The Looming Threat of MBOs to Small-Cap Private Equity: A Perspective from the Trenches
In the private equity world, competition is fierce, but the satisfaction of successfully executing a deal makes the grind worth it. We scour the market, build relationships, assess value and structure fair deals to drive growth for companies with high potential therefore creating value for our investors, the society and the economy. As PE players, we thrive in the complexities of sourcing, negotiating and closing deals that often require a delicate balance of strategic insight and operational know-how.
But lately, there’s been a looming threat on the horizon: Management Buy-Outs (MBOs). MBOs are not a new phenomenon in the M&A world, but their increasing prevalence in small-cap deals has become a particular challenge for players like us. What stings us the most is when we do all the heavy lifting — only to see the company handed over to its management team at the very last steps of the transaction process.
As small-cap PE investors, we understand the importance of aligning incentives with management teams. However, the rise of MBOs is starting to feel like an unfair game, one where PE players are being left out in the cold after having paved the way for success. In this article, we’ll explore why this trend is so concerning and how it threatens not only the hard work we put into deals but also the future of small-cap private equity.
Understanding the Dynamics of Management Buy-Ins
A Management Buyout (MBO) occurs when a company’s existing management team purchases the business, often with the help of external financing. In an MBO, the managers become the new owners of the company, and this can be an attractive option for both the company’s management and the current owner.
From the perspective of the current owners, an MBO often provides a smooth transition, as the managers are already familiar with the business and can ensure operational continuity. For the management team, an MBO offers them the chance to take control of the company they know intimately and potentially benefit from its future growth.
However, from the perspective of a PE firm, MBOs can represent a huge loss — particularly when they come late in the deal process. After all, it is the PE firm that often does the heavy lifting, from identifying value in the company, negotiating with stakeholders and creating strategic growth plans. To be cut out at the last minute by the management team stepping in with an offer can feel like a betrayal after months of work.
The Private Equity Journey: From Identification to Deal Execution
The path to a successful deal in small-cap PE is rarely straightforward. It begins with finding the right company — often an underappreciated or undercapitalized business that has untapped potential. We spend countless hours analyzing the market, reviewing financials, understanding the industry and identifying opportunities for operational improvement or strategic growth.
Next, we approach the company, build relationships with the key stakeholders and position ourselves as value-added partners. This often involves more than just showing up with a checkbook; we demonstrate how we can contribute strategic insight, operational expertise and the capital required to scale the business.
The due diligence process is another major investment of time and resources. We assemble teams of experts to assess the company’s financial health, uncover hidden risks and validate growth assumptions. This phase involves detailed legal work, financial modeling and long, intense negotiations.
At the culmination of all this hard work, we structure a deal that benefits everyone involved — only to find, at the last minute, that the management team has secured financing from elsewhere and has arranged an MBO. Suddenly, everything we’ve built—the trust, the relationships, the investment of resources — vanishes.
The Growing Prevalence of MBOs in Small-Cap PE
Why are MBOs becoming such a common issue for small-cap PE players? There are several contributing factors:
Access to Capital: Managers today have unprecedented access to financing options, particularly from non-traditional sources like family offices, private debt funds and mezzanine lenders. These sources often offer favorable terms, making it easier for management teams to pursue buyouts without relying on external PE firms.
Owner Preferences: For business owners, selling to management often represents the path of least resistance. Management teams already know the business inside out, reducing the perceived risks associated with transition. Owners may feel more comfortable selling to familiar faces rather than bringing in an outside PE firm, which may implement significant changes to operations, strategy, or leadership.
Manager Ambitions: For managers, the prospect of owning the business they run is highly attractive. With an MBO, they can take control of their own destiny, enjoying both the autonomy of ownership and the financial upside that comes with it.
Trust and Relationship: Management teams often have long-standing relationships with the business owner. This gives them an inside track and allows them to negotiate directly with the owner while PE firms are still navigating the formalities of structuring deals.
Strategic Motivations: Some management teams view MBOs as a way to ensure stability. They may feel that bringing in outside investors, such as PE firms, could disrupt the company’s culture, introduce new pressures or lead to changes in leadership. By organizing an MBO, they can maintain control while keeping the business on its current course.
The Frustrations of Being Sidelined
For a small-cap PE firm, being cut out by an MBO after months of hard work is frustrating on many levels. First, there’s the financial loss. We invest significant resources — both time and money — into sourcing and structuring deals. Whether it’s engaging consultants for due diligence, assembling legal teams for negotiations or spending months building relationships with key stakeholders, the costs add up quickly. When an MBO occurs at the last minute, all of this becomes a sunk cost.
But the financial loss is only part of the frustration. There’s also the emotional toll. Deal-making is not just about money; it’s about relationships, strategy and the satisfaction of seeing a vision come to life. To be sidelined after months of hard work can feel like a betrayal—especially when the management team uses the value we’ve helped uncover to execute their own buyout.
What Can Small-Cap PE Players Do to Protect Themselves?
While the rise of MBOs is a challenge, it is not insurmountable. There are several strategies that small-cap PE players can implement to protect themselves from being sidelined:
Early Engagement with Management: Building strong relationships with the management team from the outset is crucial. By aligning their interests with ours early on, we can position ourselves as partners rather than competitors. This can reduce the likelihood of management pursuing an MBO behind our backs.
Incentivizing Management: Offering management a stake in the business as part of the deal structure can help align interests and prevent them from pursuing an MBO. If management feels they have a meaningful role and stake in the business’s success, they’re less likely to go rogue with a buyout.
MBO Protection Clauses: Including clauses in the initial stages of deal negotiations that give us protection against MBOs can be a safeguard. This ensures that if an MBO is on the table, we can get our costs reimbursed.
Demonstrating Our Value Beyond Capital: PE firms need to continue showcasing the value they bring beyond financial resources. Whether it’s operational expertise, industry knowledge, or access to broader networks, we must emphasize that our involvement can accelerate the company’s growth in ways an MBO may not.
Better Due Diligence on Management Intentions: During the early phases of negotiations, it’s important to assess the likelihood of an MBO attempt. Understanding management’s ambitions and potential access to financing can help us foresee and address the risk early in the process.
Management buyouts are increasingly becoming a thorn in the side of small-cap private equity players. While MBOs provide attractive benefits for management and business owners, they represent a significant challenge for PE firms that invest so much time and effort into structuring deals, only to be cut out at the last minute.
“Our firm position on this, is that we do not start due diligence, if we do not feel protected enough. Doing multiple due diligences without having MBO protections would make every small cap PE bankrupt these days. In other words, we don’t gamble the DD costs anymore to find out in two months that the company is sold to its managers. We had painful experiences in the last few years and decided to put an end to that.” – says Fabian Kroeher, Managing Partner at Winterberg Group
As PE players, we must stay vigilant and proactive in addressing the threat of MBOs. By building stronger relationships with management, offering creative deal structures and showcasing the unique value we bring, we can mitigate the risk of being sidelined. After all, in the world of small-cap private equity, adaptability is key — and it’s often the difference between a deal closing in our favor or slipping through our fingers.