Management Buyout

In an ordinary buyout an outside investor takes control of a company. In a management buyout the buyer is already inside the building.

The team running the company borrows heavily, buys enough shares from the existing shareholders to hold a majority, and becomes the owner as well as the manager. The strategy belongs to management teams who believe they know how to run the business better than its current shareholders are letting them — and are prepared to put their own money and a great deal of borrowed money behind that belief.

It is a species of leveraged buyout, and inherits every feature of one, including the uncomfortable arithmetic that the company ends up servicing the debt raised to buy it.

A leveraged buyout is a buyout done with significant borrowing, the debt secured against the target company's assets. It is attractive to an acquirer because a high return is available on a small upfront equity cheque — and risky for exactly the same reason.

The control threshold in the workbook is 51% or more of the share capital or voting rights of the target. That is the point of the exercise: without control, the acquirer cannot execute the plan that is supposed to service the debt.

LBOs are typically attempted where there is a large forecast of cash flows contingent on unlocking value — a new project, a business plan, a corporate restructuring. The lender takes a view on those lumpy future cash flows and demands a return that reflects the extra risk. An LBO can take a listed company private, or carve out a business vertical for sale.

In a management buyout, that acquirer is a group led by the current management. The workbook's illustration: a listed company where management holds 25% and the public holds the rest; in an MBO the management purchases enough shares from the public to end up holding at least 51%.

Where the money comes from matters for this paper. A Category II AIF running a private credit strategy is a natural supplier of the subordinate tranche — the leveraged loan that sits behind the banks and carries an equity kicker.

Shares to acquire = (51% − management's existing stake) × Total shares

Deal value        = Shares to acquire × Offer price per share

Interest cover    = EBITDA ÷ Annual interest on acquisition debt

ABC Ltd is listed. 10 crore shares at a market price of Rs 240, so a market capitalisation of Rs 2,400 crore. Management holds 25% — 2.5 crore shares — and the public holds the rest.

The cheque. To reach 51%, the team must buy another 26%, or 2.6 crore shares. At an offer of Rs 300 a share — a 25% premium to market, which is what it takes to prise shares out of public hands:

2.6 crore × Rs 300 = Rs 780 crore

The funding stack.

Debt to equity on the acquisition vehicle is 600 : 180 = 3.3 : 1.

The stress test. At a blended 13%, annual interest is Rs 78 crore. Against ABC's EBITDA of Rs 260 crore, interest cover is 3.3 times — comfortable. Now take a bad year in which EBITDA falls 40%, to Rs 156 crore:

Interest cover = 156 ÷ 78 = 2.0 times

Still serviceable, but the covenant headroom has gone, and it is the AIF's subordinate Rs 200 crore — not the banks' Rs 400 crore — that absorbs the pain if it falls further. That asymmetry is what the 13% blended rate and the warrants were paid for.

Chapter 9 (Investment Strategies), in the sequence that runs Leveraged Buy-out straight into Management Buyouts as "a common form of Leveraged Buyouts". The chapter's own sample questions include a true/false on whether an LBO acquirer seeks majority control of the target — it does, to ensure the upside from growing the target's value.

Expect the 51% figure, the definition of an MBO as an LBO by the incumbent management, and a question separating a buyout (control acquisition) from a plain growth investment.

• An MBO is a subset of an LBO, not an alternative to one. The only distinguishing feature is who the buyer is.
• The control threshold in the workbook is 51% or more of share capital or voting rights. It is not a simple "largest shareholder" test.
• The borrowing sits at the acquisition vehicle or the target, not at the AIF. A Category II AIF that lends into an MBO has taken no fund-level leverage and has not breached the leverage prohibition.
• Buy-out versus buy-in. A management buy-in is an outside team taking control; a management buy-out is the incumbent team. One letter, opposite parties.
• The debt is secured on the target's own assets. The company effectively pays for its own purchase out of its future cash flows — which is why lumpy, contingent forecast cash flows are the classic trigger and the classic risk.
• The lender's return is not the equity upside. A private credit AIF funding an MBO gets interest plus an equity kicker; the managers keep the equity appreciation.
• Do not confuse an MBO with a secondary buyout, where one financial sponsor sells to another.