors who monitor performance and can act right away if

something goes awry. Again, the private ownership is not intended to be permanent. The most

successful LBOs go public again as soon as debt has been paid down sufficiently and

improvements in operating performance have been demonstrated by the target company.

What Does Leveraged Buyout -

LBOMean?

The acquisition of another company

using a significant amount of borrowed

money (bonds or loans) to meet thecost of acquisition. Often, the assets of

the company being acquired are used

as collateral for the loans in addition to

the assets of the acquiring company.

The purpose of leveraged buyouts is to

allow companies to make large

acquisitions without having to commit a

lot of capital.


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History of LBO

During the 1980s, leveraged buyouts (LBOs) worked like a machine gun firing bullets of junk bonds,

hitting one company after another on Wall Street. At one time, it looked as if the whole world would

soon become a playground for LBOs. But the collapse of junk bonds in the late 1980s silenced the

machine guns.

It took some years before the second wave of LBOs started hitting the shores of the financial market.

With the growth of private equity players in the mid-2000s, the US and the rest of the world saw the

second boom in LBOs. But now, with the onset of the credit crisis in 2008, it seems LBOs may have to

rediscover themselves.

However, while it is unclear when the first leveraged buyout was carried out, it is generally

agreed that the first early leveraged buyouts were carried out in the years following World WarII.

Prior to the 1980s, the leveraged buyout (previously known as a bootstrap acquisition) was for

years little more than an obscure financing technique.

In the years following the end of World War II the Great Depression was still relatively fresh in

the minds of Americas corporate leaders, who considered it wise to keep corporate debt ratioslow. As a result, for the first three decades following World War II, very few American

companies relied on debt as a significant source of funding. At the same time, American business

became caught up in a wave of conglomerate building that began in the early 1960s.

Executives filled boards of directors with subordinates and friendly outsiders4 and engaged in

rampant empire building. The ranks of middle management swelled and corporate profitability

began to slide. It was in this environment that the modern LBO was born.


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An easy way out for explaining the what, who & where of LBOs through a

dramatic conversation b/w Jinny n Johnny.

Johnny: All of us at some point in our life rediscover something. I hope LBOs also maintain that

spirit. But tell me, Jinny, how did LBOs start?

Jinny: Leveraged buyouts, or what you call LBOs in short, first emerged during the 1980s in the

US, Canada and to some extent, the UK. TheJournal of Economic Perspectives (Volume 23, No.

1) in one of its studies mentions that during 1985-89, when the process of LBOs was at its peak,

these three countries accounted for 93% of the worldwide transaction value. The frantic growth

in mergers and acquisitions on Wall Street during the 1980s fuelled LBO growth. At one point, it

was thought LBOs would change the face of corporate finance forever. But during the 1990s,

things didnt turn out as expected; LBOs of public companies took a back seat.

Johnny: I am really curious to know why. But before that, it would be better if you could first

explain how the process of LBOs actually works.


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Jinny:The process of LBOs during the 1980s was most commonly used for converting a publicly

listed company into a private company by buying back the shares from shareholders. The beauty

of this process was that it appealed to both saints and sinners of high finance. While the

management of a company or some friendly investment firm used the process to unlock the true

potential of a company, corporate raiders used it as a deadly weapon in a hostile takeover. LBOs

work perfectly well for all sorts of corporate acquirers. The process of LBOs, in its most basic

form, involves the acquisition of a company by using a small portion of equity and a large

portion of outside debt financing.

Johnny: So thats the secret formula: a small portion of equity and a large portion of debt. Thats

why I think the whole process is called leveraged buyout.

Jinny: Thats right. A typical LBO is financed with 60-90% debt. The acquirer himself has to

put less of his own money in the acquisition. For instance, suppose you intend to convert a

publicly listed company into a private company by buying shares from the existing shareholders.

