How Private Equity Screens for LBO Candidates

Kateri Zhu | May 28, 2014

The leveraged buyout (“LBO“) has become well-practiced among private equity professionals, and is now standard industry practice as a means by which to acquire private companies.

Yet it can be used by any capital provider with the experience, credibility and business to secure the confidence from the financing sources required to execute an LBO.

The LBO gained prominence in the 1980’s thanks to Jerome Kohlberg and his associate, Henry Kravis. These two joined forces with the latter’s cousin, George Roberts, J.D., to conceive what would become a private equity triumvirate with the birth of their firm, KKR. Today over 2,800 private equity firms exist in the US alone, buying tens of thousands of companies each year.

As its name implies, the use of financial leverage, or debt, is one of the primary elements that distinguish an LBO from a traditional acquisition executed with cash or stock. Leverage can enhance equity returns to the sponsors, who have discretionary control over all cash flows that exceed the debt payments incurred. Because interest payments on debt are tax-free, leverage improves equity returns by reducing the amount of equity required to acquire a company, and then further magnifies those returns through the favorable tax treatment that interest payments receive under US tax code.

Not every company is a viable LBO candidate, however.

Detailed below are a set of characteristics that deal professionals typically seek when assessing a target company’s viability for an LBO-style change of control transaction.

Hard Assets

Banks lend more cheaply against hard assets as collateral. If your assets consist predominantly of your employees, it can be very challenging to gain bank financing. Bank debt is usually collateralized by the physical assets of the company, so the more plentiful, sizable, valuable, and stable the assets – machinery, inventory, receivables, real estate – the more available and cheap the leverage for your deal becomes. While these hard assets certainly help the credit structure, intangibles like brand names, goodwill, and human capital have nonetheless become increasingly important considerations in an LBO.

Steady Cash Flows

Free cash flow is king in an LBO, and it’s generally defined as the amount of cash that a business generates in excess of what’s required to maintain its current operations. The reason this is so critical is because the free cash flow of a company’s operations determines how much leverage that company is capable of supporting without imperiling its ability to stay solvent in a downturn.

Maturity of Market

Companies selling into an established, well-defined market (e.g., automotive valves, soft drinks, etc.) are more conducive to an LBO than those selling into a fledgling market (e.g., social networks, nanotech, etc.).  Indeed while an entity’s growth prospects are important, they are secondary to stability. A mature market with predictable demand, steady revenue, and no eminent game-changing, competitor-crushing disruptions is ideal for a buyout because the cash flows of the company are likely to be substantively more predictable.

Low Capital Expenditure Requirements

The lower the annual investment required to operate a business, the better. Consistently high levels of capital expenditure are unwelcome, as they consume cash that could otherwise go toward paying interest payments, principal debt payments, or dividends to the equity holders.

Non-Core Assets

There are few ways to boost cash flow more painlessly than to liquidate non-vital assets that carry an attractive value to the right bidder. If a publisher derives the majority of its topline from digital media but maintains a costly and unprofitable printing press, it can sell the latter for cash. An experienced financial sponsor keen on leaning out of a business often spots this kind of low-hanging fruit quickly, and might move to sell anything of value that’s not functionally synergistic with the core business.

Forced Divestitures

Regulators from time to time mandate corporate spin-offs for antitrust reasons. For instance, if two coal companies merging would cause their combined revenue or market share to eclipse acceptable antitrust thresholds, the approval of the merger would be contingent upon spinning off certain mines to a third party. The regulatory divestiture typically presents a buyer with a good deal, as the sale process is typically extremely hurried so as not to delay the proposed merger.

Sample Due Diligence Checklist - Inline CTA

Non-Core Corporate Divisions

Sometimes some of the subsidiaries or divisions of large conglomerates no longer make sense or fit in with the future of the company’s plans. In these instances companies will “spin off” these less relevant divisions, realize the cash, and reinvest it in accordance with the new strategic directives of the organization. In October 2011 for example, Smith & Wesson announced that it was spinning off its security division to concentrate on its more profitable firearms business.

Businesses with Sub-Par Management

The most successful private equiteers often possess high degrees of specialization, and for that reason, can add tremendous value to the organizations that they acquire. It’s meaningfully more easy for savvy industry veterans to spot solid businesses that are underperforming as a consequence of poor management. Such a business is an attractive LBO candidate to a buyer that is confident in its ability to more efficiently operate the company and survive the debt burden.

Businesses Lacking a Succession Plan

This qualifier is especially pertinent today as baby boomers retire in the United States and leave healthy businesses lacking heirs. Private equity firms typically love these companies as they present opportunities to acquire a high quality business that needs minimal help, but comes with an owner that simply wishes to cash out.

Businesses Impaired by Underlying Industry

Sometimes businesses with attractive long-term earnings capacity are held hostage by a poor underlying industry or economy, causing deflated trading prices and valuations. Such opportunities are attractive, offering a chance to buy companies for cheap before an expected rebound in the market price.
Bottom line: understanding how private equity firms screen for and think about LBO feasibility is exceptionally beneficial to advisors evaluating which assignments to take on, entrepreneurs thinking about who to sell to, management teams considering an MBO, and corporations evaluating which buyers will be interested in purchasing their non-core divisions.
(Source: Scoopbooks’ The Practioner’s Guide to Investment Banking)

Sample Due Diligence Checklist

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