Syllabus D. Corporate Reconstruction And Re- Organisation D2. Business re-organisation

D2c. Management buy-out (MBO) and buy-in 5 / 7

Question 1a -

Around seven years ago, Opao Co, a private conglomerate company involved in many different businesses, decided to obtain a listing on a recognised stock exchange by offering a small proportion of its equity shares to the public. Before the listing, the company was owned by around 100 shareholders, who were all closely linked to Opao Co and had their entire shareholding wealth invested in the company. However, soon after the listing these individuals started selling their shares in Opao Co, and over a two-year period after the listing, its ownership structure changed to one of many diverse individual and institutional shareholders.

As a consequence of this change in ownership structure, Opao Co’s board of directors (BoD) commenced an aggressive period of business reorganisation through portfolio and organisational restructuring. This resulted in Opao Co changing from a conglomerate company to a company focusing on just two business sectors: financial services and food manufacturing. The financial press reported that Opao Co had been forced to take this action because of the change in the type of its shareholders. The equity markets seem to support this action, and Opao Co’s share price has grown
strongly during this period of restructuring, after growing very slowly initially.

Opao Co recently sold a subsidiary company, Burgut Co, through a management buy-in (MBI), although it also had the option to dispose of Burgut Co through a management buy-out (MBO). In a statement, Opao Co’s BoD justified this by stating that Burgut Co would be better off being controlled by the MBI team.

Opao Co is now considering acquiring Tai Co and details of the proposed acquisition are as follows:

Proposed acquisition of Tai Co
Tai Co is an unlisted company involved in food manufacturing. Opao Co’s BoD is of the opinion that the range of products produced by Tai Co will fit very well with its own product portfolio, leading to cross-selling opportunities, new innovations, and a larger market share. The BoD also thinks that there is a possibility for economies of scale and scope, such as shared logistic and storage facilities, giving cost saving opportunities. This, the BoD believes, will lead to significant synergy benefits and therefore it is of the opinion that Opao Co should make a bid to acquire Tai Co.

Financial information related to Opao Co, Tai Co and the combined company

Opao Co
Opao Co has 2,000 million shares in issue and are currently trading at $2·50 each.

Tai Co
Tai Co has 263 million shares in issue and the current market value of its debt is $400 million. Its most recent profit before interest and tax was $132·0 million, after deducting tax allowable depreciation and non-cash expenses of $27·4 million. Tai Co makes an annual cash investment of $24·3 million in non-current assets and working capital.

It is estimated that its cash flows will grow by 3% annually for the foreseeable future. Tai Co’s current cost of capital is estimated to be 11%.

Combined company
If Opao Co acquires Tai Co, it is expected that the combined company’s sales revenue will be $7,351 million in the first year and its annual pre-tax profit margin on sales will be 15·4% for the foreseeable future. After the first year, sales revenue will grow by 5·02% every year for the next three years. It can be assumed that the combined company’s annual depreciation will be equivalent to the investment required to maintain the company at current operational levels.

However, in order to increase the sales revenue levels each year, the combined company will require an additional investment of $109 million in the first year and $0·31 for every $1 increase in sales revenue for each of the next three years.

After the first four years, it is expected that the combined company’s free cash flows will grow by 2·4% annually for the foreseeable future. The combined company’s cost of capital is estimated to be 10%. It expected that the combined company’s debt to equity level will be maintained at 40:60, in market value terms, after the acquisition has taken place.

Both Opao Co and Tai Co pay corporation tax on profits at an annual rate of 20% and it is expected that this rate will not change if Opao Co acquires Tai Co. It can be assumed that corporation tax is payable in the same year as the profits it is charged on.

Possible acquisition price offers
Opao Co’s BoD is proposing that Tai Co’s acquisition be made through one of the following payment methods:

(i) A cash payment offer of $4·40 for each Tai Co share, or

(ii) Through a share-for-share exchange, where a number of Tai Co shares are exchanged for a number of Opao Co shares, such that 55·5% of the additional value created from the acquisition is allocated to Tai Co’s shareholders and the remaining 44·5% of the additional value is allocated to Opao Co’s shareholders, or

(iii) Through a mixed offer of a cash payment of $2·09 per share and one Opao Co share for each Tai Co share. It is estimated that Opao Co’s share price will become $2·60 per share when such a mixed offer is made.

Similar acquisitions in the food manufacturing industry have normally attracted a share price premium of between 15% and 40% previously.

(a) Distinguish between a management buy-out (MBO) and a management buy-in (MBI), and discuss why Opao Co’s board of directors (BoD) might have sold Burgut Co through an MBI. (4 marks)

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Question 3a -

In order to raise funds for future projects, the management of Bento Co, a large manufacturing company, is considering disposing of one of its subsidiary companies, Okazu Co, which is involved in manufacturing rubber tubing. They are considering undertaking the disposal through a management buy-out (MBO) or a management buy-in (MBI). Bento Co wants $60 million from the sale of Okazu Co.