If the value of all the shares is currently Rs100 crore, you may just need to use Rs10 crore of

your own for acquiring equity worth that much in the company. To raise the rest of the money

for the buy-back, acquirers issue bonds to other institutional investors. At one point, LBOs of big

companies with a thin layer of equity mostly relied on junk bonds to raise the required money for

the buy-back. The junk bonds used to finance LBOs offered high returns to investors, albeit at a

greater risk due to high leverage.

Johnny: Like a late night party, LBOs attract all sorts of characters, it seems.

Jinny: In any LBO you would find two classes of investors. One, the actual acquirers who invest

some portion of their money to acquire the equity of the target company. Two, the lenders who

invest their money in the bonds issued by the company, the proceeds of which are used by the

company to buy back shares from the remaining shareholders. The company extinguishes the

shares purchased through the buy-back.

In other words, the equity base of the target company decreases as a result of an LBO whereas its

debt increases. Subsequently, the target company has to repay the bondholders out of its future

income or by resale of its surplus assets. This requirement to compulsorily meet the obligation of


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bondholders has one obvious advantage. It forces the company to cut costs and make better use

of its cash flows, which in turn helps in creating a lean and more efficient organization. But as

actual experience shows, many companies fail to do that.

A large number of high-profile LBOs of Wall

Street during the 1980s ultimately ended in

default. As a result, LBOs of public

companies virtually disappeared during the

early 1990s. During lean times, LBOs of

private companies were the only ray of hope.

Things again picked up only in the mid-2000s,

when LBOs of public companies made acomeback.

Johnny: Well, thanks for explaining all this, Jinny. I think, with the changing fortunes of the

financial market, things would continue moving up and down.

What: The process of LBOs involves

acquisition of a company by using a small

portion of equity and a large portion of

outside debt financing.

Who: LBOs are most commonly used by

private equity players.

Where: LBOs first emerged during the 1980s

in the US, Canada and UK


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Sources of leverage

y Bank Debt is usually provided by one of more commercial banks lending to the

transaction. It is usually comprised of two components: a

revolving credit facility and term debt. Bank lenders have the

most senior claim against the cash flows of the business. As

such, bank debt has the senior claim on the assets of the

Company, with bank debt principal and interest payments

taking precedence over other, junior sources of debt financing.

- A revolving credit facility (bank revolver) is a source of

funds that the bought-out firm can draw upon as its working

capital needs dictate. A revolving credit facility is designed to

offer the bought out firm some flexibility with respect to its

capital needs. It serves as a line of credit that allows the firm to

make certain capital investments, deal with unforeseen costs, or

cover increases in working capital without having to seek additional debt or equity

The purpose of an LBO is to

allow an acquirer to make

large acquisitions without

having to commit a significa

amount of capital. In a typic

international LBO structure,

acquisition company is set u

in the target company's

jurisdiction, which then

acquires the target. The debis secured through the asse

of the target company.


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financing. Credit facilities usually have maximum borrowing limits and conservative

repayment terms. The model below assumes that the company uses excess cash flow to

repay outstanding borrowings against its credit facility.

- Term debt, which is often secured by the assets of the bought-out firm, is also provided

by banks and insurance companies in the form of private placement investments. Term

debt is usually priced with a spread above treasury notes and has maturities of five to ten

years. The amortization of term debt is negotiable and can be a straight-line amortization

or interest-only payments during the first several years with full amortization payments

thereafter.

y Mezzanine Financing is so named because it exists in the middle of the capital structure

and generally fills the gap between bank debt and the equity in a transaction. Mezzanine

financing is junior to the bank debt incurred in financing the leveraged buyout and can

take the form of subordinated notes from the private placement market or high-yield

bonds from the public markets, depending on the size and attractiveness of the deal.

