Motivating management: The BIMBO's back

The management team is a fundamental part of any buyout. Larger houses usually change a substantial part of management in businesses they back. Since the EUR10bn buyout of TDC in 2006, for example, backers Apax, Blackstone, KKR, Permira and Providence have replaced every one of the 48 top managers - despite press reports at the time suggesting the chiefs would stay put.

Indeed, industry estimates suggest that three quarters of buyouts above the £100m mark involve changing management - a buy-in (MBI) or buy-in/buy-out (BIMBO) - whereas just a quarter of those done below the £100m threshold do so. "Buy-in risk increases with smaller deals," says Jeremy Hand, managing partner of Lyceum Capital. "The CEO of a small company will be more hands-on and replacing him carries a greater risk of unwanted disruption."

If the deals aren't outright MBIs, they still often involve changing a significant part of the team at the larger end of the market. This is because the dynamics change with a large organisation once there is new blood at the helm. Permira's last fund, for example, introduced a new management team in eight of the 10 businesses it backed.

This changes as you move down the deal value spectrum, where private equity has a more hands-on role to play. Barclays Private Equity for example, has only changed management around 10% of the time.

But this may be changing. Mick McDonagh, private equity specialist partner at KPMG, suggests that at least half of "pure" MBOs, even at the smaller end, have at least some element of management coming on board and the trend may be increasing. "Management of companies being bought out today become less stable. This is because with valuations down, the team comes to a realisation that they'll never reach the sums they'd aimed for. If this is the case, can you trust this once-motivated team to keep up its momentum?" questions one buyout house.

Many of the firms currently on the block are being sold by distressed sellers, meaning the targets may be less savoury than private equity is accustomed to. "The management teams of underperforming businesses are less backable than those of strong ones. As a result the proportion of buy-ins is likely to increase," says Hand.

Unlike most buyout houses operating in its sweetspot, Lyceum has done its fair-share of pure MBIs. In 2003 the firm (then West Private Equity) backed the £33.4m buyout of Clinovia from its French parent LVL Medical. The deal saw Lyceum team up with a new management team to carve the business out, ultimately cashing in three years later when BUPA paid £87.7m to purchase the business. Keen to repeat its success in the homecare segment, Lyceum backed members of the same MBI team to acquire care services provider Carewatch from parent Nestor in a £37m deal last September. Carewatch is understood to have performed well since then.

Post-buyout change

Management change also often occurs long after a deal completes, and this is also becoming more common as many firms that never intended to shake things up are being forced into action as businesses struggle in the current climate. If a company needs a major turnaround and quickly, fresh blood is often necessary. "You would have backed the team with a goal of growth, but suddenly the priority becomes staying afloat. Unfortunately at this point you often find that the team that has been running it is visibly unable to cope with everything falling apart. Even if they can identify what needs to be done, they are often emotionally incapable of taking such steps," says one buyout chief.

Indeed, growth CEOs often prove less spectacular in down markets, when their relative lack of ability to cut costs and focus on margins becomes an issue. "Different skills are required from management for the growth phase of a business than are needed when that company is being challenged," says Paul Marson-Smith of Gresham, which had first-hand experience of this earlier this year when its portfolio company Betts Global breached its banking covenant.

Some companies may not be so far gone as to require a turnaround but are stagnating, so management is under-motivated. "Where management is in a private equity-backed deal and the equity is now under water, they will naturally lose motivation. As a result, some deals need to be re-cut," says McDonagh.

Marson-Smith says Gresham is not looking at changing any of the terms in their 14 portfolio companies. "We cut a deal and we stick to it. Rewards in private equity are very long-term, unlike public companies. In the latter, management may make short-term returns but it may jeopardise the long-term health of the company." Currently, Gresham is eyeing up the £25m take-private of AIM-listed sports and talent-management agency Formation Group.

It is not always the private equity backer that decides to shake things up. "An astute management team may look to buy the business out from its private equity owner," says Michael Gebauer of interim management specialists Pilot Partners. This was the case with hardware chain Robert Dyas, whose management amassed £1m to buy itself out from Change Capital Partners, which had pumped £29m into a £61m buyout of the firm in 2004. "The equity was under water, but the target was sound," Gebauer explains, adding that onerous leases were the root of Robert Dyas' troubles.

Pilot introduced Ian Gray, a seasoned turnaround chief whose successes include Tottenham Hotspur football club, to the business. Gebauer explained how Gray went to see each and every landlord, explaining that Robert Dyas' situation at the time was sure to mean no one would make any money. Within four weeks he had convinced them to change the terms so that the business could continue. Incumbent bankers Lloyds and Allied Irish Bank backed the new buyout, saving more than 1,200 jobs. "It was not a management issue, it was a classic case of retail in distress," Gebauer says.

R Capital is currently aiming to turnaround roadside eatery chain Little Chef. Jamie Constable of RCapital bought it out of administration for £9m in 2007 and has teamed up with interim CEO Ian Pegler (introduced by Pilot) to assign Heston Blumenthal to Little Chef's books, in the hopes that the esteemed chef can turn the image of Little Chef round and smooth the roll-out to 200 stores by 2011. It is now profitable, reporting a 17.5% increase in revenues year-on-year

Buying in management support

Before you can win a deal you need to convince management, and this is becoming more difficult. With leverage down but the need for returns the same or even greater, as associated risk is up in today's market, something has to give. Often it is management's upside getting squeezed by the private equity house, making the deal less sweet for the former.

To boot, the troubles faced by yesteryear's buyouts have been well-documented, meaning owners considering a buyout will be all too aware of the potential pitfalls of teaming up with a private equity backer. "More management teams now are very sceptical. They are reading news of companies running out of cash and undergoing refinancings as a result of too much debt taken on by private equity firms, so it is understandable," McDonagh says. "Two years ago management teams thought buyouts were a step towards becoming a millionaire, now they need convincing. This is a job for advisers like me and the private equity firm."

It used to be that negotiating management terms took two to four weeks, but this has shot up to six to eight weeks given the difficulties in today's deal doing. "Management teams are definitely asking more questions," McDonagh says. "They are spending more time with us asking about structures. For example, they want to know what it means for them if they're 10% below budget, or ahead. They want more figures so they feel more comfortable with the deal."

In addition to being more explicit with the teams private equity is looking to back, it may mean shelling out more upside. Says McDonagh: "Buyout houses are pushing hard on management terms. They cannot afford to be too generous nowadays because they have less leverage to drive returns. But it may be precisely this lack of upside potential that makes management seem less motivated. It's a natural result of the market."

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