Characteristics of a Good Leveraged Buyout (LBO)
The purpose of a leveraged buyout is to use the target firm's cash to pay back the debt used to buy the firm as quickly as possible. Based on this overall purpose, several characteristics of a good leveraged buyout (LBO) can be identified.
- Steady and predictable cash flow - A steady and predictable cash flow will ensure that the LBO target firm will be able to meet its interest payments for the debt it will take on. Steady and predictible makes it easier to get a loan since there is less risk that the firm will not be able to meet interest payments.
- Low Enterprise Value/EBITDA multiple - The Enterprise Value (EV)/EBITDA (Earnings before interest, tax, depreciation, and amortization) multiple is an indicator of how easily the cash flows will be able to cover the purchase price. Enterprise Value refers to the total value of the firm--market capitalization (equity) plus long term debt (don't forget the current portion of LTD).
- Large amount of tangible assets for loan collateral - Tangible assets will help to obtain more low-interest financing. The more low-interest financing the acquiring firm can get, the less cash will be necessary to repay the loans. Loan collateral includes current assets such as cash and inventory, as well as long term assets like factories, property, and equipment.
- Potential for expense reduction - If the acquiring firm has good managers on hand (which is often the case in a leveraged buyout), then they hope to be able to reduce expenses when they acquire the target. Reducing expenses will free up cash and allow for faster repayment of the debt. Private firms that are targets for LBO's often have room for expense reduction since management is often entrenched and has little experience outside the firm.
- Minimal future capital requirements - The acquirer doesn't want to have to make large cash outlays to keep the company running and growing. The acquirers want to use all the cash possible to pay of the debt.
- Limited working capital requirements - This is pretty much the same as the point above. Any year-over-year increases in working capital result in less free cash flow (less money to pay down the debt). LBO's need money!
- Clean balance sheet with little debt - Little debt will mean few obligations to pay off other loans. This makes the deal less risky (lower leverage = less risk) and allows excess cash to go to the debt necessary for the leveraged buyout.
- Strong market position - A strong market position can ensure that the target company won't be squashed after the leveraged buyout goes through. Such a position makes cash flows less risky.
- Divestible assets - Divestible assets provide the acquirers with extra means to raise cash, particularly if the cash flows are jeapordized, but also simply to pay off the debt more quickly. Such assets can include equipment, land, brands, etc.
- Viable exit strategy - The point of a leveraged buyout is to get a return on the equity investment, this involves selling the company a few years after the LBO goes through. Without a good exit in site, the LBO probably won't (and shouldn't) happen.