Mezzanine financing is compensated for its lower priority and higher level of risk with

SUMMARY OF SOURCES

y LBO sponsors have equity funds raised from institutions likepensions & insurance companies

y Balance from commercial banks (bridge loans, term loans,revolvers).

y Banks concentrate on collateral of the company, cash flows, levelof equity financing from the sponsor, coverage ratios, ability to

repay (5-7 yr)

y Some have Mezzanine Funds as well that can be used for juniorsubordinated debt and preferred

y Occasionally, sponsors bring in other equity investors or anothersponsor to minimize their exposure.


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higher interest rates, either cash, paid-in-kind (PIK) or both, and, at times, warrants to

purchase typically 2% to 5% of the pro forma companys common equity.


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Ideal LBO candidate

The following are the features which one should try to find out in a target company before

acquiring it.

According to Jennifer Lindsey in her bookThe Entrepreneur's Guide to Capital,the best

candidate for a successful LBO will be in growing industry, have hard assets to act as collateral for large

loans, and feature top-quality, entrepreneurial management talent. It is also vital that the LBO candidate

post a strong historical cash flow and have low capital requirements, because the debt resulting from the LBO

must be retired as quickly as possible. Ideally, the company should have at least twice as much cash flow as

will be required for payments on the proposed debt.

At a high level, potential LBO candidates would be undervalued stocks with strong cash flows,

and relatively low debt. Other characteristics of target companies include:

y Large asset base

y Low future capital requirements

y Potential for process improvements or cost reductions

y Strong market position

y Relatively low enterprise value

y Steady and predictable cash flow

y Divestible assets

y Clean balance sheet with little debt

y Strong management team

y Strong, defensible market position

y Viable exit strategy

y Limited working capital requirements

y Synergy opportunities

y Minimal future capital requirements

y Potential for expense reduction

Finally, the ideal leveraged buyout candidate would be a company that can be easily separated

into logical subdivisions and / or presents the acquirer with a clear exit strategy.


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Gains through LBOs

A successful LBO can provide a small business with a number of advantages. For one thing, it

can increase management commitment and effort because they have greater equity stake in the

company. In a publicly traded company, managers typically own only a small percentage of the

common shares, and therefore can participate in only a small fraction of the gains resulting from

improved managerial performance. After an LBO, however, executives can realize substantial

financial gains from enhanced performance.

This improvement in financial incentives for the firm's managers should result in greater effort

on the part of management. Similarly, when employees are involved in an LBO, their increased

stake in the company's success tends to improve their productivity and loyalty. Another potential

advantage is that LBOs can often act to revitalize a mature company. In addition, by increasing

the company's capitalization, an LBO may enable it to improve its market position.


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Examples of LBOs

As a business group Tata has been fairly aggressive in cross borderM&A deals across sectors.

Few of the major deals announced by the group in the recent past are:

Tata Teas acquisition of 30% in US Glaceau (Energy Brands) in August 2006 for

$677 million.

Tata Tea bought 33 per cent in South African tea company Joekels through its

subsidiary Tetley Group

Tata Tea acquired US-based EightO clock coffee company for $220 million in June

2006

Taj Hotels acquired 100% stake inRitz- Boston for US$170

Tata Chemicals picked 63.5 per cent

in UKs BrunnerMond Group for

Rs 508 crore in December 2005

Tata Steel acquired Millennium Steel of Thailand in December 2005 for $404 million

TCS acquired Chilean BPO firm Comicorn for $23 million in November 2005

Case of TATA and its acquisitions

The takeover of Corus by Tata Steel reminds us of another acquisition by the Tata Group. This

was Tata Teas purchase of Tetley, owner of the iconic tea brand, in 2000. The purchase of

Tetley was the largest cross-border deal by an Indian company at the time, just as the Corus deal

is one of the biggest of its type today. In both deals, the acquirer was smaller than the target.

Both involve an overseas special purpose vehicle to raise junk bonds to fund leveraged buy-outs

(LBOs). And Tata Tea shareholders were initially concerned that the Tetley acquisition would

dilute the earning power of their equity; Tata Steel shares fell sharply on Wednesday on similar

concerns. But the Tatas did eventually turn around Tetley and used the extra cash flow to re-pay

the expensive debt raised to fund the acquisition. Can they do an encore with Corus?

