Ownership strategies - The leader within

It seems that not a month goes by without a broker announcing the completion of a management buyout. With the ongoing credit crunch and the tempting lure of networks and consolidators, can brokers still find the money to finance an MBO?

An MBO acts as a form of succession planning and provides a long-term future for the company, allowing it to maintain its staff and culture. Gary Thorpe, partner at insurance specialist law firm Clyde & Co, says: "If we look at it from a shareholder's point of view, the current management may be concerned that an external buyout could bring in someone they don't like; we all know that insurance broking is a people business. They need personal chemistry, not just between the broker and its clients but also between the management and staff."

From the broker's point of view it is also an opportunity for a new board to take over the established reins and push the business forward. Aberdeen's Central Insurance Services completed its MBO in January; managing director Iain Henry explains it was an attractive offer from a consolidator that spurred the board to action. "The board decided an MBO would be better for the company," Henry says. "We already had a succession plan in place and had secured major income sources so it was a case of lifting the plans into action." Keeping the buyout in-house can also protect a firm's way of operating. This was key to Berkeley Burke, a Leicester-based broker currently undergoing an MBO. Chief operating officer Tim Maxted notes: "An MBO is a way of preserving a firm's culture, which will have evolved over a long time."

There are four main options open to brokers looking to finance an MBO, though most use a combination rather than rely on one single financial source. The choices are: insurer finance, where an insurer buys a broker's shares to provide them with funds; vendor finance, where the majority shareholder sells to the management team, normally for a lower immediate payment but with funds paid later (the owner often becomes a non-executive chairman); debt finance, where the funds are provided by either a bank, and private equity finance.

James Britton, director of corporate finance at private equity firm KBC Peel Hunt, says that the best way to view MBO funding is as a spectrum (see box below): "At one end of it you've got the banks that might lend at 200 basis points plus the London Interbank Offered Rate. At the other extreme there are big private equity firms and venture capitalists and their aspiration for return is between 30 to 40% a year."

The private equity firms will take a hands-on approach to running the business, which may interfere with the management team's ideals. In between these extremes are what are known as mezzanine and pay-in-kind firms, which look typically for a 15 to 20% return on investment and act like a bank. Typical mezzanine investments consist of a debt combined with an equity component that secures the mezzanine lender.

The debt component meanwhile, which generates steady interest payments, provides a measure of downside risk protection. The most common form is an agreement which may provide for both current-pay cash interest and PIK interest, paired with warrants to acquire the stock of the borrower. PIK loans are more expensive than mezzanine loans - they are usually unsecured and accrue interest throughout the duration of the loan that is finalised when it has reached full maturity, typically after five years. The loan also carries a detachable warrant (the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time) to allow the lender to share in the future success of the business.

Each of these financing options has benefits and drawbacks. Insurer financing, for example, can be good for providing a sizeable amount of capital quickly, though how much the insurer then wants to be involved in the running of the business could compromise the broker's independence. Private equity companies are experienced and can provide access to extra capital for events like acquisitions, yet they could also want a say in how the business is run and tend to finance larger brokers only (those with turnover of £10m or more).

Debt is the cheapest option for financing an MBO but, with the ongoing credit crunch, obtaining those funds and proving due diligence to the bank can be problematic. Vendor finance can be useful for lowering the asking price of the broker, though it relies entirely on a good relationship between the shareholders and the new management team and can involve compromise on both sides.

Comprehensive planning is required to prove your business plan is sound. Bill Cooper, managing director of Lloyds TSB's corporate financial markets division, emphasises the advantages of hiring experts to generate accurate business forecasts: "The testing of these forecasts, whether by a bank or a PE firm, is thorough, so the figures must be robust."

As with any serious financial transaction there are hidden costs. The outlay needed to perform due diligence tests after the price has been agreed is often underestimated according to Cooper, who comments: "Verifying all the numbers can be expensive because the lender will want to send out its own accountants to check everything, for which they charge a fee." Cooper also warns of ongoing adviser fees if the MBO goes on longer than expected and a potential drop in commission rates if key insurer partners decide to move on.

Other potential hiccups include taxation issues, warranty disputes and the cost of the manager's time as they attempt to run a company and the MBO. Brokers should also beware frayed relationships between MBO partners and staff anxiety as a result of poor communication. Clyde & Co's Duffy notes: "You need to establish the pecking order early on; leaving those details until the end can cause problems." KBCPH's Britton adds that it was important to keep the staff informed at every stage: "If you transfer from one regime to another without taking the staff along with you then you will fail."

Despite the scope for problems, brokers that go through an MBO believe their firms have improved. Duffy and Thorpe said that their clients benefited from a "new sense of pride and ownership" and that staff members have an incentive to stay with the firm for longer. The credit crunch has made the process more difficult but Maxted at Berkeley Burke reamins confident: "It's only a matter of timing now." Brokers are still an attractive investment prospect, and Duffy adds: "I think the broking sector is doing quite well. Income streams are strong, the market conditions are good and people are better at coming to terms with regulation."

BRITTON'S SPECTRUM OF FINANCE

Return on investment expectation

0% a year: ROI expectation

15% a year: ROI expectation

15-20% a year: ROI expectation

25-30% a year: ROI expectation

30-40% a year

Banks; Mezzanine funds; Pay-in-kind funds; Small private equity firms; Large private equity firms and venture capitalists

CASE STUDY - CENTRAL INSURANCE SERVICES

CIS considered the MBO to be more of a succession plan than a means to make money. The management team is made up of seven people aged in their 30s to early 40s, six of whom are equity holders. The new managing director, Iain Henry, is the primary shareholder, owning 45% of the equity. The other five equity members own 11% of the business.

The MBO took 10 months from initial idea to completion. The decision to set up a holdings company may have lengthened the process but according to Henry it was "an easier mechanism for carrying out the whole process."

Unusually, it was financed entirely through debt finance with Royal Bank of Scotland. CIS has enjoyed a relationship with RBS since 1973 and Ken Matheson, the group's non-executive chairman, has history with the bank which made choosing a financial partner easy. The first sign of the credit crunch occurred midway through the MBO and caused anxiety for the management team. Henry says: "We were concerned when the headlines about the US sub-prime market hit the UK ... but RBS reassured us that they were still happy to continue lending."

Matheson's expertise saved CIS "a lot of money" according to Henry, because with him on board there was no need to hire external advisers, though accountants and lawyers were still required. Henry recommended negotiating a flat fee with advisers early on in the process to save money. The brokerage itself cost the management team £13m and the additional fees required for lawyers and accountants totalled around £100,000, though without Matheson's knowledge CIS could have paid up to £250,000 in costs.

Following the completion of the buyout, CIS' new £3m headquarters in Aberdeen was opened by First Minister of Scotland, Alex Salmond, in February 2008.