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LBO Candidate Characteristics

Guide to Understanding the Characteristics of an Ideal LBO Candidate

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LBO Candidate Characteristics

In This Article
  • What characteristics make a company a good LBO candidate?
  • Which factors determine the characteristics of an ideal LBO candidate?
  • What types of industries tend to attract more interest from private equity firms?
  • What are the key product/service considerations for LBO candidates?

Determinants of a “Good” LBO Candidate

In a leveraged buyout (LBO), a private equity firm – often referred to as a “financial sponsor” – acquires a target company with a significant portion of the purchase price funded using debt.

The reliance on debt securities like loans and bonds to fund the transaction causes there to be fixed financial costs (e.g. interest expense, principal repayment). Such a transaction structure determines which type of a companies are usually deemed to be “good” LBO candidates.

Before an LBO can occur, the sponsor must first secure the necessary financing commitments from financial institutions such as corporate banks and specialty lenders.

The sponsor must convince the lenders that prospective LBO target is capable of handling the post-LBO debt load in order to raise the amount of financing needed to fund the transaction.

To protect their downside risk and potential for capital loss, lenders must be adequately assured that the borrower (i.e. the LBO target) is unlikely to default on its financial obligations.

LBO Capital Structure Considerations

One of the main LBO levers that drive returns is deleveraging – i.e. the paydown of debt during the holding period – which causes the value of the private equity firm’s equity contribution to rise in value over time as more debt principal is paid down using the free cash flows (FCFs) of the target.

The remaining funds needed to finance the transaction are contributed by the private equity firm in the form of equity.

Moreover, the less the initial capital contribution necessary by the sponsor to fund the LBO, the higher the returns – all else being equal.

Why? The cost of debt is lower than the cost of equity because debt is higher up on the capital structure in terms of priority (i.e. bankruptcy proceed distribution waterfall) and because of the “tax shield” from tax-deductible interest expense.

Therefore, sponsors attempt to finance LBOs with as much debt as possible but still within reason to avoid placing an unmanageable debt level that would put the company at a high risk of default, e.g. causing a missed interest expense payment or missed mandatory principal amortization.

LBO Capital Structure (Debt/Equity Mix)

The standard LBO capital structure is cyclical and fluctuates substantially based on the prevailing financing environment, but there has been a structural shift from debt-to-equity ratios of 80/20 in the 1980s to a more conservative 60/40 mix in recent years.

The different debt tranches used to fund LBOs – in order of descending seniority – is shown below:

The majority of the debt raised will consist of senior, secured loans from banks and institutional investors before riskier types of debt are used.

As for the equity component, the equity contribution from the private equity firm represents the largest source of LBO equity.

What Makes a Good LBO Candidate?

Before delving deeper into the characteristics of an ideal LBO candidate, view our lesson below summarizing what investors look for when searching for a potential buyout target.

Source: LBO Modeling Course

Characteristics of a Good LBO Candidate

  • Strong Free Cash Flows (FCFs): Considering the large debt burden placed on the post-LBO company’s capital structure, strong FCF generation is paramount for the company to be able to sufficiently meet all debt obligations and reinvest into growth plans – as well as raising enough financing from debt lenders at favorable terms.
  • Recurring Revenue: If revenue is recurring, the cash flows of the company are more predictable, which directly increases the debt capacity of a borrower and implies less default risk associated with the company, e.g. multi-year customer contracts, scheduled product/service customer orders.
  • “Economic Moat”: Companies that possess a “moat” have a differentiating factor with the potential to create a sustainable, long-term competitive edge, which leads to the maintenance of its current market share and protection of its profit margins from external threats (i.e. barrier against competition).
  • Favorable Unit Economics: A consistent, industry-leading margin profile is a byproduct of favorable unit economics and an efficient cost structure, which can be improved from implementing operational best practices and benefiting from economies of scale (and scope).
  • Minimal CapEx and Working Capital Requirements: Fewer capital expenditures (CapEx) requirements and less working capital needs (i.e. less cash tied up in operations) results in more FCFs, which can be used to service interest payments and paydown debt principal – both mandatory and optional payments.
  • Operational Improvements: After obtaining a majority stake in the post-LBO company, sponsors immediately work with management to streamline the business model to operate with more efficiency via cost-cutting and the removal of redundancies.
  • Strategic Value-Add Opportunities: Often, companies targeted by PE firms are performing well, but there are opportunities not being pursued that could unlock significant value, e.g. expansion into adjacent markets, different pricing models, sub-par marketing & sales team, etc.
  • Asset Sales / Divestitures: If the target owns assets or a business division that is either misaligned with its core business model or is underperforming, the PE firm can divest the assets to use the sale proceeds to reinvest into operations or service debt payments.
  • Low Purchase Multiple (Undervalued): Companies can be underpriced from the industry having fallen out of favor with the market or that has been impacted unfavorably from temporary macro conditions or short-term headwinds – however, such opportunities are increasingly scarce because of the influx of capital into the private markets and high competition in sale processes, especially auction-based sales with strategic acquirers on the buyer list.
  • “Buy-and-Build”: One method to increase the odds of achieving multiple expansion (i.e. exiting at a higher exit multiple than the entry multiple) – other than purchasing a company for a lower price – is to acquire smaller-sized companies, referred to as “add-ons,” which can potentially increase the sale price from increased scale, diversified revenue sources, etc.
Rollover Equity – Committed Management Team