One of the largest LBOs on record was

the acquisition of HCA Inc. in 2006 by

Kohlberg Kravis Roberts & Co. (KKR), Bain &

Co., and Merrill Lynch. The three

companies paid around $33 billion for the

acquisition.


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The nature of the business is different. Unlike Tetley, Corus is in a notoriously cyclical business

where cash flows are volatile. A downturn in the steel industry could threaten this LBO.

Today, 18% of TataMotors' revenues and 20% of Indian Hotel's revenues comes from

international operations, for Tata Tea, it's 70%. And of course, far more people around the world

drink Tata Tea products than TCS products.

Tata Tea is now the second largest player in the branded tea segment globally and has a presence

in 40 countries. The international expansion has all been through Tetley, which is a Tata Tea

subsidiary. Peter Unsworth, the London-based chief operating officer of The Tetley Group says,

"We have now moved beyond Tetley UK, to create a global brand portfolio. "This has been

through acquisitions like Good Earth(USA), Jemca (Czech Republic) and Vitax and Flosana(Poland).

This gives the company a presence in both the emerging and developed markets, along with

reducing dependency on any one geography. According to Unsworth, the evolution of Tetley and

Tata Tea has been somewhat parallel, with Tetley too changing focus from packed tea to brands

and now to beverages. The company has reinvented itself over the years, from being a

predominantly black tea business when it was acquired to having a significant presence in fruit

and herbal teas.

Tata Tea's acquisition of UK-based

Tetley for 271 million was

highlighted in the media as India's

first mega LBO.


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List of buyouts by Indian

companiesTarget Company

Country Indian Acquirer Value Type

Tetley United Kingdom Tata Tea 271 million LBO

Whyte &Mackay United Kingdom UB Group 550 million LBO

Corus United Kingdom Tata Steel $11.3 billion LBO

Hansen Transmissions Netherlands Suzlon Energy 465 million LBO

American Axle1

United States TataMotors $2 billion LBO

Lombardini2

Italy Zoom Auto

Ancillaries

$225 million LBO


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News related to LBO in India

22 MAY, 2008, 01.01AM IST, GAURAV TANEJA

Inbound acquisitions and investments are continuing in India. But a few prominent challenges

revolving around the tax and regulatory environment may prove to be potential road blocks, if

not proactively identified and addressed. Let us begin with leveraged buyouts (LBOs).

Perhaps LBOs are easier for Indian companies when they are acquiring an overseas target. Here,

the acquisition company is set up abroad and as regards foreign debt, this company is bound

largely by the banking norms and regulations of the foreign country.

On the other hand, a foreign company, wishing to use the LBO route, by setting up an acquisition

company in India and acquiring an Indian company, perhaps faces more challenges. One of the

main regulatory hurdles relates to restrictions on borrowings by an acquirer company set up in

India for the purpose of acquiring an Indian target.

Indian companies are permitted to borrow from domestic banks for purchasing equity in foreign

joint ventures, wholly-owned subsidiaries and other companies as strategic investments. Indian

companies also have the option of funding overseas acquisitions through external commercial

borrowings.

Recently the regulations have been further liberalised to permit total overseas investments by

Indian companies to be as much as 400% of the net-worth, as on the date of their last audited

balance sheet.


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MANAGEMENT BUYOUT

A management buyout (MBO) is a form ofacquisition where a company's existing managers

acquire a large part or all of the company.

Management buyouts are similar in all major legal aspects to any other acquisition of a company.

The particular nature of theMBO lies in the position of the buyers as managers of the company,

and the practical consequences that follow from that. In particular, the due diligence process is

likely to be limited as the buyers already have full knowledge of the company available to them.

The seller is also unlikely to give any but the most basic warranties to the management, on the

basis that the management know more about the company than the sellers do and therefore the

sellers should not have to warrant the state of the company.

