What makes an lbo good

There are some important characteristics of an LBO that a company should be aware of:. Good LBO candidates are companies with mature products and low capital intensity. Mediocre companies with great management teams will still achieve acceptable LBO returns.

Great companies with mediocre management teams will likely not be successful. Management must manage for cash and focus on reducing costs and increasing working capital efficiency. Often, strategic divestment of non-core assets can product extra cash that can be used to reduce the debt.

If the IRR is acceptable — as in it clears what is an acceptable hurdle for the firm — a private equity firm should invest in the opportunity upon conducting the appropriate due diligence. However, it is really easy to get a floor valuation for a company by just switching the algebriac equation for what the private equity analyst is solving for.

If we take a minimum acceptable IRR and plug it into the model, we are solving for purchase price. Investment bankers will do this in an Ability to Pay analysis to see what the floor price is, because any lower and a private equity firm will come in and purchase it.

Like other valuation methodologies, the implied LBO valuation is also very market dependent. Leveraged buyouts are associated with high yield bonds and leveraged loans because private equity firms are looking to take on as much debt as lenders will give them provided that the cost of debt is low enough to continue boosting the IRR.

As such, this depends on credit availability and interest rates. If the interest on leveraged loans and high yield bonds are prohibitive, cash flow will not be able to meet interest obligations as easily and accordingly the amount of leverage that could be used to fund the LBO decreases. This is the all-in interest rate, which may be high because underlying risk free rates are high government bonds are yielding a high number or if the credit spread is wide.

So how the economy is doing does not necessarily give a read through on the viability of an LBO. If debt markets are robust and frothy, banks have credit appetite for institutional term loan Bs and high yield bond investors are starved for yield, LBOs become far more attractive for private equity firms.

However, the market is efficient and this accordingly raises the floor price for purchasing a company. Share on Facebook Share. 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!