Investment Banking: How to Identify Attractive Companies for a Leveraged Buyout
In some time periods in the financial markets, it seems to investment bankers like all firms are candidates for LBOs. There are boom and bust periods in LBOs much like there are cycles in other sectors of investment markets.
Notwithstanding boom and bust periods, there are certain underlying characteristics of companies that make them attractive targets for LBOs. The characteristics include the following:
Strong management: Probably the most important characteristic of a firm that is a potential LBO candidate is high quality management who is willing to work closely with the LBO sponsor. After the firm undergoes the LBO, the management will be under the gun to generate high cash flows in order to pay both the interest and principal on the debt.
Private equity sponsors are active investors and need to work hand-in-hand with management to enact the changes necessary to unlock the hidden value in firms.
Low leverage: The sponsor wants to effectively replace equity with debt in an LBO, so firms that make good targets for LBOs should have little or no debt. Having unused debt capacity is a major element that sponsor firms find particularly attractive.
Because interest payments to debt holders are tax-deductible expenses, while dividend payments to shareholders are not, much of the value of an LBO is realized through the potential tax savings afforded by the higher levels of debt.
The U.S. tax code effectively encourages corporations to fund their operations by issuing debt instead of equity. In fact, the tax deductibility of interest payments is often referred to as a “tax shield,” effectively protecting the target from paying corporate income taxes.
Strong asset base: To induce lenders to lend money with the firm’s assets as the collateral for the loan, the quality of assets must be strong and marketable. An asset is marketable if it can be sold easily and without substantial loss of value. Firms with a large percentage of assets booked as “goodwill” are not attractive LBO candidates, while firms with large tangible asset bases are very attractive.
That’s because goodwill is an asset that cannot be bought or sold easily, but instead, is a line item on financial statements to reflect the value of brands and other trademarks. Also, firms carrying excessive amounts of cash and working capital are attractive candidates because those funds can be drawn upon to buy assets, pay down debt, and accomplish various other tasks.
Low business risk: Firms that are seen as attractive LBO candidates tend to be in relatively staid, low-tech businesses. Firms like RJR Nabisco and the supermarket chain Albertsons were the targets of two of the biggest LBOs in history. These kinds of firms don’t typically have the need for a high degree of research and development expenditures, because of their low-tech nature. Boring businesses make the best LBO targets.
Stable cash flows: Because a sponsor firm seeks to reorganize the target firm and have it carry much more debt, the target firm should have predictable revenues and stable cash flows that will allow it to service the debt — paying the interest and principal.
If a target firm’s cash flows are unstable — high one year and low the next — lenders are likely to balk at committing funds because they’ll be worried about the firm being able to pay down the debt during unprofitable periods.
Out of favor: Private equity sponsors look to buy undervalued or out-of-favor companies. One of the best ways to identify undervalued companies is to look at their P/E ratios. A high P/E ratio means that the marketplace has high hopes for the future of a company and puts a premium on its valuation.
On the other hand, a low P/E ratio generally means that a firm is out of favor with investors. Low-P/E firms offer the greatest upside for LBOs, because if the company can indeed be turned around and its fortunes reversed, the P/E ratio that the market places on the firm will likely increase.
Divisions that don’t fit the firm: Many LBO targets are not entire firms but are divisions of firms that really don’t fit within the larger firm and may not be receiving the care and feeding necessary to maximize their potential.
Conglomerates frequently spin off or sell unwanted divisions in LBOs and are often under pressure by shareholders to jettison businesses that aren’t performing well for whatever reason. Once these divisions are operating as freestanding companies and get the attention they warrant, unlocked potential can be realized.