In many cases the company will already be a private company, but if it is public then the

management will take it private.

Some concerns about management buyouts are that the asymmetric information possessed by

management may offer them unfair advantage relative to current owners. The impending

possibility of an MBO may lead to principal-agent problems, moral hazard, and perhaps even the

subtle downward manipulation of the stock price prior to sale via adverse information

disclosure - including accelerated and aggressive loss recognition, public launching of

questionable projects and adverse earning surprises. Naturally, such corporate governance

concerns also exist whenever current senior management is able to benefit personally from the

sale of their company or its assets. This would include, for example, large parting bonuses for

CEOs after a takeover or management buyout.

Since corporate valuation is often subject to considerable uncertainty and ambiguity, and since it

can be heavily influenced by asymmetric or inside information, some question the validity of

MBOs and consider them to potentially represent a form of insider trading.

The mere possibility of an MBO or a substantial parting bonus on sale may create perverse

incentives that can reduce the efficiency of a wide range of firms - even if they remain as public

companies. This represents a substantial potential negative externality.


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Purpose

The purpose of such a buyout from the managers' point of view may be to save their jobs, either

if the business has been scheduled for closure or if an outside purchaser would bring in its own

management team. They may also want to maximize the financial benefits they receive from the

success they bring to the company by taking the profits for themselves. This is often a way to

ward off aggressive buyers.


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Financing

Debt Financing

The management of a company will not usually have the money available to buy the company

outright themselves. They would first seek to borrow from a bank, provided the bank was willing

to accept the risk.Management buyouts are frequently seen as too risky for a bank to finance the

purchase through a loan.Management teams are typically asked to invest an amount of capital

that is significant to them personally, depending on the funding source/banks determination of

the personal wealth of the management team. The bank then loans the company the remaining

portion of the amount paid to the owner. Companies that proactively shop aggressive funding

sources should qualify for total debt financing of at least four times (4X) cash flow.


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Private Equity Financing

If a bank is unwilling to lend, the management will commonly look to private equity investors to

fund the majority of buyout. A high proportion of management buyouts are financed in this way.

The private equity investors will invest money in return for a proportion of the shares in the

company, though they may also grant a loan to the management. The exact financial structuring

will depend on the backer's desire to balance the risk with its return, with debt being less risky

but less profitable than capital investment.

Although the management may not have resources to buy the company, private equity houses

will require that the managers each make as large an investment as they can afford in order to

ensure that the management are locked in by an overwhelming vested interest in the success of

the company. It is common for the management to re-mortgage their houses in order to acquire a

small percentage of the company.

Private equity backers are likely to have somewhat different goals to the management. They

generally aim to maximise their return and make an exit after 35 years while minimising risk to

themselves, whereas the management rarely look beyond their careers at the company and will

take a long-term view.

While certain aims do coincide - in particular the primary aim of profitability - certain tensions

can arise. The backers will invariably impose the same warranties on the management in relation

to the company that the sellers will have refused to give the management. This "warranty gap"

means that the management will bear all the risk of any defects in the company that affects its

value.

As a condition of their investment, the backers will also impose numerous terms on the

management concerning the way that the company is run. The purpose is to ensure that the

management run the company in a way that will maximise the returns during the term of the

backers' investment, whereas the management might have hoped to build the company for long-

term gains. Though the two aims are not always incompatible, the management may feel

restricted.


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The European buyout market was worth 43.9bn in 2008, a 60 per cent fall on the 108.2bn of

deals in 2007. The last time the buyout market was at this level was in 2001 when it reached just

34bn.[1]

Seller Financing

In certain circumstances it may be possible for the management and the original owner of the

company to agree a deal whereby the seller finances the buyout. The price paid at the time of

sale will be nominal, with the real price being paid over the following years out of the profits of

the company. The timescale for the payment is typically 37 years.

