Cashing in on buy-outs in a strong market
While for some business owners the value of their business is inherently linked to the level of their involvement - whether buying or selling, a strong management team can be what drives real value writes Anya Cummins, Partner, Corporate Finance, Deloitte
A combination of attractive Irish targets and a well-funded market underpinned a strong M&A landscape in 2015 and a rise in overall deal values. M&A activity in H1 2016 was slightly softer, with less very large transactions, but the market overall remained strong with positive market sentiment across the range of business sectors.
The high proportion of outbound deals by Irish corporates acquiring businesses internationally as compared to our European peers is a defining feature of the Irish market and acquisitive Irish corporates continue to actively seek and acquire businesses across the globe. Within the Irish domestic market, inbound private equity activity has been a strong and growing driver of deal activity and private equity deal values increased to €8.5bn in 2015. This has largely comprised private equity acquiring stakes in privately owned businesses; and private equity investors are particularly attracted to backing strong management teams with international ambitions, a track record of growth, and market leading positions (or the potential to grow to such) in specific industry niches. We have observed many of these characteristics amongst the winning companies in the Deloitte Best Managed Companies Awards Programme.
The impact of the recent Brexit vote on the Irish M&A market will take some time to become clear, but uncertainty typically brings a slowdown in major investment decisions and therefore M&A activity levels are widely expected to reduce for the remainder of the year. In saying that, with uncertainty also comes opportunity and well capitalised Irish corporates are continuing on the acquisition trail internationally, in some cases capitalising on an anticipated softening in deal values, in particular for UK targets.
Acquisition as a growth strategy – the value of management teams
Depending on the ambitions of any business, combining traditional organic growth with growth by acquisition in specific niches or markets can be a key growth accelerator. However acquisition strategies must be treated with caution and the most successful acquisitions tend to be driven from the top of the acquiring organisation, with hands on involvement and ownership from key individuals within the acquiring business.
Acquisition strategies should be well defined with the value creation model well tested and validated. The drivers for acquisition typically include accelerating access to a new market or product, improving the financial performance of the target or gaining access to a skill or technology that is difficult or slow to create organically. Building the capabilities and skills of the management team to not just identify but negotiate and integrate acquisitions, as well as ensuring that the business is appropriately funded and structured to cope with the level of growth and complexity that an acquisition can bring, is therefore critical.
Maximising value on exit – how important is the founder?
One of the biggest misconceptions that business owners have is that the value of their business is inherently linked to the level of their direct involvement in running the business. In fact the opposite is often the case. Some of the most successful entrepreneurs recognise their limitations to take their business to the next level of growth, and therefore build a strong management team around them with the breadth and depth of varying skills and expertise to meet this challenge. To maximise the capital value of a business, the attractiveness to a buyer is what is transferable on acquisition; which is the management team and the underlying business, rather than the founder who would ultimately exit. Therefore, a strong management team will inherently add value to any business – in addition to the monetary value they bring in increasing profitability – and in a sales process a strong management team will open the buyer pool to both strategic trade buyers and private equity investors. To some business owners, taking a back step and bringing in a management team can be a difficult decision to make, but if the business can’t grow without the founder leading it, its value will be reduced irrespective of strong underlying trade and market position.
Appropriate incentivisation of management teams driving growth strategies on behalf of the shareholders is key and some of the most successful businesses ensure that the shareholders’ goals are entirely aligned with those of their driving teams. Using share option schemes can be one of the most effective means of reward, particularly where growth is the key objective and the ultimate sale of the business, either in whole or in part, is a medium to long term objective - even if the founders plan to take a step back on the day to day running of the business at a point in the future. On any ultimate exit of the business, management will enjoy reward equivalent to the value they have created and their core objective is to maximise the capital value of the business. Share based remuneration has been shown to improve company performance, and is one of the fundamental drivers of the private equity business model whereby management teams acquire equity stakes in the business they are buying, supported by a financial sponsor. This commerciality has been clearly recognised given the Department of Finance’s recent pubic consultation on the topic and Deloitte responded highlighting 10 tax changes that could further enhance such remuneration for businesses and their employees.
MBOs – a happy compromise?
