Private equity is back: How to do a management buyout


We have seen a solid trending of private equity financings and interests from private equity firms that began in 2010. Both private equity as well as the debt markets to finance a management-led buyout are on solid footing today.

This article will walk a potential management team through the basic steps of performing a management-led buyout and in the end show the management team how they will realize their wealth, even if they do not have a lot of capital to invest in the transaction. Below is the hypothetical example of a management/leveraged buyout in which the chemical division of a large Texas-based holding company is acquired through a management-led buyout. The board of directors of Diversified Industries has decided to sell off its chemical division in order to refocus its corporate strategy. After much deliberation, three key managers decide to join forces and execute a leveraged buyout of the division.

  • Financial analysis of the division. After a detailed financial analysis of the chemical division, the division generates approximately $10 million of annual cash flow and the business is worth $50 million, or five times annual cash flow.
  • Bid offer made and signing of the letter of intent. The managers submit a $50 mil-lion cash purchase price offer to Diversified Industries, which ultimately accepts the offer. A letter of intent is drafted and signed between the two parties defining their preliminary understandings and crystallizing in writing the basic terms of the transaction.
  • Structuring and arranging financing. The investment bank creates and circulates to capital providers a confidential offering memorandum. Term sheets from three separate capital providers are received, negotiated and signed that provide for the $50 million in financing as follows: (1) $20 million of senior secured bank debt, (2) $15 million of mezzanine debt and (3) $15 million of private equity capital.
  • Performing due diligence. Over the next 60 days, the managers, their investment bankers, attorneys, accountants and lenders all continue to pursue their necessary levels of due diligence to satisfy their internal requirements. 
  • Negotiating the purchase agreement and closing. Upon successful completion of due diligence, the attorneys for the chemical division management team and Diversified Industries will have drafted and negotiated the final terms of the acquisition purchase agreement. Other issues to be dealt with between the chemical division and the holding company include human resource issues, tax allocations issues and the treatment of certain liabilities. The transaction closes 135 days after the signing of the letter of intent.
  • Selling the business at the end of five years. Over the next five years, the former chemical division managers double the division’s cash flow from $10 million to $20 million at the end of the fifth year. The chemical division is sold at the end of the fifth year to a strategic buyer for the same multiple that it was purchased for, a five times multiple of cash flow. Thus, the chemical division doubles in value from $50 mil-lion (at close) to $100 million at the end of the fifth year. During the five-year holding period, the managers use the free cash flow of the chemical division to repay one-half of its debt, reducing it from $35 million at close to $17.5 million by the end of the fifth year. Thus, the net equity value of the chemical division increases from $15 million at close to $82.5 million.
  • Management’s equity participation. The primary upside received by the management team for undertaking the buyout and ultimately creating the new value was an investment into the company and stock options to collectively purchase 20 percent of the common stock. When the company was sold at the end of the fifth year, the three managers’ 20-percent ownership position was cashed out for $16.5 million ($82.5 million times 20 percent). This article does not constitute legal or federal tax advice and is not intended or written to be used, and may not be used, for the purpose of avoiding tax-related penalties under the Internal Revenue Code.  

For more information, contact Jeremy Osterberger at (281) 538-9996 or