Given below are extracts from the most recent financial statements for Okazu Co:

Year ending 30 April (all amounts in $000)

Total non-current assets 40,800
Total current assets 12,300
Total assets
Equity 24,600
Non-current liabilities 16,600
Current liabilities
    Trade and other payables 7,900
    Bank overdraft 4,000
Total current liabilities
Total equity and liabilities
Year ending 30 April (all amounts in $000)
Sales revenue 54,900
Operating profit 12,200
Finance costs 1,600
Profit before tax 10,600
Taxation 2,120
Profit for the year

Notes relating to the financial statements above:

(i) Current assets, non-current assets and the trade and other payables will be transferred to the new company when Okazu Co is sold. The bank overdraft will be repaid by Bento Co prior to the sale of Okazu Co.

(ii) With the exception of the bank overdraft, Bento Co has provided all the financing to Okazu Co. No liabilities, except the trade and other payables specified above, will be transferred to the new company when Okazu Co is sold.

(iii) It is estimated that the market value of the non-current assets is 30% higher than the book value and the market value of the current assets is equivalent to the book value.

(iv) The group finance costs and taxation are allocated by Bento Co to all its subsidiaries in pre-agreed proportions.

Okazu Co’s senior management team has approached Dofu Co, a venture capital company, about the proposed MBO. Dofu Co has agreed to provide leveraged finance for a 50% equity stake in the new company on the following basis:

(i) $30 million loan in the form of an 8% bond on which interest is payable annually, based on the loan amount outstanding at the start of each year. The bond will be repaid on the basis of fixed equal annual payments (constituting of interest and principal) over the next four years;

(ii) $20 million loan in the form of a 6% convertible bond on which interest is payable annually. Conversion may be undertaken on the basis of 50 equity shares for every $100 from the beginning of year five onwards;

(iii) 5,000,000 $1 equity shares for $5,000,000.
Okazu Co’s senior management will contribute $5,000,000 for 5,000,000 $1 equity shares and own the remaining 50% of the equity stake.

As a condition for providing the finance, Dofu Co will impose a restrictive covenant that the new company’s gearing ratio will be no higher than 75% at the end of its first year of operations, and then fall to no higher than 60%, 50% and 40% at the end of year two to year four respectively. The gearing ratio is determined by the book value of debt divided by the combined book values of debt and equity.

After the MBO, it is expected that earnings before interest and tax will increase by 11% per year and annual dividends of 25% on the available earnings will be paid for the next four years. It is expected that the annual growth rate of dividends will reduce by 60% from year five onwards following the MBO. The new company will pay tax at a rate of 20% per year. The new company’s cost of equity has been estimated at 12%.

(a) Distinguish between a management buy-out (MBO) and a management buy-in (MBI). Discuss the relative benefits and drawbacks to Okazu Co if it is disposed through a MBO instead of a MBI. (5 marks)

Question 4a -

Proteus Co, a large listed company, has a number of subsidiaries in different industries but its main line of business is developing surveillance systems and intruder alarms. It has decided to sell a number of companies that it considers are peripheral to its core activities.

One of these subsidiary companies is Tyche Co, a company involved in managing the congestion monitoring and charging systems that have been developed by Proteus Co. Tyche Co is a profitable business and it is anticipated that its revenues and costs will continue to increase at their current rate of 8% per year for the foreseeable future.

Tyche Co’s managers and some employees want to buy the company through a leveraged management buy-out. An independent assessment estimates Tyche Co’s market value at $81 million if Proteus Co agrees to cancel its current loan to Tyche Co.

The managers and employees involved in the buy-out will invest $12 million for 75% of the equity in the company, with another $4 million coming from a venture capitalist for the remaining 25% equity.

Palaemon Bank has agreed to lend the balance of the required funds in the form of a 9% loan. The interest is payable at the end of the year, on the loan amount outstanding at the start of each year.

A covenant on the loan states that the following debt-equity ratios should not be exceeded at the end of each year for the next five years:

Year 1 2 3 4 5
Debt / Equity (%) 350% 250% 200% 150% 125%

Shown below is an extract of the latest annual income statement for Tyche Co:

Sales Revenue 60000
Materials and consumables  12000
Labour costs 22000
Other costs 4000
Allocated overhead charge payable to Proteus Co  14000
Interest paid 2000
Taxable Profit 6000
Taxation  1500
Retained Earnings 4500

As part of the management buy-out agreement, it is expected that Proteus Co will provide management services costing $12 million for the first year of the management buy-out, increasing by 8% per year thereafter.

The current tax rate is 25% on profits and it is expected that 25% of the after-tax profits will be payable as dividends every year. The remaining profits will be allocated to reserves. It is expected that Tyche Co will repay $3 million of the outstanding loan at the end of each of the next five years from the cash flows generated from its business activity.


Briefly discuss the possible benefits to Proteus Co of disposing Tyche Co through a management buy-out. (4 marks)