Management buyouts or MBOs are a very attractive option for founders seeking to exit the business in whole or in part, whereby they can retain some ‘skin in the game’ and potentially some involvement under a new minority or majority ownership.
The level and type of private equity activity in the Irish market has changed significantly over the last number of years and today there are a number of dedicated investment funds in Ireland providing growth capital and supporting MBOs across varying sectors and valuation ranges. Private equity backers will typically invest in, support and incentivise strong management teams which have credible organic or buy and build growth strategies that deliver attractive returns to all shareholders, and are usually looking for an ultimate exit from the business within a circa five year period.
The UK private equity community is also becoming increasingly active in the Irish market, with funds like Synova Capital investing in Merit Software last year, ECI Partners and BC Partners both backing Cartrawler, Octopus Ventures’ investment in CurrencyFair, and Exponent’s investment in Fintrax to name but a few. US investors are one of the most active venture and private equity investors in Europe, although activity to date in the Irish market has primarily been focused on the technology sector. Scale (typically €100m revenue or €5m EBITDA) and proof of concept in the US are usually top of their criteria list. Businesses that have begun expansion plans into the US market and can prove that they have the capacity to grow in this market maximise appetite and value for US investors. There are some exceptions to the scale requirements, particularly in the technology sector (including FinTech and MedTech) where smaller, high growth businesses with particularly innovative technology solutions where the opportunity to scale internationally is clear will be targeted by US funds. Within the consumer products and food and beverage sectors in particular, brands which can easily transition into the US market are front of mind also.
Going forward, and even in a post Brexit environment, we anticipate continued high levels of equity growth capital and MBO activity backed by both Irish and international funds for ambitious, well-structured management teams operating in high growth potential businesses with international reach or appetite. In addition to private equity, MBOs can also be debt funded and the alternative lending market has also grown significantly as an alternate to equity financing for particular businesses.
Executing a successful MBO – planning is everything
For management teams and the shareholders of the businesses considering an MBO, there are a number of considerations. Firstly, both parties should recognise that there is a natural conflict of interest which needs to be carefully managed. The shareholders, while seeking a good home for the business, are typically also driven by maximising the underlying value achieved on exit. Management teams may have limited equity stakes in the businesses they are seeking to acquire (largely depending on the extent to which share option schemes have been utilised). For these teams, acquiring the business at a lower price and maximising their terms will generate the highest return for the management team on the ultimate exit, which is usually the end goal.
Secondly, before entering into discussions with any prospective investors regarding an MBO, preparation for a sales process is key. If a business is going to open itself up to intense scrutiny, which is what the due diligence process by incoming investors involves, being well prepared is critical. The team and the shareholders carefully evaluate the plans for the business over the investment hold period and articulate the ultimate exit strategy for all parties - where will the business be in three to five years’ time, what level of funding do we need to get there, and what’s our ultimate goal at that point? Being due diligence ready by identifying and addressing potential issues in advance of sale maximises the prospects of a successful outcome. Considering the areas of the business that will be most attractive to potential investors and positioning the business to maximise its attractiveness and therefore valuation is also a key consideration.
Management teams and shareholders should also consider what they are seeking in an investment partner. An MBO process involves the investor getting very comfortable with the management team, but the management team must also trust and value the investor and what they bring to the business. For example, do they have particular expertise in our sector? Can they help open doors and connections in a new market e.g. the US? Who will join the board and how can they add value? Understanding the merits and expertise of any particular fund and the fit with the management team is imperative. Early sight of the equity term sheet from the investor during the deal process also enables management teams, and indeed founders who are remaining with the business, to evaluate and negotiate their terms while the process is competitive.
For successful high growth businesses seeking to grow organically, by acquisition, or through a combination of both, having the appropriate management team is critical. The management team today in the best managed businesses require a mix of skillsets to enable them to ensure that the business is appropriately funded, through debt and/or equity, and is exploiting the opportunities presented to it both in its home market and internationally. Management buy-outs can offer a win-win solution whereby founding shareholders can extract some capital from the business but may not wish to exit entirely, and management teams are motivated to take the business on to the next level of growth. The funding market for MBOs in Ireland is particularly strong, and where businesses can articulate well formulated growth strategies and the potential to become market leaders in their particular niche, the opportunities to attract world-class financial partners to support their growth are clear.