In this article, I’ll discuss the characteristics that define a strong LBO candidate, but before proceeding further, you may want to review my previous article on “Leveraged Buyout: An Overview”.
During the due diligence process, the financial sponsor evaluates the characteristics of an LBO candidate (including its strengths and risks). Most of the time, an LBO candidate will be one or combination of the following, but irrespective of the situation, the target becomes a LBO opportunity only if it can be acquired at a price and using a financing structure that generates acceptable returns with a viable exit strategy.
- Non-core or under-performing business unit of a large enterprise
- Distressed company with a turnaround potential
- A public company that is perceived as undervalued
- A public company that is considered as a high growth potential but not being exploited by its current management
- A solid performing company with a compelling business model, defensible competitive position and strong growth potential. This may also tally with the above point
- Companies in fragmented markets that can be consolidated into a single entity with higher size, scale and efficiency. This is called roll-up strategy.
(1) Strong Cash Flow
LBO sponsors seek candidates with strong, stable and predictable cash flows because of the debt-laden financing structure. This is the MOST MPORTANT characteristic that separates a good candidate from the rest. The debt investors who fund the LBO require a business model that demonstrates the ability to service the scheduled interest payments and debt repayment over the life of the loan. As such, most of the LBO candidates that become opportunities are:
- in a mature or niche market with a stable customer demand, or
- established brands with strong customer base and long-term contracts
Both the points provide comfort to its potential buyers and financers because of its predictable cash flows.
(2) Strong Asset Base
A strong asset base serves as collateral against the loan and gives the lenders greater comfort and assurance of the debt repayment. It increases the chances of acquiring a higher bank loan for the borrower. Strong asset base also signifies that the market, in which the target operates, has a higher barrier to entry (because of the higher capital investment required) and hence, lower new entrants.
However, if a candidate does not have a strong asset base but demonstrates the capability to generate stable predictable future cash flows, it can still be an attractive one for the sponsor.
(3) High Growth Potential
The sponsors look for candidates that have the potential to grow both organically and inorganically (including “bolt-on” acquisitions). Profitable outstanding sales growth generates cash flows for debt repayment, while also offering an opportunity to enhance the EBITDA and Enterprise Value during the investment horizon, thus further enhancing its potential returns. Higher growth trajectory also gives them speedy and better exit options, especially when the target is designated as an eventual IPO exit. It also enhances the EBITDA multiple.
(4) Efficiency Improvement
Candidates that offer sponsors the opportunities to save cost through operational efficiencies prove to be a strong candidate as well. These cost saving measures can be lowering of overhead costs, downsizing, streamlining of processes, headcount reduction, rationalizing the supply chain, new MIS, etc. The sponsor may also look for re-negotiations with partners (like suppliers) and customers. The successful implementation of all these measures creates substantial value to equity given an eventual exit.
(5) Low CapEx Requirement
Low capital expenditures (capex) enhance a company’s cash flow generation capabilities. Hence, best LBO candidates tend to have lower capex needs. During due diligence process, sponsors evaluate the need for maintenance capex (like PP&E) and growth capex (like purchasing of new assets or expanding existing asset base).
However, an LBO candidate with strong growth profile, high profit margins and sound business model will still be consider strong despite having high capex needs.
(6) Sound Management Team
A proven talented management team is considered critical to the success of an LBO, given the need to operate under highly debt-laden capital structure with ambitious performance output. As such, leaders with prior LBO experience, implementing restructuring initiatives or integrating acquisitions are highly regarded by the sponsors. Such management is usually retained after the acquisition with an equity stake under the new ownership.
In a nutshell, an LBO target becomes an opportunity when it has a strong predictable cash flows, strong asset base and high growth potential. The financial sponsor will invest in such an opportunity only when he finds that the purchase price is justifiable against the sought returns upon exit.
This brings us to the end of this chapter. In the next article, we’ll discuss The Key Participants of an LBO. Stay tuned …
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