MANAGEMENT BUYOUTS

A management buyout occurs when incumbent management takes ownership of a firm by purchasing a sufficient amount of the firm's common stock. These transactions vary due to the conditions under which the firm is offered for sale and the method of financing employed by the managers.

Consider the conditions that may encourage managers to purchase a controlling interest in the firm's stock. The owners of a corporation are its stockholders. These stockholders are concerned with increasing the value of their investment, not only in one specific firm, but for all investments. Therefore, if a majority of the firm's stockholders perceive that the value of their investment will be enhanced by agreeing to be acquired by another firm, they will elect to sell their stock to the acquiring firm at a price they consider fair. Managers of a firm may consider this transfer of ownership a benign event. They may also, however, be concerned that the new owners will not manage the firm most efficiently, that they will have less control over the management of the firm, or that their jobs will be less secure. In this situation, the current managers of the firm may consider purchasing the firm themselves.

Another situation that frequently leads to management buyouts is the case of financial distress. If the firm is having serious difficulties meeting its financial obligations, it may choose to reorganize itself. This can be done by closing failing operations to slow the drain on financial resources and by selling profitable operations to an outside party for the cash needed to restore financial viability to remaining operations. It is not uncommon for firms in this situation to give managers of the divisions being divested the opportunity to buy the assets. This makes sense for two reasons. First, management probably has the greatest expertise in managing the subset of assets offered for sale. Second, it saves the cost of searching for an external party with an interest in the division for sale.

Once incumbent management has decided it is interested in purchasing the firm or a particular portion of the firm, they must raise the capital needed to buy it. Managers in many corporations are encouraged to become stockholders in the firm by including stock and the option to buy more stock as part of their compensation package. The nonmanagement stockholders, however, will expect some compensation from this sale and the value of manager-owned stock is not likely to be sufficient to finance the purchase of the firm or one of its divisions. This means that managers must raise cash from other sources such as personal wealth. If managers have sufficient capital in other investments, these can be sold and used to finance the remainder of the purchase price.

While a management buyout is relatively straightforward when managers have sufficient personal capital to meet the purchase price, the more common scenario requires managers to borrow significant amounts. It is not uncommon for managers to mortgage homes and other personal assets to raise needed funds, but in many transactions these amounts are still not sufficient. In these cases, managers will borrow larger amounts using the assets of the firm they are acquiring as collateral. This type of transaction is called a leveraged buyout, or LBO. The LBO is a common form of financing for large transactions. It provides the management team with the financing needed to control the assets of the firm with only a small amount of equity. Nevertheless, the new firm that emerges from this transaction has very high financial risk. The large amounts of debt will require large periodic payments of interest. If the firm can't meet this obligation during any period, it can be forced into bankruptcy by the debtholders.

This description of a management buyout can be generalized to define an employee buyout. In some situations, it is feasible that all employees, not just a small group of managers, can collectively purchase a controlling interest in a firm's stock. This may be the long-term result of a carefully designed employee stock ownership plan (ESOP), that management has instituted. It may also result from the pressures of financial distress. In 1994 United Airlines was faced with declining profits and strained relations with labor. Management and labor eventually agreed on a swap of wage concessions for a 55 percent equity stake in the firm. In the five following years, the firm became more profitable, the stock price rose significantly, and employees retained a controlling interest in United's common stock.

It is important to note that managers (or employee owners) are no different than other investors. They will assess the risk and rewards associated with a buyout, leveraged or otherwise, and will act in their own best interests. As managers, they have specialized knowledge of the firm that may prove advantageous in charting a future course of action for the acquired firm. By assuming ownership of the acquired firm, they will also assume a riskier position personally. If the potential rewards associated with control are perceived as adequate compensation for this risk, then the management buyout will be consummated.