Three dirty letters – MBI

The M&A market is both broad in its range of differing transactions and circumstances and deep in that each has its own technical nuance. As with any market, the competitive frontier continually changes as the market finds new ways to solve old problems. There are, however, certain axioms that exist which endure so long that they become self-fulfilling – the markets typically negative attitude to MBI transactions is one such example. This article looks explore the causal factors for this and whether they are justified and relevant in today’s market?

Why the caution initially?

In the pre-2008 economic boom of the early nineties onward, liquidity was plentiful and many funders supported MBI/Management-Buy-In transactions as funders looked for more ways to deploy capital. When the macro-conditions changed and the market turned, funders were found to have over-extended themselves into overleveraged transactions led by inexperienced leaders and teams who often didn’t have material investment (“skin in the game”) themselves. Subsequently, provisions & losses accrued for the funders – arguably in a set of market conditions which would have challenged any business model irrespective of ownership class.

On reflection, whilst MBI transactions may have given rise to a disproportionately larger frequency of losses, the concept of an MBI (“an external individual buying into an existing business”) being fundamentally flawed was missing the point. The symptom was the quantitative number of losses but the illness that caused the symptom was qualitative – in that too many “poor” MBI had been backed.

The perfect storm

Along with the competitive market conditions forcing liquidity to be deployed at increasing levels of risk for ever reducing margins – the liquidity climate of the pre-global-financial-crash was compounded a range of factors which proved to be the match that lit the bonfire.

• Many credit institutions were built for scale and increasingly so,
• Poor systems (forget left arm not talking to right arm, left arm didn’t know there was a right arm!),
• Out-of-date-data (many institutions running on client data 12-18m old),
• Pyramid structures meaning key credit decision makers never met let alone understood clients,
• Skills-gaps meant that those at the client coal-face often didn’t have the technical competency to appreciate what was going on or just as importantly how that could change over time

With such structural inefficiency, funders were never able to understand what they had nor were they able to operate with the deftness and nimbleness required to optimally react in time. Meaning that by the time they were aware it was often after the event and by which time there were no options available.

What was the reaction by funders?

The resulting outcome wasn’t recalibration or an iterative contraction of funding in that market but instead a complete collapse. This consensus market view of MBI deals were that they were synonymous with losses.

Because Independence Capital didn’t exist and the market had no evidence of successful non-sponsored MBIs. That lack of MBI transactions then resulted in the inference that if something wasn’t happening at volume, there wasn’t a market to serve – so why push against market norms and invent products and liquidity to serve a market that didn’t exist? Obviously this was missing the point, they weren’t happening not because there wasn’t a market but because there wasn’t an eco-system built to 1) raise awareness for mgmt 2) liquidity with appetite to transact 3) advisors with expertise to manage all of the above.

The imbalance between buy-side and sell-side experience

In order to make a success of any buy-side transaction one of two things have to happen. You need either an experienced buyer or an inexperienced buyer paired with an appropriately skilled & experienced advisor. In 2022 that doesn’t sound like it should be too much of an ask. But there is a problem and its been brewing for decades.

Research conducted by Independence in 2018 – sampling the experiences of the Corporate Finance community – found that less than 29% of the community had any buy-side experience and those who did often did by exception as opposed to by design and custom. The reason this phenomena exists is five-fold:

1. Selling businesses yields higher fees – which is a gravitational pull of its own
2. Selling creates immediate gratification – the success of buying is largely realised years later
3. 85% of business sales (by volume) are under £5m in value – the fee potential of smaller deals means advisors cannot really justify the time-cost/experience of seasoned advisors and as such a great swathe of the M&A market has become more of a “process” than an advisory product. That process requires a very different set of skills and is often made of a chain of discrete skills/people.
4. Sell-side advisors often have their engagements termed such that clients and buyer have little to no recourse to advisor. The buyers advisor however often has to carry material amounts of professional indemnity cover and accept through their engagement a material level of risk which can endure for an extended period of time whilst the post-completion period matures.
5. Growth in private equity and industry M&A roles has seen leading talents with buy-side experience taken away from the corporate finance marketplace.

The outcome of this skills imbalance means that management are poorly served with options and in fact only medium-to-large corporates are effectively served – as they are the only parties with the resources to justify the fees of the Big-4/Nationals who (because of the size of their teams) do have relevant experience but command a minimum fee size which is not economical for individuals/startups.

External individuals investing are considerably more risky than incumbent mgmt…..or are they?

In a mature, scaled and sector-leading corporate the above is almost certainly fact. That is so because in business of that profile, size and maturity, you would expect a capable team, mature infrastructure, credible reporting and liquidity & capital which allows the business to think and plan operationally as well as strategically. But that accounts for a tiny fraction of the market, so what’s left:

• The owner-managed SME

  • Often a limited 2nd line management/succession team
  • Often a narrow base of experience outside of the business
  • Often with limited resources and access to capital
  • Often with a regional/independent advisor with limited advisory experience
  • Often of a scale where power imbalanced between customers/suppliers

• The medium-sized company

  • Traversing a journey to large but without the experience of what it takes to cross the chasm
  • Often of a scale to be attractive to national/global advisors
  • Often of a scale to be able to pay enough to attract/invest in talent
  • Often of a scale to be attractive to debt and equity providers alike
  • Often of a scale to have some influence on customers/suppliers

• High-growth companies

  • Have outperformed their resources and achieved scale despite minimal resources
  • Are inherently not built for maturity or increasing growth
  • Often led by leaders who have talent at growing small businesses but not larger ones

• Under-performing companies

  • Whether big or small, they have a deficiency which drives underperformance
  • The fact underperformance exists means that mgmt have failed to identify and mitigate

The only advantage any incumbent team would have above external new-to-company talent is their domain knowledge of the company but surely that can be learnt quicker than the experience gained across multiple careers.

Clearly, adding sub-standard new talent is only likely to add risk to any situation. But adding sector-leading talent to any of the above scenarios should only be additive the only question is how by how much? For medium companies, the lowest opportunity arbitrage exists with the gains made over the incumbent likely to range much narrower than SME and growing companies where the skills-premium versus the incumbent team is far larger and therefore so too should the potential to enhance enterprise value be more acute.

The Independence Mission – championing premier leadership into MBI opportunities

At Independence Capital, we see MBI as an untapped market of opportunity. We choose to bridge many gaps in the M&A market and doing so champion the potential of some great teams:

• We create an alternative to traditional private equity
• We bring market-leading buy-side experience
• We have expertise in prospecting off-market SME & Mid-Market deals
• We share risk on transactions
• We redefine the role of the advisor/investor which makes us affordable to and aligned with mgmt
• We create exceptional MBI cases which will renew market faith (debt/equity) in MBI
• We provide investors with a new asset-class by tapping into the top-of-market talent
• We provide owner-managers with a route to scale/exit by leveraging the talents of people they ordinarily wouldn’t afford to be able to bring into their business

Its early in our mission to redefine the attractiveness of those three letters. But change is coming…