Private equity firms complete LBOs across a huge array of industries, geographies, and business models. But, even with all that variation, there are a few core items that differentiate good LBO candidates.
We’ve broken down the key points below, which will be helpful if you’re either considering an investment, interviewing for private equity, or just generally interested in learning more about the asset class.
Key Characteristics of a Good LBO Candidate
Recurring or Predictable Revenue
Any business benefits from stable, recurring revenue sources. This is particularly true with private equity-backed companies that have the added consideration of debt service.
They need to ensure that they have a consistent business in order to meet their interest payments and mandatory amortization (repayment) of their debt.
Realistically, lenders won’t provide debt financing if the business is project-based or has significant fluctuation.
The holy grail for this point is recurring or re-occurring revenue.
Recurring revenue is something like a subscription-based or SaaS business, where clients are locked into long-term contracts with predictable revenue.
Re-occurring revenue is not as locked in as SaaS revenue, but does represent services that are expected to continue indefinitely, with a high degree of predictability. This is in opposition to something like a one-time purchase or one-time project.
Strong Cash Generation
Another important consideration for a potential LBO is the target’s cash flow profile. Ideally, businesses have a high degree of cash conversion and have stable, predictable (see a theme?) cash flow.
This means that ideal LBO candidates will convert a relatively greater percentage of their EBITDA into cash.
Practically, this means they have relatively lower working capital needs. They also have lower capital expenditures, both for maintenance capex and future growth capex.
For instance, traditional private equity firms would might shy away from a business focused on heavy manufacturing. This type of business likely has high capex needs to maintain and build new factories, as well as high working capital needs due to increased inventory and AR.
Returning to our SaaS example, a stable digital products-based company can be a great target from a cash flow perspective. A SaaS business with an existing product likely has low capex, and may even see cash inflows from its working capital as subscription revenues are paid upfront.
Getting back to why this is important, we need to again consider debt servicing. If you’re blowing all your cash on launching rockets into space or boring large tunnels, you’re probably not going to have a lot leftover for your debt repayments and interest expense. Thus, not good LBO targets (Twitter, on the other hand, not the worst target, on paper at least).
Steady or Growing EBITDA
Along with revenue, you’ll also want to make sure you have stable, or preferably growing EBITDA. A good candidate’s margins will be consistent or expanding, both at the gross margin level (direct expense) and EBITDA margin (adding indirect expense).
A business with growing revenue may actually have declining EBITDA if costs are getting out of hand. Maybe skilled labor is scarce and wages have shot up, or there’s a supply chain shock that ratcheted up your cost of goods.
EBITDA is the most critical metric, because it’s both a proxy for earnings and also plays a defining role determining your exit value.
Leveraged buyout investments will almost always will exit via an exit multiple applied to EBITDA. If your EBITDA sucks, your exit value is going to suck, and then your returns are going to suck.
Strong Management Teams
The next item on our list is the necessity of having a strong management team, or the ability to put one in place.
Private equity firms are investors, not operators, so they need someone capable running the day to day.
A good management team vs. a bad management team can be the difference between a home run investment or a painful donut.
Frequently, private equity firms will include human capital evaluations as part of their diligence process. They’ll go into the investment with a view on which members of the leadership team will stay and which will likely need to go.
If the sponsor doesn’t feel confident with the existing team, they’ll probably go into the deal with a replacement in mind. This might be a new CEO that they specifically recruit for the opportunity, or an executive/operating partner that they have on the bench waiting for a good fit.
Quality of leadership is not only a concern at investment entry. If the investment is mid-way through the hold and the team isn’t performing, the sponsor will have no qualms about replacing them with someone who can.
Don’t feel bad for them, they probably snagged a juicy severance package on the way out and are doing just fine.
Those more versed in management theory can offer more insight, but there are also times where the right team at the onset of the investment is not the right team later. Certain operators excel with certain types and stages of businesses. The scrappy founder who built the company might not be ready to lead a professionalized organization.
Defensive or Non-Cyclical Industries
Going hand in hand with predictable revenue and cash flow, it’s critical that the target be in a non-cyclical industry. This is an industry that performs well regardless of the broader macro environment.
For example, you would not have wanted to LBO a house builder in 2007. This would be one of the most cyclical industries out there.
Instead, focus on something that is mission-critical, has few potential substitute products, and is decoupled from broader economic trends.
The name of the game here is stability, and while you might catch a boom time, the bust is going to hurt if you’re in the wrong sector.
High Barriers to Entry
When thinking about what makes a good LBO candidate, high barriers of entry is one of the most important points.
This is the idea that it’s going to be difficult for new competitors to come into your industry and do what you do (lowering your volumes and eroding pricing).
These barriers come in all shapes and sizes. Here are a few of the most common:
- High upfront investment required (telecom network, large factory, etc.)
- IP limitations (existing patents, copyrights, etc.)
- Entrenchment (sticky contracts and client relationships that are very difficult to displace)
- Economies of scale or network effect
- Regulatory barriers (required licensure, permitting, etc.)
- Geographic barriers such as access to raw materials and suppliers, ease of distribution, etc.
- Knowledge barriers (specific know-how or hard to hire personnel)
Any reasonable moat that protects your business will be highly attractive. It doesn’t have to be perfect, but the harder it is to penetrate, the better.
The interesting thing here is that occasionally things that would otherwise make a target less attractive also provide good barriers to entry. For example, high capex businesses might dissuade new entrants, or products with sticky client relationships may make new contract wins more difficult, but provide you with some protection at the same time.
But, Don’t Forget Price
Last but not least, you always need to think about the price you enter the investment at. The best company that checks all the boxes is going to have everyone trying to buy it. That means it’s going to be expensive.
If it’s too expensive, eking out good returns from your LBO becomes a lot more difficult. Any company that looks great on paper could turn out to be a terrible investment if you get caught overpaying.
Conversely, businesses with one or two obvious problems may be available at an attractive price. At the end of the day, your entry valuation can make your break you. So, it’s important to get it right.
That said, there’s no hard and fast rule and there will always be puts and takes when evaluating a business or an industry. One investor’s trash is another investor’s 4.0x return.
Closing Thoughts On Good LBO Candidates
If you made it through that, you’re ready to kick it with the best private equity investors. You’ll be saddling midwestern industrials companies with excessive leverage in no time, as long as they have a strong management team.
Keep in mind there will always be more factors that determine whether a target will make a good LBO candidate or not. Maybe their customer concentration is too high, they have litigation issues, you can’t hire enough workers, or they’re falling behind from an innovation perspective.
Each situation is unique, but that’s all part of the fun of it.