This report has been prepared considering the following points:
- The key motivation for corporate restructuring and the potential benefits and drawbacks of an MBO;
- Techniques appropriate for the valuation of an organisation; and
- Financing methods available for an MBO.
According to the Centre for Management Buyout Research "the UK buy-out market fell from a record 46.5 billion at the end of 2007 to just 4.4 billion by the end of the third quarter of 2009. Indeed, this year only 280 buy-outs had completed by the end of the third quarter compared to 487 for the same period last year." The current financial crisis has seen banks re-trenching and private equity fund re-consider their investment portfolios. Although Quantitative Easing has helped stimulate aspects of the market, fresh capital sources for MBOs has proved challenging. The Government appointed Lord Sugar as the Enterprise Champion responsible for promoting entrepreneurship and advising the Department of Business, Innovation and Skills as a means of keeping the government informed of problems encountered by Small and Medium sized Enterprises (SMEs) in the current economic climate. SMEs have complained in recent months of banks foreclosing on overdrafts and loans, with any new financing available at a significant premium. For a number of organisations restructuring has become key to their survival in the current climate. This has led many organisations to downsize, reduce working hours and in extreme cases close down.
According to Kemper and Khuen, "corporate restructuring is a key area in strategic, management, finance and organisational theory". The motivation behind any corporate restructures depends heavily on a set of specific circumstances and problems which then bring in turn a need for management action. As we will go on to explain, this can take the form of either and enforced or reactive set of actions or pre-planned proactive planning on the part of the Board of Directors. Kemper and Khuen go on to state that, "corporate restructuring is one of the most complex and fundamental phenomena that management confronts".
Motives for Corporate Restructuring
There are a number of motives as to why a company may consider restructuring and this restructuring may take many forms. Generally organisations restructure due to underperformance; financial problems; changes in strategy or policy (this may have been due to a change in management team or re-branding strategy); and because of information gaps between the organisation and capital markets.
The first two restructuring reasons are reactive and usually stem from a decline in profitability, competitive position within the market in which they operate or severe financial distress, the latter two reasons can be considered proactive restructuring where the management team has identified a need to streamline the business or take advantage of a changing climate. From a stakeholder wealth perspective taking a pre-planned approach provides the greatest return, however it can be difficult to persuade stakeholders to go ahead with the restructure.
According to Bowman et al, there are three modes of restructuring:
- Portfolio restructuring - significant changes in the mix of assets owned by a firm or the lines of business in which a firm operates, including liquidations, divestitures, asset sales and spin-offs;
- Financial restructuring - significant changes in the capital structure of a firm, including leveraged buyouts, leveraged recapitalisations, and debt for equity swaps; and
- Organisational restructuring - significant changes in the organisational structure of the firm, including divisional redesign and employment downsizing.
Management Buy-Outs: Advantages and Disadvantages
Although in general all aspects mentioned above are impacted, the area I will focus on for this report is on financial restructuring and in specific a specific aspect of leveraged buy-out, which is management led and referred to as a management buy-out or MBO. A leveraged buy-out (LBO) is basically an acquisition which is financed by debt, when this LBO is led by the incumbent management team it is referred to as an MBO. There are a number of ways to finance an MBO which I will cover in due course.
Focusing initially on the advantages and disadvantages of an MBO:
- The MBO will give the management team complete control of the business and allow them to run the business in the manner which they consider most effective;
- The new organisation will be highly motivated, in a number of recent MBOs staff have also contributed to the capital required for the MBO; and
- The due diligence process generally undertaken at the time of an MBO is easier and less-time consuming as the incumbent management should have a full understanding and insight into the organisation being acquired.
- An MBO usually requires significant finance, generally from a third party, usually a bank, Private Equity Company (PE) or Venture Capitalist (VC) fund. These lenders place stringent controls and covenants on the funds loaned which can be restrictive for the new organisation. In many cases a representative from the bank or VC will be appointed to the Board;
- A large financial commitment and the acceptance of risk by the management and investors. As the management and possibly staff move from being employees to owners the financial risk assumed is significant and if the company were to fail potentially painful;
- Although the due diligence should be less time consuming, management will still need to invest in additional advice from consultants, financiers, accountants etc to ensure that they have the complete picture, this process can be expensive and is non-refundable if the MBO does not go through; and
- As the MBO is highly leveraged, the company is not in the best financial position for growth. The debt equity ratio is generally high which makes additional financing problematic and could impact on the company's ability to grow or invest id Research and development.
