Criteria for Private Equity and LBO Candidates

A number of important points are looked in evaluating the acquisition of an entity. These include but are not limited to the following.

1.

Clean balance sheet with little debt:- This is important because one of the criteria that debt holders evaluate in determining the viability of a fund to be able to repay its debt is the ability for the acquired entity to generate revenue and create value. If the entity is already laden with debt then the buyout fund will have to service two or more layers of debt, which is risky. A clean balance sheet should also accompany a heavy asset base. This allows for the credit rating of the entity to go up which means that the interest expenses will be lower.

2.

Strong defensible market position and synergy opportunities:- This is important because the investors need to be convinced that the company is able to make money. Reducing the cost and burden of debt is great but LBO’s expect huge profits and for this the company needs to be in a position to be able to generate huge revenues. This is often aided by a unique market position a firm has with high barriers to entry. Synergies will also help generate high revenues if an acquired firm can be combined with an existing company in the portfolio to create even greater value than the two companies separate.

3.

Minimal future capital requirements:- This will save the company from constantly having to refinance itself. If an LBO manager feels that the majority of the money has to be raised only for the initial buyout, the confidence in the ability to generate profits will increase.

4.

Strong Management team:- As much as private equity firms involve themselves with the inside workings of management, most buyout firms already have a large number of companies in their portfolio and cannot possibly manage the actual companies all themselves. What will be important for a company or a division is to already have a smart management team and use the private equity fund’s own experts to involve themselves in management. Very often they will change management if they feel it is not operating efficiently. Reducing pay is also an option. (See discussion on Activist Hedge funds in my Hedge Fund article).

5.

Steady and predictable cash flows and divestible assets. Whether a fund emphasizes on steady cash flows or divestible assets depends if it is taking an “investing” approach or a more short term “trading” approach in its outlook to buyout a company. Either way a private equity analyst needs to convince the
partners that profits are to be made and the more predictable the potential profits the more likely partners will venture in to the idea.