November 10, 2016    6 minute read

Finding The Ideal LBO Candidate

Essential Deal Requirements    November 10, 2016    6 minute read

Finding The Ideal LBO Candidate

The conventional LBO transaction includes several steps, starting with “The Sourcing” and continuing with “The Screening.” During the Screening, financial sponsors conduct research on potential targets trying to understand the one that deserves investment. The ultimate goal is to find the ideal candidate.

Strong, Reliable And Predictable Cash Flows

As the name implies, leveraged buyouts rely massively on the use of debt, which usually accounts for 60-70% of the overall financing. Thus, the key factor of a sound LBO candidate is represented by the ability of the selected firm to generate robust, stable and recurring cash flows.

The greater the amount of cash generated, the larger the room for leverage, since the company is more likely to meet its obligations and lenders are more willing to lend.

Stable Customer Base And Barriers to Entry

The environment in which the target operates is more and more critical to the final decision. The ideal LBO candidate shows several features such as protection from competition and stabilising cash flows. Among other attributes, customer base stability and barriers to entry are also key factors, which financial sponsors focus on.

Intangible assets such as brand recognition and an established customer base play a central role in assuring investors on the quality of the target for all the reasons stated above. Among other characteristics, a favourable cost structure, scale benefits, long-term sales agreements and better products and services are viewed as the best guarantee for stable and recurring cash flows.

Qualitative And Experienced Management Team

As above stated, the target – after the transaction – will operate in a highly leveraged scenario with ambitious return goals. Thus, the experience and quality of the management are critical in the evaluation of the potential target.

Indeed, the management of PE-backed firms still manage the day-to-day activities with strategic guidance offered by the sponsor. To conclude, a management team with a remarkable track record in such scenarios or with experience in bolt-on acquisitions and restructuring initiatives enhances the value of the LBO candidate.

Room For Margins Improvement

Although a robust business model is a desirable element of the ideal LBO candidate, sponsors seek margins for efficiency upgrading through operational changes and cost savings, since the correct implementation of these measures may lead to higher equity value at exit.

Financial sponsors usually hire consultants or former C-managers to implement measures aimed at increasing the overall efficiency of the firm by reducing the headcount, lowering corporate overhead and, at the same time, creating new management information systems and even new agreements with suppliers and customers. Managers have the task to achieve higher efficiency without jeopardising the existing business, which may undergo extreme cuts in R&D and marketing, damaging customer relationships and growth potential.

Relatively Low CapEx And NWC Needs

One of the elements of the free cash flow is represented by Capital Expenditures (CapEx) which negatively affect the amount of cash generated by the candidate. Thus, the lower the CapEx, the higher the free cash flow and the ability of the target to pay periodic interest, meet principal obligations and distribute dividends. During the due diligence process, sponsors try to separate the maintenance CapEx from the growth one. The growth CapEx – aimed to enhance the asset base – is discretionary and can be eliminated during downturns without affecting the current level of output.

The purpose of maintenance CapEx is to keep the asset base constant year by year. Thus, the lower the maintenance CapEx, the higher the flexibility regarding the capital allocation of the candidate and the greater the value of the target for the financial sponsor.

The target presents also lower financial risk. The rationale equally applies to the Net Working Capital (NWC) since, all else being equal, with lower NWC there is less cash required to run the core business and a larger amount of cash available to debt and equity holders.

Growth Opportunities

During the due diligence, growth plays a central role as the key indicator of a solid LBO candidate. Growth is categorised into two forms of growth: internal (or organic) and external. The former refers to company’s investments aimed at expanding its operations through new products, customers, locations and geographies, whereas the latter refers to takeovers and mergers. Growth provides benefits such as higher EBITDA, cash and enterprise value.

Positive growth opportunities drive higher multiples which are one of three typical ways of value creation in LBOs, together with operational improvement and debt. For all the reasons stated above, higher growth potential is beneficial for an LBO candidate increasing its value for private equity firms and the potential profitability of the deal.

Solid Asset Base

One of the starting points is usually the balance sheet, where investors carefully examine the asset base. The more sizeable the hard assets pledged as collateral, the higher the bank’s willingness to lend. Bank debt represents the cheapest way of LBO financing, and it is proportionally higher – compared to the overall liabilities – when the target presents valuable tangible assets like factories, machinery, real estate, inventories and receivables to pledge as collateral. Thus, the stronger the physical asset base, the higher and cheaper the leverage results.

Moreover, a sizeable asset base represents a barrier to entry to new competitors, favouring the stability of cash flows and the ability to meet debt repayment schedules of the target. Thus, banks are even more confident to lend, increasing the availability and cost of leverage.

Strong Market Position

Financial sponsors spend a long time during the due diligence to accurately understand the competitive position of the target in the market. Indeed, well-positioned companies may benefit from favourable industry trends, such as groundbreaking technology or changes in demographics and customer habits resulting in greater market growth and higher equity returns.

Conclusion

To conclude, the choice of a strong candidate is critical for the success of the deal, even for the most experienced PE investors, since the disaster caused by poor financial fundamentals cannot be avoided by the expertise and the quality of investors and managers.

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