Depending on the structure of the deal, i.e. if staff are allowed to invest in the MBO another problem that could be encountered by the management team would be restructuring the workforce and workflows, it may be difficult to announce redundancies if you have relied on those employees to provide capital for the MBO. I will cover the various methods of financing an MBO in greater depth in as I progress through this report.
The company I have chosen to analyse for a potential management buyout is National Express Group PLC (NEX). There are a number of reasons I have chosen to analyse this organisation, primarily because it is a company I worked for five years as the Head of Group Risk and feel I have a good understanding of the company and the transport sector. Secondly, NEX has received a significant amount of attention in the last twelve months for a number of reasons which include:
- The surrender of the East Coast Mainline rail franchise due to NEX's inability to maintain franchise payments to the Office of the Rail Regulator (ORR), the franchise was handed back in November 2009;
- The failed attempt by First Group PLC to acquire NEX, July 2009;
- The failed acquisition attempt by a consortium led by CVC Capital Partners and the Cosmen family, July 2009 with a subsequent reviewed proposals failing in August and September 2009; and
- 360 million rights issue in November 2009.
There has also been significant speculation around a potential acquisition by Stagecoach PLC with Stagecoach confirming in December 2009 that it would no longer pursue a possible acquisition as well as one other offer from an un-named organisation.
The organisation has seen a significant change in its fortunes since the appointment of Richard Bowker in September 2006, which are illustrated well when reviewing the five year share price illustrated in the figure below. At its height the share price sat at 13.02 in April 2007 with a 5 year low of 0.78 in April 2009 with the subsequent departure of Mr Bowker in July 2009.
The organisation continues to struggle with significant debt, reported to be circa. 977 million, on its balance sheet and the recent announcement by the ORR that its East Anglia franchise would be terminated in 2011 with no extension available, usual practice is that if the franchise operator has been performing well and 2 - 4 year extension is made available. News reports in the Financial Times stated that analyst say that it needed to raise at least 350 million to avoid breaching debt covenants in early 2010.
National Express Group describes itself as a "leading transport provider delivering services in the UK, North America and Spain".
Considering the snapshot financials above for NEX it would appear to be a healthy organisation with solid year-on-year growth, however, as mentioned previously, NEX's current financial strength has been brought into question and the success of the rights issue will be key to its survival.
Valuation techniques and the value of NEX
There are a number of key techniques which I will use to value NEX, the main type of approach include:
- Asset valuations - these vary depending on the assets being valued, whether tangible or intangible;
- Price/Earnings Ratio - this approach could be considered if the company being considered is maintaining sustainable profits;
- Discounted Cash Flow - there are a number of DCF models which we will consider later. This model is appropriate when considering a company that is investing in long term projects such as NEX and the 7 to 9 year franchise commitments where it is looking at steady cashflows.
- Industry rule of thumb - this method may have been established for a particular industry sector, this is more relevant to smaller acquisition and not appropriate in the context of NEX.
Considering each of these main areas we will focus on the methods available under points two and three. The reasoning behind this is that the main assets owned by NEX are ether commercial buses, coaches or school buses with ages varying between 2 years and 25 years old. Contractually NEX is only required to maintain an average fleet age; in North America that average is generally 15 years, in the UK 12 years and in Spain no average age is applicable. At new vehicle values average around 35,000 and as no fleet breakdown is readily available it would be difficult to fully assess the values, the numbers provided in the Balance Sheet would have to be considered as fair value.
As for the method raised in point four, no 'industry rule of thumb' appears readily available so this method will be ignored.
Focusing on the other two areas I have carried out a number of calculations detailed below based on NEX's annual report and accounts as well as other data available from the financial press.
Market Capitalisation Method
This method measures the size of the organisation with respect to the number of shares available and the current trading price of the shares. It is subject to daily variations depending on how well or badly the share price trades on the market. As we have seen in the five year share price tracker above at its highest the share price was 13.02. At this point the market cap would have been 2,014M, a significantly higher value than the one calculated below at current trading levels. This illustrates the volatility of this method. When you consider the financials of the company revenues have remained around 2.5bn over the past 5 years.
