The LBO as a means by which to acquire private companies has become well-practiced among the private equity industry and is now standard practice.
Yet it can be used by anyone who has the experience, credibility and business to secure the confidence and credit from the required financing sources needed to execute an LBO.
The Leveraged Buyout gained prominence in the 1980’s thanks to Jerome Kohlberg and his associate, Henry Kravis. These two and the latter’s lawyer cousin, George Roberts, would form a triumvirate in private equity with the birth of their firm KKR and immortalised in the book Barbarians at the Gate. Today, over 4,100 private equity firms exist, and they buy thousands of companies each year. Knowing what they look for and how they think about financing their transactions is critical.
As its name implies, the use of financial leverage, or debt, is one of the primary elements distinguishing an LBO from a traditional acquisition executed with cash or stock. Leverage can enhance equity returns to the sponsors, who have discretionary control over all cash flows that exceed the debt payments incurred. Because interest payments on debt are tax-free, leverage improves equity returns by reducing the amount of equity required to acquire a company and furthers those returns thru the favourable tax treatment interest payments receive in the US tax code.
Not every company is a viable LBO candidate. Below are characteristics that LBO professionals typically seek when assessing a target company’s viability for an LBO-style change of control transaction.
Banks will lend more cheaply against hard assets as collateral. If your assets go up and down in the elevator each and every day (your assets are your people), it can be very challenging to gain bank financing. Bank debt is usually collateralized by the physical assets of the company, so the more plentiful and valuable the assets – machinery, inventory, receivables, real estate – the more available and cheaper the leverage becomes. While these hard assets certainly help the credit structure, intangibles like brand, goodwill, and human capital have become increasingly important considerations in an LBO.
Steady Cash Flows
Free cash flow is king in an LBO; free cash flow is generally defined as the amount of cash a business generates in excess of its requirements to maintain its current operations. The reason this is so critical is because the free cash flow of the business determines how much leverage the business is capable of supporting without imperiling the business’ ability to stay solvent in a downturn.
Maturity of Market
Companies selling into an established, well-defined market (automotive pumps and valves, soft drinks) are more conducive to an LBO transaction than those companies selling into a fledgling market (cloud computing, social networks, nanotech); while growth prospects for the company are important, they are secondary to stability. A mature market with predictable demand and revenue, and no game-changing, competitor-crushing disruptions in sight is conducive to the LBO transaction because the cash flows of the company are likely to be very predictable.
Low Capital Expenditure (CapEx) Requirements
When it comes to the LBO, the less annual investment that is required to operate a business, the better. In the case of an LBO, high CapEx is unwelcome, as it consumes cash that could otherwise go to paying interest payments, principal debt payments, or dividends to the equity holders.
There is no easier way to boost cash flow than to liquidate non-vital assets that carry an attractive value to the right bidder. An experienced financial sponsor keen on leaning out a business might spot this kind of low-hanging fruit quickly, and immediately moves to sell anything of value that is not required to operate the core business. If a publisher drives most of its revenue from digital media but maintains a costly and unprofitable printing press, it can sell the latter for cash.
After identifying the above micro-economic characteristics, LBO practitioners target companies that fall into the following categories:
Regulators from time to time mandate corporate spin-offs for antitrust reasons. For instance, if two coal companies merging would cause their combined revenue or market share to eclipse the acceptable antitrust thresholds, the merger may be allowable only contingent upon spinning off certain mines to a third party. The regulatory divestiture typically presents a buyer with a good deal, as the sale process is typically extremely hurried so as not to delay the proposed merger.
Non-core Corporate Divisions
Sometimes some of the subsidiaries or divisions of large conglomerates no longer make sense or fit in with the future of the company’s plans. In these instances, companies will “spin off” these no longer relevant divisions, realise the cash, and reinvest it in accordance with the new strategic directives of the organisation. Recently, Smith & Wesson (Nasdaq: SWHC) announced that it is spinning off its security division to concentrate on its more profitable firearms business. Likewise, if a holding company oversees five disparate operating companies like a rail car fleet, a timber farm, a solar power plant, a bottling company, and a ski resort, and decides it wants to merge and focus solely on the first two, it needs to sell the other three.
Businesses with Sub-par Management
The most successful private equiteers often possess high degrees of specialisation, and can add tremendous value to the organisations they acquire. It’s easy for savvy industry veterans to spot solid businesses underperforming because of poor management. Such a business is an attractive LBO candidate to a buyer who is confident enough in his ability to more efficiently operate it and survive the debt burden.
Businesses Lacking a Succession Plan
This qualifier is especially pertinent today as baby boomers retire in the United States and leave healthy businesses lacking heirs. Private equity firms typically love these opportunities to acquire a high quality business that doesn’t need much help but where the owner simply wishes to cash out.
Businesses Impaired by Underlying Industry
Sometimes businesses with attractive long-term earnings capability are held hostage by a poor underlying industry or economy causing deflated trading prices and valuations. Such opportunities are attractive, offering a chance to buy companies for cheap before an expected rebound in the market price.
Key Takeaway: Knowing how private equity firms screen for and think about LBO feasibility is beneficial to management teams who are considering an MBO, advisors evaluating which assignments to take on, entrepreneurs thinking about who to sell to, and corporations evaluating which buyers will be interested in purchasing their non-core divisions.
(Source: ScoopBooks’s The Practioner’s Guide to Investment Banking)
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