This represents a disadvantage for the selling party, which must wait to receive its money after it

has lost control of the company. It is also dependent on the returned profits being increased

significantly following the acquisition, in order for the deal to represent a gain to the seller in

comparison to the situation pre-sale. This will usually only happen in very particular

circumstances.

The vendor may nevertheless agree to vendor financing for tax reasons, as the consideration will

be classified as capital gain rather than as income. It may also receive some other benefit such as

a higher overall purchase price than would be obtained by a normal purchase.

The advantage for the management is that they do not need to become involved with private

equity or a bank and will be left in control of the company once the consideration has been paid.


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Examples

A classic example of anMBO involved Springfield Remanufacturing Corporation, a former

plant in Springfield, Missouri owned by Navistar (at that time, International Harvester) which

was in danger of being closed or sold to outside parties until its managers purchased the

company.

In the UK, New Look was the subject of a management buyout in 2004 by Tom Singh, the

founder of the company who had floated it in 1998. He was backed by private equity houses

Apax and Permira, who now own 60% of the company. An earlier example of this in the UK was

the management buyout of Virgin Interactive from Viacom which was led by Mark Dyne.


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The Virgin Group has undergone several management buyouts in recent years. On September 17,

2007, Sir Richard Branson announced that the UK arm of Virgin Megastores was to be sold off

as part of a management buyout, and from November 2007, will be known by a new name,

Zavvi. On September 24, 2008, another part of the Virgin group, Virgin Comics underwent a

management buyout and changed its name to Liquid Comics. In the UK and Ireland, Virgin

Radio also underwent a similar process and became Absolute Radio.

LATEST DEVELOPMENTS INMBO

Management buyouts gaining momentum

PRIVATE EQUITY WATCH

Reena Zachariah /Mumbai July 24, 2007

Private equity players in India, triggered by consolidation of domestic businesses, cross-border

M&As (merger and acquisitions) and split in family-owned companies, are going for big

buyouts, mostly, management buyouts.

The first six months of the year alone saw 29 PE deals worth $2,435.3 million taking place in the

country, compared with 68 deals worth $2328.3 last year (full year), according to Thomson

Financial.

Globally, India ranks 16 among the countries with most PE deals signed in 2007. It tops the chart

among the BRIC (Brazil, Russia, India and China) countries, followed by Brazil, which had PE

buyout deals worth $1,543.6 million. In comparison, China struck deals worth $678.7 million

and Russia saw deals worth $68.1 million.

With more and more family-owned businesses are becoming smaller or are splitting, andentering into other businesses, domestic firms are entering into M&A deals and consolidations

taking place, we will see a lot more PE deals in India.Most of our buyouts have been not for

leverage but for growth, said Aluri S Rao, director, ICICI Ventures.


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Some of the buyouts by ICICI ventures are Tebma Shipyard, Ace Refractories and Ranbaxy Fine

Chemicals, which were later converted into management buyout (MBO).

PEs bring a lot more focus into a company. They also bring corporate governance into

companies, which are family-run businesses, by converting them into management-run

businesses. Besides, they also incentivise the management with equity, he explained.

This year we expect private equity investments in India to be in excess of $10 billion, said Atul

Mehta, partner of Ernst &Youngs PE practice.

Some of the top management buyouts in India in the past include the UK-based CDC Capital

Partners buying into ICI India and OakHill Capital Partners buying out exlService.com (I).

India is moving towards global trends and some of the largest PE deals globally have been

MBOs. MBOs will continue in the days to come and it will be seen across sectors. However, we

will see more such deals in the captive BPO segment, as lot of the large companies are exiting

from their non-core businesses. The ticket size ofMBOs will continue to increase, he added.

Last month, US-based private equity firm Blackstone bought 80 per cent in Intelenet, a business

process outsourcing firm from Barclays and HDFC for close to $109 million.

Through our conversations with Barclays and HDFC, we thought that one of the best options

for us would be as a management to tie up with a PE firm. From the perspective of employee

retention also, it made a lot of sense, said Susir Kumar, CEO, Intelenet.


