LBO

Question 1

What is a LBO?

Answer 1

• acquisition of a company, division, business, or a collection of assets using debt to finance a large portion of the purchase price
• The remaining part of the purchase price is funded with equity from the PE firm
• LBOs are used to acquire control of a range of businesses, both public and private, as well as divisions
• The main goal is to realize an acceptable return on its equity investment upon exit, normally through a sale or IPO of the target
• Normally, PE funds go after 20% return and an investment exit of 5-10 years
• Debt normally compromises 60-70% of the financing structure with equity compromising 30-40%
• The amount of debt depends on the projected free cash flow of the target company. The company needs to have enough cash to pay interest and principal payments as they come due. It’s important for a PE firm to have a good level of debt in order to contribute less equity and hence have a higher return on their equity
• The use of leverage provides tax savings because interest payments are tax deductible
• Invesment bankers play an important role in the closing of a deal, they normally act as arrangers/underwriters of debt used to fund the purchase price

Question 2

Who are the key participants in an LBO Model?

Answer 2

PE firm
Investment Banks
Bank and Institutional Lenders
Bond Investors
Target Management

Question 3

Characteristics of a strong LBO candidate

Answer 3

1. Strong Cash Flow Generation
2. Strong Market Position
3. Growth Opportunities
4. Efficiency improvement Opportunities
5. Low CAPEX Requirements
6. Strong Asset Base
7. Proven Management Team

Question 4

Why does having strong cash flow generation make a company a strong LBO candidate?

Answer 4

• Ability to generate stable, predictable cash flow is very important for targets
• Debt investors need a target to have a business model that shows the ability to make interest payments and principal payments as they come due
• Business characteristics that support the predictability of robust cash flow increases a company’s attractiveness as an LBO candidate
• For instance, many candidates operate in a mature or niche business with stable customer demand and end markets. Have a strong brand name, established customer base, and/or long-term sales contract which all increase the predictability of cash flow
• PE firm look for drivers of cash flow generation during due diligence process to confirm target management’s projections
• Cash flow projections are normally stress tested based on historical volatility and potential future business and economic conditions to ensure the target’s ability to support the LBO financing structure under challenging situations

Question 5

Why does having a strong market position make a company a good LBO candidate?

Answer 5

• Looking at the target’s barriers to entry
• For instance if the company has strong customer relationships, brand name recognition, superior products and services, a favorable cost structure
• The more barriers to entry the company has the more stable and predictable will be the company’s cash flows
• During due diligence, PE firms look at this characteristics that show that the target’s market position is secure and can be expanded
• Sometimes depending on the expertise of the PE firm, consultants are hired to perform independent analysis on the market share and the barriers to entry

Question 6

Why does strong growth opportunities make a company a good LBO candidate?

Answer 6

• Target needs to have growth potential, both organically and through potential future acquisitions and mergers
• Profitability growing the company helps drive returns, generate greater cash available for debt repayments while also increasing EBITDA and enterprise value
• Growth enhances the speed and value of exit opportunities
• For instance, a strong growth profile is very important if the target is expected to have an eventual IPO exit

Question 7

Why does Efficiency Enhancement Opportunities make a company a good LBO candidate?

Answer 7

• While target company must have a strong fundamental business model, PE firm also looks for opportunities to improve operational efficiencies and generate cost savings
• Cost saving measures may include introducing lean manufacturing and six sigma processes (lean manufacturing is a production practice dedicated to eliminating waste. Six Sigma is focused on improving output quality by identifying and eliminating defects and variability) implementing efficient systems
• Can also involve sourcing new terms with existing suppliers and customers

Question 8

Why does Low CAPEX Requirements make a company a good LBO candidate?

Answer 8

• Low capex requirements improve a company’s cash flow generating abilities
• Best LBOs have limited capital investment needs
• During due diligence, the PE firm focus on differentiating those expenditures that are necessary to continue operating the business from does that are not

Question 9

Why does Strong Asset Base make a company a good LBO candidate?

Answer 9

• Strong asset base can be used as collateral against the loans which increases the likelihood of principal recovery in the event of bankruptcy and liquidation, which increases lenders willingness to provide debt to the target
• Look at tangible assets as a percentage of asset base.
  The more tangible assets there are, the stronger the asset base of the company
• Accounts receivable and inventory are considered high quality assets because of their liquidity
• PP&E are long-term assets, that cannot be converted to cash as quickly
• Strong asset base is also a sign of high barriers to entry because of substantial capital investment needed, which serves to drive away potential competitors in the market

Question 10

Why does a Proven Management Team make a company a good LBO candidate?

Answer 10

• strong management team makes the target more attractive which is important in an LBO scenario where the company is expected to grow efficiently in a fast pace
• There needs to be ambitious leaders to help PE firm meet its investment objectives and to drive company performance
• When there is a strong management, the PE firm doesn’t have to worry about replacing existing team

Question 11

Pros of LBO Modelling

Answer 11

• Does not rely on information from the public market which could be wrong
• Capture the value of optimizing a company’s capital structure, by using more debt than the public market is used to
• Can capture the value of improvements made in the company that private owners could make that would be hard for a public company to do

Question 12

Cons of LBO Modeling:

Answer 12

1. Requires making uncertain assumptions about a company’s operating and financial performance 3-5 years in the future
2. Requires more data and more work than valuations based on multiples, precedent transactions and market value