Calculating the market cap of an organisation is a good way to value the equity of the organisation, the formula used to calculate this is:Market Capitalisation = (No. of shares outstanding X current share price), for NEX based on outstanding shares reported in their 2008 Report & Accounts and the closing price on the London Stock exchange of 11 December 2009:
= (154,687,284 x 1.82)
Discounted Free Cash Flow Valuation
This method is considered to be the most reliable and stable method of financial analysis when valuing an organisation.
This method takes into account the time value of money. All future cash flows of the organisation are taken into account and discounted to give the present values. The discount rate normally applied to this method of calculation is the 'weighted average cost of capital'. The formula for this approach is:
V0= FCF0 (1 + g)
WACC - g
Where, FCF = Free Cash Flow
WACC = Weighted Average Cost of Capital
g = growth rate for free cash flow
WACC = kE(E/V)+kD(D/V)(1 - tc)
Where, kE = cost of equity = (dividend per share)/(current market value) + dividend growth rate
= (0.12/1.82) + 0.1 = 0.166
kD = cost of debt = LIBOR + 0.5% = 1.1%
E = value of equity = 1,730,200
D = value of debt = (3,981,100)
V = value of the company, V = E + D = 1,730,200 + 3,981,100 = 5,711,300
Tc = corporate tax rate
Therefore WACC = 0.166(1,730,200/5,711,300) + 1.1(3,981,100/5,711,300) x (1 - 0.28)= 0.303 + ((1.1 x 0.7) x 0.72) = 0.303 + 0.05544 = 0.35844
Price Earning Ratio
The P/E ratio is used more when valuing unlisted companies which operate within sectors that have established listed competitors. Investors can use the P/E ratio of a comparable competitor and then multiply the earnings of the unlisted company by the P/E ratio of the known listed company.
P.E. Ratio = Market Value of Share
Earnings Per Share
Earnings per share = Net Income - Dividends on Preferred Stock
Average Outstanding Shares
= 118,800,000 - 34,600,000
Therefore, for the P.E. Ratio for NEX (as at 11 December 2009)
Based on the trailing twelve months (as per Reuters) the P.E. Ratio is 4.13.
A P/E ratio 4.04 could suggest one of two things, the stock is under-valued or that earnings are thought to be in decline. From the second section of this report we commented on the recent turbulence within NEX and the attempted failed acquisitions. When considering the drop in share price to a current price of 1.82 and the CVC/Cosmen offers of 4.50 and 5.00 per share in September 2009, it would appear that the offers made were generous and that the Board were possibly a little short-sighted. However, it must be noted that this approach is considered optimistic.
Applying the P/E to current earnings = 4.04 x 144.6M = 584.184M
Discounted Cash Flow - Direct Value Method
This method can be used when measuring the value of mature listed companies which have maintained a stable dividend policy and considered by the market as reliable when applied in this manner.
Direct Value (V) = Equity Value (E) + Value of Net Debt (D)
Therefore V = 579.3 + (380.2) = 199.1M
There are a number of methods of financing an MBO however traditional funding, i.e. shareholders is unavailable. The reason for the restructure/MBO will also have an impact on the type of financing available and the interest rates of the financing.
Methods of financing an MBO
There are a number of ways of financing an MBO including:
- Bank loans - both business & personal, depending on why the MBO is occurring and how financial secure the management team are personal bank loans may be available, either secured or unsecured. From the business perspective secured loans against assets may be available. This is one of the least expensive forms of finance available to an MBO
- Private Equity - this can be broken down into a number of categories, including:
- Venture Capitalist - typically comes from either institutional investors, (such as insurance companies, pension funds, hedge funds) or mutual funds or high net worth individuals (in general terms defined as individuals with investable funds in excess of USD1M).
- Leveraged buy-out transactions (including MBOs) are highly leveraged deals which involve a financial sponsor whom agrees to the acquisition without committing all of the capital required. A diagram of a typical leveraged buy-out is detailed below.
- Distressed & Special Situations - this type of capital falls into two broad categories "Distressed-to-Control" where an investor will acquire debt equities in and organisation which is restructuring on the hope to control the company, and "Turnaround", which is often known as "rescue financing", where the investor provides both debt and equity investments to orhanisations which are undergoing financial problems.