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MANAGEMENT BUY-IN

A management buy-in (MBI) is the purchase of a business by a new management team, usually

with private equity funding. Unlike a management buy-out (MBO), there is a complete change of

management. Whether this is a good or bad thing depends on the business. The advantages of a

MBI are:

y A wider choice of buyers means the business can be sold for a better price a possible

MBO may deter other potential buyers.

y The change may be desirable if the business is not currently well managed.

y The new management team may be better placed (contacts, reputation, etc.) to find

backing.

The disadvantages are:

y The new management team do not know the business.

y They are regarded as riskier, so can be harder to get backing for.

y The existing management are likely to be demotivated in the meantime.

y Difference to management buy-out is the position of the purchaser. They are either

already working for the company in the case of a buy-out, or, a manager or management

team is from another source in the case of a buy-in.


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y

y

Among the private equity groups and executive search firms that focus on management

buy-ins are GTCR Golder Rauner, Frontenac Company, and Pinnacle CEO Recruiters.

What DoesEmployee Buyout - EBOMean?

A restructuring strategy in which employees buy a majority stake in their own firms. This form

of buyout is often done by firms looking for an alternative to a leveraged buyout. Companies

being sold can be either healthy companies or ones that are in significant financial distress.

For small firms, an employee buyout will often focus on the sale of the company's entire assets,

while for larger firms, the buyout may be on a subsidiary or division of the company. The

official way an employee buyout occurs is through an employee stock ownership plan (ESOP).

The buyout is complete when the ESOP owns 51% or more of the company's common share.

Put simply, an employee buy-out is a transaction in which the employees of a business join with

financing institutions to buy the business from its present owners.

The institutions put up most of the finance required in the form of debt and equity, with the

intention of realising a significant return on their investment in a short period of time (typically

five to seven years).

The employees retain a significant part of the equity, If the initial high levels of debt are repaid

as planned, a significant part of the value of the business will accrue to the employees.


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To date, management buy-outs have been more common in Australia than employee buy-outs.

Management buy-outs usually only involve the top executive managers buying the business from

the present owners. Recognition that there are potentially greater benefits from involving all

employees in a buy-out can result in employee buy-outs becoming much more prevalent in the

future.

Employee ownership makes sense commercially as real life examples

point to substantial increases in motivation, productivity and

profitability following an employee buy-out.

Comments from new employee owners

..you just put 150% in instead of 100%.

..yeah, I mean you tried your hardest before because, I mean, thats

a job you got to do your best at your job. But now I suppose you just

put that little bit extra in.

Im my boss and I dont perform we dont make extra money and

I dont get dividends, I dont get bonuses.

You know that its for you, not someone else, so you seem to have

more pride, I suppose youd say, in your work.

Divestment

A parent company may wish to sell a subsidiary, which is not part of its core business or part of

its future plans, in order to obtain funds to reduce borrowings or make an investment elsewhere.

Businessin distress

A poorly performing business may be threatened with closure by its current owners to prevent

further losses. In order to save their jobs, the employees could buy the business from the current


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owners. This is a high risk situation and the comments on a financially viable business (page 8)

should be noted.

Privatization

It is common for governments to seek to sell public sector enterprises to the private sector, to

reduce the burden on the public sector. An alternative option to a trade sale or a float is a sell off

to the employees of the business.

Effective employee team

The optimum employee buy-out team is one which:

is strong in each fundamental area of the business

has a proven track record in the business

has the required management capability

is harmonious

is ambitious

The employee team will need to convince financing institutions that it has the capability to

manage the business in an independent environment, and to provide sufficient returns on the

finance provided by the institutions.

It does not necessarily follow that an employee team which has been effective in running the

operations of the business will have the motivation and ability to cope successfully with the

strains of management and ownership following a buy-out.

