What’s the appeal of a management buy-out?

One of the mantras of entrepreneurial life is that no one ever gets rich on a salary. Yes, you can be comfortably off or even extremely well to do, but when it comes to acquiring real wealth the secret is to secure an equity stake in a successful company.

The game plan that begins with a start-up and ends with a lucrative exit is built into the DNA of entrepreneurs, and many are prepared to work for years for little reward while keeping their eyes firmly on the prize of the big payoff. Meanwhile members of the management team beaver away, knowing that their own share of the proceeds will at best be limited.

Hence the appeal of the management buyout (MBO). As the founder – or a corporate owner - prepares for exit number one, managers have an opportunity to put their own game plan into play. Bring in a private equity backer, buy the business, implement a growth strategy and work relentlessly towards exit number two in five to 10 years' time.

Typically, MBOs are fronted by the chief executive but in theory at least they should also be good news for ambitious chief financial officers. It's not just about taking an equity stake and cash in some time in the future. Private equity backed buyouts are inevitably predicated on the kind of rapid growth that will deliver a significant return for the investors.

For the finance chief, there is an opportunity to shift up a gear – perhaps making the transition from financial controller to a commercially minded partner or even the chief executive. And in doing so, new doors open. One successful buyout on the CV may well pave the way for a new and lucrative career path if you chose to step out of pure finance.

But that's only if you can successfully ride the, oft heated, train that leads from a 'pre' to 'post' buyout environment. Private equity backers are known for their forensic scrutiny of prospective management teams and they won't hesitate to replace any individual who is not perceived as up to the job. If the CEO is not up to scratch, the deal probably won't happen but if there are questions marks over the CFO, he or she will simply be replaced.

So a CFO looking seriously at taking part in a buyout transaction should look long and hard at how the role will evolve after the transaction as well as the expectations of private equity backers.

Dealbreaker

According to Alan McBride – former finance chief and current CEO and principal consultant at recruitment firm Camino partners – the biggest obstacle facing pre-buyout CFOs is often their lack of experience. McBride specialises in finding suitably qualified CFOs for private equity-backed companies and as he sees it, the skillsets offered by the incumbent CFOs often fail to match the expectations of investors.

"If you take the example of an owner-managed business, an FD in that environment may well be doing the job of a financial controller," he says. "Private equity investors will be looking for someone who can show evidence of a greater independence of mind – someone who can provide a bridge between the CEO and themselves."

And if the incumbent finance chief falls short, McBride says they will likely get short shrift. "In my experience, private equity people tend to be very focused," says McBride. "They want to reduce the risks and generally they want someone with sector experience who has worked previously in a PE-backed environment."

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There are of course risks associated with breaking up a tightly-knit management team, but as Hedley Mayor, CFO of AIM-listed software company System C (and former CFO of private equity company Octopus Investment) observes, in many cases the finance chief will be semi-detached from the other managers.

"What you often find is that an FD has been brought in at some stage, often in the role of financial controller. The company probably didn't have an FD before and the new man isn't really part of the team."

So the existing head of finance may be doubly vulnerable. Not quite meeting the specifications of the incoming private equity investors and not having the personal ties with other managers that might help protect his position.

Nevertheless, CFOs can and do make the MBO transition. Richard Fetterman of corporate finance advisors Livingstone says that although the PE industry might prefer to draw from the ranks of those with previous form, the door is still open for talented CFOs to walk through.

"No one actually has experience until they get experience," he says. "It's certainly not unknown for a finance director who hasn't had experience of a PE-backed company to make the transition."

Greater pressures

Those that do almost inevitably find themselves recalibrating their role to meet the requirements of the financial backers, who will be seeking constant assurance that their investment is on target to deliver a handsome return.

As Mayor says, that means taking a different perspective on the financial progress of the company. "Typically a privately owned company won't be that concerned about year-end results," says Mayor.

"As long as order books are healthy and the company is making a profit, the owner won't be too worried about the year in which the profits fall. In contrast, private equity backers will want to see the profits dropping into the right years."

And the reporting regime is likely to be more onerous. Harvey Mitchell, now a principal partner at part time FD provider Orchard Growth Partners was finance chief at Blue Pumpkin Software before and after a management buy-out, when it was bought from its corporate owner and dropped into a vehicle named Optimis.

"A lot of FDs – even in plc companies – are accustomed to providing accurate figures only on a quarterly basis," he says. "When the investor is private equity finance partner you'll have to provide accurate figures every month."

Looking forward, the likelihood is that the new backers will expect forecasts that are more comprehensive than those required by the previous owner. "The forecasting has to be very robust," says Mayor. "Investors will be looking for complex forecasts that can be sensitised in line with 'what if' scenarios."

Given that the majority of MBOs are funded by leveraged private equity investment or bank loans, the progress of the business has to be seen in the context of the debt on its balance sheet. "Cash management skills are essential," says Alan McBride. "They have to be because of the debt that the business will have taken on."

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Arguably, the skills needed to provide accurate forecasts and manage cash effectively should be part of any CFO's toolkit, but the arrival of outside investors may well mean the finance chief taking responsibility for non-financial functions.

"If you're a finance director who hasn't taken responsibility for matters, such as the management of risk, you'll learn quickly that you'll be expected to take on that role because part of your job is to protect the investment," says Mitchell.

Potentially the wider role will extend beyond risk management. In the case of the Blue Pumpkin buy-out, HR functions that once handled by the corporate parent dropped into the lap of the finance chief.

Business plans built to deliver rapid growth will require the CFO to become a commercial partner to the CEO and in that respect the finance chief will be working closely with other managers to formulate and deliver strategy. However, investors will also want a CFO who is simultaneously able to keep their distance from the other managers when it comes to presenting figures and forecasts.

"No private equity company will want to see a block of management," Fetterman says. "They want to see an FD who can exercise a high degree of independence."

In other words, rather like a non-executive chairman, the MBO chief financial officer is seen by investors as their man on the board. As McBride points out the circle can be quite difficult to square. "Investors want to see a team player but they also want someone who is independent."

The private equity environment isn't for everyone. "Investment partners like to keep their management teams under stress," says Mitchell. Typically, that will mean the main players having something to lose something, such as their houses, should the business fail.

Running a company post-MBO can undoubtedly be thrilling and financially rewarding, but CFOs can't take it for granted that they'll always be part of the new team. Ultimately, getting a seat at the post-buyout table is about having the skills, the cultural fit and the ability to talk the same language as the investors. And as Mayor points out, securing the role is often about chance - being in the right place at the right time.