Making sure MBO debt doesn’t have a sting in the tail
When considering a management buy-out (MBO), it’s important to look at the potential changes to a company’s debt structure from a credit point of view. This is just one of many details in this sort of deal but if left unaddressed, it can become a real sting in the tail.
An MBO can be an exciting time. However, as with any significant development in a company’s history, it presents new challenges as well as new opportunities.
It is normal for there to be an increase of debt on the balance sheet after an MBO, this doesn’t have to be a problem. But if ignored, it may affect the way trade creditors assess the risk of doing business with the company. This could result in unfavourable changes to suppliers required terms and conditions of trade.
In the process of arranging an MBO it would be easy to overlook the credit rating agencies but given many creditors look to these agencies to decide the terms of credit they may offer a business, doing so can have commercial ramifications.
Why is credit worthiness important?
Credit worthiness is assessed by one of a limited number of agencies. Among the best known are Experian, Dunn & Bradstreet and Equifax. Their assessment of a business is used by other firms for a number of purposes.
Suppliers will use a company’s credit rating to assess the risk that they may not be paid. Firms issuing long-term contracts will want assurance that their chosen partner has the financial stability to see the deal through. Many more institutions will use credit ratings to help them determine their terms of trade.
This means that a reduction in a company’s credit rating may increase the working capital demands on the business, affecting both cash flow and liquidity.
How credit ratings are assessed
Experian calculates credit worthiness on a score card with 50 criteria, which are both financial and non-financial. These include profit and loss and balance sheet metrics, as well as the company’s recent supplier payment history, the sector it operates in and broader economic factors. A key metric is net assets, which is often reduced by the increased debt taken on during an MBO. Other agencies work in a similar way, but with variations. Amongst other metrics, Dunn & Bradstreet collate payment history through eligible suppliers on its Trade Exchange Program.
Is an increase in debt always a valid reason for a less favorable credit rating?
No. When assessing a company’s credit worthiness, the changing terms and security of the debt structure should be more important – and different types of debt should have a different impact on a credit rating. However, this is not always transparent to the credit rating agencies from publicly available data. When unable to assess the terms of the debt, agencies will usually take a prudent view, possibly with an adverse effect on the credit rating.
For example, secured bank debt can reasonably be seen as putting more onerous obligations on the company than unsecured vendor loan notes. Bank funding of an MBO will often be on terms which give the bank considerable control over the business if covenants are breached. Funding by a vendor rarely carries such strict conditions. To a supplier, the consequences of default on bank debt are more severe than a vendor loan note. External parties can often not distinguish between the many types of debt instrument that might accompany an MBO so treat these in the same way.
Can anything be done?
Credit ratings can only reflect what the credit rating agencies know about a business and if there is no press coverage the agencies may not register the MBO of an SME. When accounts are filed this is often the flag that rings in the changes. Agencies will only amend their credit ratings on the information available. If this is limited as is often the case with filed accounts, a prudent view will be taken based on a worst-case scenario.
The solution is for companies to inform rating agencies themselves, ensuring they understand the full rationale for the deal.
Experian will undertake a credit review for a small fee. This assesses the management’s actions, the business plan and takes credit references from suppliers. The process will review details such as the strategy behind the deal structure and the management’s motivation for it. Importantly, it will also assess the MBO funding to differentiate between varying terms and charges on assets.
Dunn & Bradstreet will consider amending a credit rating on sight of a business’s full accounts, which is an important consideration for companies that have previously used the abbreviated files at Companies House.
With contacts at the relevant credit rating agencies and by enabling greater transparency on the terms of MBOs, we have enabled credit rating agencies to make a more informed decision on the credit worthiness of our clients, benefiting their ongoing trading.
Finally, the level of credit a supplier extends to a business is in most cases is a decision of that supplier. It is wise to speak directly to key suppliers at the time of a deal or shortly afterwards, to ensure that they understand the impact of an MBO and are prepared for any adverse news that may come from a credit rating agency.
In the absence of published statistics it is hard to assess how widespread credit rating downgrades are after a management buy-out. However, in our experience this one of several issues that often crop up and needs to be considered.
With significant experience in advising managements through the MBO process, we are focused on delivering the best results for our clients – while ensuring they avoid an number of pitfalls less experienced advisors may overlook. If you are thinking about an MBO – get in touch.