It is essential to ensure the recognition by all people of a leader within the group to control the

day to day operations of the business. This may involve re-training and the use of consultants to

enhance leadership skills.

A change in work attitudes will also be required from the employees. The goal should be

securing the future rather than making short term profits. There needs to be a readiness to accept

the attitude that the survival of the business depends on all personnel, and not just the workers or


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the managers. It may also be necessary to develop a higher level of skills for many employees in

order to prepare for future changes in the market and technological advances.


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Financially viable proposition

A successful employee buy-out could be defined as the purchase of predictable cash flows at an

economically reasonable price. This definition refers to two key factors which must be present

for the buy-out to be a success:

1. Reasonable purchase price

2. Strong cash flows

It is obvious that a buy-out cannot succeed if the purchase price is excessive. An excessive

purchase price will require an upfront cash outlay and subsequent interest payments which, if

funding can be achieved at all, will place too much pressure on subsequent cash flows, with the

result that the business will fail.

Critical Success Factors

The critical success factors for an employee buy-out are:

Willing seller

This is likely to be due to:

Retirement of owner;

Realisation of personal investment;

Divestment of business by parent company;

Business in distress;

Privatisation by government.

Effective employee team

Characterised by:

Management capability;

Strength in all areas of the operation;

Recognition of a leader;

Additional training;


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Long term attitude.

Financially viable proposition

A combination of:

Reasonable purchase price;

String and predictable cash flows.

Forms of employee buy-outs

There are several different forms of employee buy-outs, which provides the flexibility to adapt a

buy-out to a particular situation. In this booklet we will only cover the major forms of employee

buy-outs, as these will probably be the forms you choose to use in your own buy-out. Every

business and group of employees is different, and professional advice will need to be obtained to

ensure the form of buy-out that you select is appropriate to your situation.

The main structures used for employee buy-outs are:

Co-operatives

Employee Share Ownership Plans (ESOPs)

Co-operativesA co-operative is a form of business organisation similar to that of a company. Like a company,

the members of a co-operative have limited liability. A co-operative is a democratic organisation

and is formed when a group of people get together to work towards a common objective. A co-

operative may be formed to supply goods and services to the general public or to it's members. In

an employee buyout, the common objectives can include preserving employees' jobs and

generating an additional income for members by sharing profits.

Underlying all co-operative enterprises are the seven basic co-operative principles adopted by the

International Co-operative Alliance (ICA). These are:

1. Voluntary association and open membership

2. Democratic member control

3. Member economic participation


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4. Autonomy and independence

5. Education, training and information

6. Co-operation among co-operatives

7. Concern for community

Traditionally, agricultural and consumer type co-operatives have been very popular. However, in

many parts of the world, workers have got together and formed worker co-operatives. In

Australia, we have a number of examples of successful worker co-operatives (now commonly

known as Employee Owned Co-operative Enterprises).

Co-operatives provide a basis for the mutual achievement of economic and social needs which

may be unavailable to the individual in the private or public sectors. It is a form of enterprise

suited to small and medium sized business, and is relatively less complex and costly to

incorporate and administer than most forms of corporate entities.


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References

y http://www.enotes.com/small-business-encyclopedia/leveraged-buyouts

y http://www.livemint.com/2008/01/09121811/Needed-A-Tetley-encore.html

y http://economictimes.indiatimes.com/features/tata/tata-teas-strategies-for-that-global-cup-of-tea/articleshow/2673792.cms

y http://en.wikipedia.org/wiki/Management_buyout

y http://www.business-standard.com/india/news/management-buyouts-gaining-

momentum/292035/

y http://www.investopedia.com/terms/e/ebo.asp#axzz1VIjJJn00

y http://www.mercury.org.au/PDFs/Employee%20Buyouts%20100909.pdf

y

http://baltimore.cbslocal.com/2011/08/11/baltimore-sun-proposes-employee-buyouts/y http://www.aeret.eu/en/contents/news/ShowNews/employee-buyout-at-trp-101

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