LBO’s are vehicles for transferring corporate ownership where the buyer uses a combination of debt and equity to fund the purchase price. The structure is usually a mix of 25% equity and 75% debt, and the debt service of interest and principal payments on the loan are calibrated to be covered by the company’s level of free cash flow. LBO’s operate on the assumption that the company being acquired has a comfortable level of free cash flow that can be used to pay down the loan used to fund the acquisition. The key drivers of the success of a LBO revolve around the stability of the acquired company’s free cash flow. For this reason it is important to know the important characteristics of a good LBO. There are 6 important characteristics for a good LBO.
- Sensible purchase price – low purchase prices are the gift that keeps on giving. The higher the price, the higher the resulting leverage on the balance sheet, which increases the pressure on post-closing earnings growth. Purchase multiples are all relative depending on the industry and company growth outlook. Practicing purchase price conservatism is a hallmark of a good LBO.
- Stable EBITDA – companies with predictable EBITDA are good LBO candidates, due to their ability to cover debt service. Lenders prefer borrowers with historically strong EBITDAtrack records when measuring credit risk.
- Strong Equity base – the deal must have equity in the form of common stock, preferred stock or other long term, non-amortizing equity like securities. This provides comfort to the lender and gives the company additional liquidity to manage through unexpected changes.
- Excess Capital Availability – buying a company without any capital to grow it, is like purchasing a car without any tires. All companies require a line of credit and extra cash to manage cash flow and to develop new business. LBO’s that are structured with excess availability as part of their structure have a higher likelihood of achieving high returns.
- Non-Cyclical Industries – throughout the 50 year history of LBO’s, the most successful have been companies with strong market shares in relatively mundane industries that are not subject to rapid change. Favored industries for good LBO’s include food, healthcare, business services, manufacturing and distribution.
- Strong management team – a quality management team is the difference between a successful LBO and an unsuccessful LBO. Running a leveraged company is very different than running an unleveraged company.
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