Tom without Jerry

An MBO without a private equity sponsor may sound rather like Tom without Jerry or fish without chips: interesting in theory, but surely something that wouldn't happen in practice, right? Wrong. There are banks in the market that are perfectly happy to go it alone when backing management in a leveraged buyout.

To take a recent example, Bank of Scotland supported management's acquisition of UK housebuilder Beechcroft Developments from John Laing in a transaction valuing the business at £34m, injecting a further £30m in working capital. The bank was the only third party provider of funding in the deal, arranging senior debt, mezzanine and equity.

Doing away with the private equity sponsor in a financing investment. To most private equity firms investing in buyouts, the availability of a controlling stake in the business they are backing is a necessary condition. Their strategy is to initially offer management a minority position in the deal, coupled with a ratchet mechanism that allows them to accumulate additional equity as the return to the sponsor increases in tandem with the value of the business.

The joint venture approach as practiced by BoS and others therefore provides a greater incentive for management to maximise the value of the asset. However, this does not imply that the bank takes no interest in the running of the business. When entering into this kind of transaction, BoS typically seeks board representation and insists on the appointment of an independent non-executive.

It is also worth noting that the structure does not come entirely without cost to the management team. As befits the ?me first? approach to downside protection that is typical of banks, there will be a requirement for the bank to have obtained a specified minimum return before management begin to realise a reward for their efforts.

The private equity view
Should this approach to leveraged buyouts cause alarm among private equity sponsors? This answer is no, for a number of reasons. First, there is only a limited amount of capital available for such transactions. Second, many banks have fared badly in direct buyout investment in recent years and have lost their appetite. Banks that do have an interest are most likely to apply this model only to smaller transactions, and preferably in industries where they feel comfortable. Bank of Scotland, for example, focuses primarily on the home building, healthcare and commercial property sectors where asset backing tends to be available.

Also, given the blend of financing provided and the relatively safe risk profile of the assets, returns are going to be lower compared to a conventional private equity ? probably somewhere in the sub 20 per cent range.

This is why even private equity sponsors that are focused on the mid-market do not feel under threat. ?I don't see them encroaching on our market, but more as additive to it? says John Snook of Close Brothers Private Equity, whose parent, independent merchant bank Close Brothers, has a team with a similar brief to Bank of Scotland's. ?[The banks involved] tend to focus on asset-rich or cash generative companies and on deals we would not necessarily do anyway.?

For managers to be involved in a buyout where there is no equity house in the mix might be a liberating experience ? as long as everything goes to plan. However, quite what the bank would do, or indeed could do, if a deal went sideways and a financial covenant were breached, is a question that many private equity investors would love to know the answer to.