In most LBOs, the existing management team remains onboard post-buyout.

There are exceptions, but management wanting to rollover a portion of their equity to participate in the potential upside is perceived as a positive signal to PE investors.

The willingness of management to rollover equity is proof of their confidence in actual value creation opportunities, as pitched in the sale process of the company.

By staying on to continue running the company, the firm can also structure an earn-out, i.e. performance-based compensation contingent on meeting targets, typically on EBITDA, as an additional incentive to outperform.

For an LBO to pan out well, the management team (and their relationship with the sponsor) is critical, i.e. management is ultimately responsible for executing the strategic plan on the front lines.

Ideal Industry Checklist for LBO Targets

Certain industries attract significantly more LBO deal flow than others – for example, industrial technology, B2B enterprise software, and healthcare services.

There are several recurring themes that make an industry more appealing to private equity firms, such as the following:

  • Non-Cyclical: Industries that are non-cyclical (or “defensive”) are stable regardless of the economic conditions, which makes their financial performance more predictable and less of a liability, particularly to lenders.
  • Low-Growth: Most industries with high LBO deal flow are anticipated to exhibit low to moderate growth in the coming years, as that tends to coincide with minimal disruption risk (and more stability) – but there are numerous exceptions, such as B2B enterprise software (which is higher growth but still attractive to PE firms as LBO targets).
  • Fragmented: If an industry is fragmented, that means that competition is local (or regional), rather than in a “winner-takes-all” industry, which reduces the risk to all companies operating in the industry as well as creates more opportunities for PE firms that specialize in add-on acquisitions and rely on inorganic growth (i.e. location-based competition).
  • Contractual (or Subscription-Based) Revenue: Not all revenue is created equally, as contractual and subscription-based revenue cause a company’s cash flows to be of “higher” quality, i.e. more recurring revenue with greater predictability relative to one-time purchases.
  • High Research & Development Spend: The more technical a product (and R&D expenditures) the fewer competitors there are, which reduces external threats given the technical barrier that deters competitors – plus, the benefits of pricing power from establishing an R&D-oriented niche and the absence of competition.
  • Synergistic Integrations: Certain industries are prone to “roll-ups,” as there are more opportunities for synergies to be realized, which can come in the form of revenue synergies (e.g. upselling, cross-selling, product bundling), as well as cost synergies (e.g. economies of scale, economies of scope, cost-cutting areas, upgrading outdated technology, improving inefficient cost structure).
  • Favorable Industry Trends: Industries positioned well to benefit from long-term structural shifts and ongoing tailwinds are more likely to be targeted by PE firms, as optimism surrounding an industry tends to warrant higher exit multiples later on, especially if add-on acquisitions were made to build the company further with more technical capabilities and expanded scale.

Ideal LBO Product/Service Features

The quality of a company’s cash flows is a function of its predictability and defensibility – as well as the certainty of occurrence with minimal risks.

Private equity firms seek product or service offerings that fit their fund strategy, i.e. industry focus, firm-specific criteria, and the specific post-LBO strategies employed.

But there are some product/services attributes commonly found across almost all LBO targets.

For starters, the ideal product/service should be “essential” to the end markets served, so the company’s customer base should be unable to function without it.

For example, an air filtration system used by an industrial manufacturer would be considered “mission-critical” because of how deeply embedded the system is in its day-to-day operations and ability to engineer high-quality parts and components without harmful pollutants and chemicals.

If a product or service is truly required by customers and necessary for business continuity, the company’s revenue is far more stable than revenue from discretionary, non-essential spending.

Hypothetically, the removal of the offering should cause significant disruption to the customer (and potentially even place their continuity as a business at risk).

Furthermore, there should be high-switching costs involved, wherein a customer’s decision to switch to a competitor should come with monetary and non-monetary switching costs that make customers reluctant to follow through with a switch, i.e. the costs should outweigh the benefits of moving to a different competitor/provider, even if cheaper.

Finally, there should be minimal risks from external threats, such as a substitute product that can provide the same features at a lower price – hence, the importance of technical offerings that cannot be easily duplicated.

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