By Giuseppe Scavolo
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 make research on potential targets trying to understand the one that deserves the investment. The 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. Highest the cash generated, largest 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 protecting from competition and stabilising cash flows. Among other attributes financial sponsors are focused mainly on the customer base stability and barriers to entry.
Intangible assets 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 of 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 manages 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 experience in bolt-on acquisitions & 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 to increase the overall efficiency of the firm by reducing the headcount, lowering corporate overhead, 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, lower the CapEx, 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 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, lower the maintenance CapEx, higher the flexibility regarding the capital allocation of the candidate and raised 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, lower the NWC, less the cash required to run the core business and larger the cash available to debt and equity holders.
During the Due Diligence, growth plays a central role as the key indicator of a solid LBO candidate. Growth is categorized into two forms of growth: internal or Organic and external. The former refers to company’s investments aimed at expanding its operations by new products, customers, locations and geographies whereas the latter refers to takeovers and mergers. Growth provides benefits regarding higher EBITDA, Cash and enterprise value.
Positive growth opportunities drive higher multiples which are one of three typical way 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. More sizeable the hard assets pledged as collateral, higher the bank willingness to lend. The 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 due diligence to accurately understand the position of the target in the market. Indeed, well-positioned companies may benefit from favourable industry trends as disruptive technology or changes in demographics and customer habits resulting in above market growth and higher equity returns.
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.