Business reorganisation and management buyouts

A conglomerate owns a bank, a brewery and a cement works. The stock market values it at less than the three parts would fetch alone. The board has choices: split it, sell a part, float a slice, or hand a division to its own managers. None of these is a rescue. They are strategic moves by a company that is not in distress.

A separate decision, the buy-back, returns cash to shareholders when the company has more than it can use.

This topic covers business reorganisation as opposed to reconstruction, demergers, divestments, equity carve-outs, sell-offs, spin-offs, split-offs, liquidations and asset stripping, management buyouts (MBOs) and buy-ins (MBIs) and how they are funded, going private and private equity, share buy-backs and the Nigerian rules on them, and the rules on dividends. The previous topic covered capital reconstructions. The next covers forecast financial statements.

The November 2014 Pathfinder paper compared closing a company with a management buyout.

Key terms in plain English

Syllabus check

This topic is in syllabus area D (mergers and acquisitions, organic growth and corporate restructuring). It covers:

• demergers and different types of divestment;
• the rules on purchase of own shares;
• management buyouts and buy-ins.

CAMA 2020 and share buy-backs

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.

Reorganisation, demerger and divestment

A capital reconstruction is for a company in difficulty. A business reorganisation follows a strategic decision, such as selling a non-core business or separating two divisions.

Demerger

A group splits into two or more independent companies, and its shareholders receive shares in each. They may hold both or sell one. Any group debt has to be allocated by agreement with lenders. A demerger needs shareholder consent and is justified only if it raises their wealth.

Reasons: a conglomerate is often valued at less than the sum of its parts; specialised businesses can focus on core competences and develop their own strategies; head office costs may fall.

Divestment

The sale of a business, such as a subsidiary, to an outside buyer: another company, a management team (MBO) or an external team (MBI). Unlike a demerger, ownership moves to others, usually for cash. Purposes: raise cash, shed a loss-maker, take an attractive price, or exit a non-core business to concentrate on core competences.

Other methods

• Equity carve-out: create a new subsidiary, transfer part of the business to it and sell a minority to the public. The parent keeps control and gets cash.
• Sell-off: sell part of the business to another company for cash or securities. It creates value if the buyer’s price exceeds the PV of the cash flows the part would give if kept.
• Spin-off: the business becomes a stand-alone company and its shares go to the parent’s shareholders in proportion. It can also make a company less attractive to a bidder.
• Split-off: holders may swap parent shares for subsidiary shares, often at a premium (for example ₦1,100 of subsidiary shares for ₦1,000 of parent shares, 10%).
• Liquidation: closing the company, because of difficulty, a completed purpose, or because the assets are worth more sold separately.
• Asset stripping: buying an undervalued company to sell its assets for a profit, which can leave the shell in poor shape.

Management buyouts and buy-ins

For the seller an MBO or MBI is a divestment. For the managers it is a business venture. In an MBO the managers of the subsidiary buy and run it. In an MBI an external team does. The team rarely has enough capital, so venture capital is needed. A venture capital firm will back it if:

• the managers have a robust, realistic business plan;
• they appear capable of making the business succeed;
• they make a significant capital contribution, so they have a strong financial motive;
• returns look satisfactory for the high risk.

A typical structure:

• managers buy shares with their own money
• the venture capital firm buys equity in a balance that keeps the managers motivated
• it also provides redeemable preference shares or unsecured loans, to be redeemed as the company becomes cash-rich
• secured bank loans make up the rest
• managers may get a share option scheme

The expected profits must cover the interest and preference dividends and leave a profit for equity.

1. Closure.
   proceeds = 1,155 − 297 = ₦858m against liabilities of ₦1,540m, so creditors receive about 55.7% and shareholders nothing.
2. Benefits of an MBO include: cheaper and quicker than other disposals; less resistance from managers and staff; possibly a better price because managers know the business; continuity of management; and stronger commitment from owner-managers.
3. Buyers need to be found, the price negotiated and due diligence done, assuming Nuts is sold as a going concern.

Going private and private equity

A listed company may go private, with its shares delisted and bought by a small group of managers and venture capital, or by a private equity firm. Reasons: no benefit from the listing (no need or ability to raise equity or to use shares for takeovers); or the chairman or chief executive, a large holder, thinks the shares are undervalued.

A trend of firms going private may suggest the market is not efficient in supplying capital to companies.