Although generally private equity is probably the more readily available method of financing it generally comes at a premium and imposes a number of covenants on the investment. In some cases the equity share demanded is in excess of the value of the finance being offered.
- Mezzanine Capital - this is finance where there is little or no security. As this is a higher risk the interest rates applied to this form of debt are generally four to eight percent over a banks standard rate.
- Family and friends - this method is a cheap form of investment capital and keeps the management team highly motivated as they do not want to disappoint friends or family.
- Equity Partners - this takes the form of someone whom not only have the financial ability to back the MBO but possibly some industry experience that may be benficial.
- Partner Investment - in certain cases a partner, or number of partners may be approacvhed to finance the MBO, in most cases they are silent and do nothing more than provide the investment capital for the MBO.
- Employee Investment - for an MBO it is possible to approach the existing staff for funding, the adbvantage of this form of debt is that it keep the workforce motivated, although can prove to be prioblematic when considering redundancies.
- Vendor financing - in certain circumstances the management buying out the company may be able to persuade the original owner to finance the buy-out, with the funds being repaid out of operating profit.
- Grants and Soft Loans - these take the form of loans supplied by Government, Local Authorities or EU agencies which provide financing and are normally subsidised by third parties and are generally less than market rates.
- Bank Overdraft - another form of high rate debt attached to the company's current account.
- Credit card - a last resort form of debt with exceptionally high interest rates attached.
The valuation range for the various methods used could be considered significant when comparing the P/E method to the Direct Approach, however when considered alongside the other two methods it would not be unreasonable to discount the P/E approach in this valuation as the range between the others is significantly less, almost confirming the accuracy of the other methods. This range narrows to 82.4M. We already know that using the Market Capitalisation method is volatile and dependent on a spot price for the day of valuation, although we could use a 52 week average to smooth this, but looking at the range between the 5 year high and low of 1,894m (2,014M and 120M), which impacts the credibility of the valuation method. However, this cannot be fully discounted as shareholders will have a value set against their price per share that they will expect to receive before surrendering their stake.
Considering other aspects of the balance sheet and annual statements we know that NEX is heavily debt burdened which may have been an acceptable capital structure during the buoyant market days, but now in a period of financial uncertainty for many companies, Governments shoring up their financial markets and corporate financing in short supply, NEX finds itself in trouble.
It has now, at a cost, disposed of the high cost unprofitable aspects of its business but in the process fallen out of favour with the government and will lose a profitable part of the business at least two years early, assuming it was unable to retain this franchise at the next set of renewals. This will also affect NEX's ability to win new franchises at the bid table in the next 2 - 4 years, having a significant impact on its future growth strategy. The reputation of the organisation has been significantly damaged and this has been translated to the share price. Its largest investors, the Cosmen Family remain a thorn in the side of company and will challenge any new CEO appointed. It would appear that NEX is ready for another restructure which will have to look long and hard at its cost base with a view to minimising unnecessary spending.
Considering some other financial data, although these numbers are for 2008 and haven't yet been impacted by the departure of the east Coast Mainline, we can see that overseas turnover continues to climb with UK numbers deteriorating. This may suggest a new focus and strategy for NEX on foreign markets, which historically proved challenging to the organisation due to cultural differences. Profits have remained stable over the past 10 years.
NEX last restructured in 2007 with a view to creating a super brand and de-centralising control to the geographical divisions, historically control had been established in a central Head Office with central functions maintaining oversight and control. Although much can be blamed on the current economic climate, NEX was de-centralising when its competitors were investing more heavily in central head office functions to maintain compliance with governance and to ensure no surprises came from the business units or divisions.
Although NEX is weathering some storms and the calculations carried out value the company at circa. 200M, this is a company that with the right senior management team and Board support can get back on track and re-establish itself as a market leader in global transportation sector.
I would therefore recommend that assuming the correct financing can be found and that the incumbent management team were willing and committed a proposal for an MBO should be produced and a suitable offer made top shareholders and the Board.
Although a valuation of NEX would suggest circa 200M to 280M with the current share price at 1.82, considering the CVC/Cosmen offers of 4.50 and 5 in September and October of 2009 were rejected, note the share price for that period was c.4.75, I would suggest an offer of 3.50 per share based on the fact that the share price is not recovering and a recent profit warning has been released by the NEX Board. This would make a total offer based on outstanding shares of c.541M.
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