by Michael Sarlitto and Dan Roman, SummitPoint Management

The public and private markets are seeing a growing trend in shareholder activism as stakeholders are more aggressively pushing their individual agendas. Companies are increasingly being pressured to shore up their balance sheets and unlock value by selling, spinning or carving out business units or other assets. Management from within its own ranks have become increasingly popular acquirers of these corporate divestitures, with many of these transactions taking the structural form of a management buy-out (MBO).

Unfortunately, the majority of MBO’s of corporate divestures fail to achieve long term stakeholder objectives. Creating a freestanding business unit from within a larger corporate enterprise presents a number of unique operating hurdles that must be anticipated and managed for the transaction to succeed. There are critical operational and strategic issues that the selling parent, key managers and financial sponsors must address to position a corporate divestiture MBO for success.

Market Trends

Every year, thousands of business subsidiaries, divisions and product lines are sold. As the private equity markets are flush with capital, it has become increasingly more common for members of management, assisted by an investment group, to be the acquirer. A number of factors have contributed to the recent growth in MBO’s of public and private corporations, including:

Global market economy. The emergence of a strong global market economy has created formidable competitive forces for companies across a wide variety of industry verticals. In response, firms are redirecting their resources into their “core business”. As a result, significant divesting of “non core” operations is occurring.

Capital availability. Capital is widely available and still relatively cheap. Therefore, financing can be readily accommodated through the public markets or through private placements to insurance companies, pension funds, subordinated debt funds or other long-term investment vehicles. Many MBO’s of companies financed in this way have produced significant financial rewards for their investors.

Individual risk-taking versus corporate allegiance. Due to significant competitive pressures, the average corporate tolerance and appetite for risk has trended downward. This decrease in corporate risk-taking is incompatible with an entrepreneurial-based growth strategy and tends to disenfranchise those managers originally attracted to a risk-taking environment. For many managers, an MBO is their first real entrepreneurial venture. Real courage is needed to leave the relative security and comfort of a management position to face the challenges of individual and independent accountability. Most managers cite the personal satisfaction of controlling their own destiny as the biggest reward from an MBO.

The MBO Advantage

Insiders who team up with private equity firms or other financial sponsors in competing for the purchase of a corporate asset possess a number of advantages over other bidders. In most cases, these advantages provide a decisive edge in the head-to-head competitive bidding process:

• Better understanding of the company culture.
• Knowledge of “hidden value” that would otherwise be hard for others to discover or realize.
• Abbreviated due diligence that consumes less resources and time.
• Key insights into potential cost savings and areas for performance improvement.
• A management-supported bid is often viewed sympathetically by the board of directors, which must ultimately decide to whom to sell.

Key Operating Risks

Creating a freestanding company through the purchase of a corporate divestiture presents a number of operating challenges. Unless key operating risks are made visible and planned for, the success of the resulting business could be in serious jeopardy. Specific operational and strategic issues that should be addressed include the following:

Stakeholder alignment. The success criteria for the selling parent company, management and investors need to be aligned and compatible in order to close the deal and ensure long term success. Additionally, the non-executive level workforce needs to be appropriately engaged, as total compensation, benefits and perks offered may not be comparable to levels seen with those of the larger parent company.

Economics of scale. As a stand alone entity, it is often difficult to achieve the level of economies of scale previously enjoyed as part of a much larger enterprise. Suppliers may not be able to offer comparable volume-based discount pricing.

Access to cash. Once out from the protection of a larger parent, access to capital at comparable rates is not guaranteed. The ability to achieve a desired capital structure (with the right cost of capital) is critical to maintaining operations and funding capital expenditures.

Support services. Most management teams take for granted the synergies that are associated with a tie to a larger parent and are ill prepared for the cost and resources required to untangle these functional linkages. A plan for key support service areas (such as information technology, legal, finance, human resources and supply management) and their associated supporting infrastructure must be designed to ensure a seamless post-close transition implementation that achieves minimum disruption to company operations.

Corporate governance. In forming a new company, leadership must develop the structures, systems and processes for exercising stewardship and overseeing the direction and management of the corporation in carrying out its mandate. This comprises the entire management and control of a company, including its organizational structure, business policy principles, guidelines and internal and external regulation and monitoring mechanisms.

Revenue sustainability. In many cases, it is not accurate to assume that all revenue lines will transition with the transaction. Sales and marketing expertise is crucial and must be ready to replace lost revenue, such as those streams originally sourced through cross-selling or achieved through sole-sourced transactions with the parent.

Intellectual property. A number of corporate divestures involve business units that have created impressive technologies or products that hold very favorable long-term prospects. However, ownership of the patents, copyrights, trademarks and trade secrets crucial to success may belong to the parent. It is critical that the new company own or have commercialization rights for these properties. Additionally, the preservation of key personnel involved with a company’s intellectual property is needed to deliver business results.

Project justification. With a potentially significant change in the cost of capital accompanying an MBO, processes controlling the prioritization, rationalization, justification and execution of developmental projects and associated R&D will invariably require adjustment.

While there are substantial operating risks associated with an MBO of a corporate asset, an insightful “lessons learned” based plan to address these risks executed by a committed and united team offers the potential for substantial personal and financial reward to those involved.

Conclusion

MBO’s of corporate divestures present great opportunities for operating companies, financial sponsors and entrepreneurial management. For corporate parents, these transactions provide an opportunity to divest non-core operations, raise cash (depending on the structure) and provide stakeholders with a separate asset having a separate market valuation, often on a tax free basis. From the perspective of management, these transactions create an opportunity to gain direct equity ownership of their business at a favorable price and reestablish an entrepreneurial environment. And for financial sponsors, corporate divestures provide an important source of deal flow. When the objectives of these stakeholders all coincide and key operating risks are made visible and planned for, a new company can successfully be launched and value released.

About the Authors

Michael Sarlitto is President and Dan Roman Vice President and General Manager of SummitPoint Management. They can be reached at 312-441-1400 or www.summitpointmanagement.com.