Private equity firms buy underperforming companies using a fund and bank borrowing, install a new management team on large incentives, may sell and lease back property or borrow against it, and later re-list the company to exit. Success has depended partly on cheap debt with tax relief on the interest.

Share buy-backs

A company buys some of its own shares and cancels them, either on the market or by a fixed-price offer to willing holders. Purposes: return surplus cash when there are no good investments (an alternative is a special dividend); raise EPS and, it is hoped, the share price; raise gearing by replacing equity with cheaper debt.

Undesirable motives: removing cash from a failing company to the detriment of creditors, or propping up the share price. Hence strict rules.

The rules. Under CAMA 2020 (s. 184 and following):

• the articles must permit the purchase
• the members pass a special resolution
• the shares must be fully paid
• the company must stay solvent
• notice is published in two national newspapers within 7 days
• the directors file a declaration of solvency with the CAC within 15 days
• creditors or aggrieved members may ask the Court to cancel the resolution within six weeks
• the company may not buy if only redeemable or treasury shares would remain
• payment is made from distributable profits (s. 185)
• treasury shares may not exceed 15% of the issued shares

For quoted companies, the SEC rules also limit a buy-back to 15% of the issued and paid-up equity capital, require a special resolution, and require debt to equity of not more than 2:1 afterwards.

ICAN’s example: X Plc repurchases shares of nominal value ₦100,000 for ₦110,000 from profits. Share capital is debited ₦100,000 and retained profits ₦10,000, with cash credited ₦110,000; then ₦100,000 is moved from retained profits to the capital redemption reserve. If ₦40,000 is raised by a fresh issue, only ₦60,000 moves to the reserve.

Dividends

Dividends are declared at a general meeting on the directors’ recommendation, and the meeting can reduce but not increase the amount. They are paid only from distributable profits: profits from using the company’s property, revenue reserves and net realised profit on fixed assets sold.

No dividend may be paid if the company is, or would be, unable to pay its debts as they fall due. None may come from the share premium account or the capital redemption reserve, which can fund bonus issues.

The rules in more depth

Why a conglomerate discount arises

Investors prefer to choose their own mix of businesses, and complex groups are harder to value.

Why managers need their own money in an MBO

It aligns their interest with the investors’ and shows confidence.

Why buy-backs are restricted

They can drain cash from a weak company at creditors’ expense or distort the share price.

Why the capital redemption reserve exists

It keeps the permanent capital of the company intact for creditors after shares are bought from profits.

Effect on analysis

Match the method to the aim, test value created, and check regulatory limits.

Worked examples

1. Maximum in a year = 15% × 200m.
2. Maximum = 30m shares.
3. A larger repurchase would breach the SEC limit as stated by ICAN.

1. Equity falls to ₦150m.
2. Debt to equity.
   300 ÷ 150 = 2.0, which is at the limit.
3. A ₦60m buy-back would give 300 ÷ 140 = 2.14, a breach.

1. Managers invest ₦50m of equity; venture capital buys ₦100m of equity and ₦100m of redeemable preference shares.
2. A secured bank loan provides ₦250m.
3. Total = 50 + 100 + 100 + 250 = ₦500m.

1. Premium = 100 ÷ 1,000.
2. The premium is 10%.
3. The premium encourages holders to swap.

How to score full marks

• Distinguish reorganisation from reconstruction.
• Name the exact method and say who ends up owning what.
• Test whether the move creates shareholder value.
• For an MBO, list the venture capital conditions and structure.
• For a buy-back, state the purpose and the regulatory limits.
• Link to the case facts.

Common mistakes in the exam

• Treating a demerger as a sale.
• Confusing a spin-off with a split-off.
• Forgetting the manager’s own investment in an MBO.
• Quoting buy-back limits without saying they must be checked.
• Paying a dividend from share premium.
• Ignoring creditors in a buy-back.

Quick revision

• Reorganisation is strategic; reconstruction is rescue.
• Demerger: shareholders hold both. Divestment: sold for cash.
• Carve-out, sell-off, spin-off, split-off, liquidation, asset stripping.
• MBO/MBI: venture capital, plan, managers’ stake, exit.
• Buy-back: surplus cash or gearing; 15%, 2:1, special resolution, solvency declaration.
• Dividends from distributable profits only.
• CAMA 2020: ss. 147, 182, 184 to 190, 426, 427 and 433.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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