In the next step I assume analysts will definitely check company's positive working capital , low CAPEX and steady cash flow. The most critical element of the whole process is to find a company with available free cash flow to service the debt and operate efficiently.
I can conclude that at this stage they move forward and trying to find companies with enough working capital; Meaning short term funds available from current assets are more than adequate to pay for current liabilities while low CAPEX means the lower the CAPEX is the higher the free cash flow and the ability for the company to pay interest and principal obligations are.
In the next step we can also check operating cash flow stable and recurring cash flow is a must because it represents a cash generated by company's day-to-day business operations and allow business to maintain and grow its operations. Positive free cash flow is important factor of this analysis because in ideal scenario PE Funds want to buy the company with senior debt and then use the free cash flow of the acquired company to pay the principal and interest. With PE , you're looking for companies that can deliver strong investment returns over a short period of time.
How do you deliver returns? You want to minimize the cash you put in and maximize your yearly cash inflows. These are capture by those points you pasted. Generally, yes, you would want a low capex. Correct me if I'm wrong, but Working capital does not necessarily have to be positive. A negative change in NWC would imply increasing receivables and inventories, and would highlight to me areas of their operations that could be tweaked, not necessarily deal breaker.
No debt is not always a requirement either. There are tons of cases of LBOs with refinanced pre-existing debt. It matters more about the company's ability to service the debt. If they have ample cash flow, they will be able to do so. Things like revenue growth and multiple expansion are nice levers to have, but they're less prominent and mature companies.
I mean, when you do an LBO , you pretty much construct the capital structure from scratch, so how telling really is that ratio? A company with minimal debt could have a great ratio, but when you lever it up, the ratio could go down the gutter, no?
Serves as an extra barrier to entry for competitors and any incremental revenues go straight to the bottom line. I don't have a lot of knowledge in this area. But I'd love to see what you come up with. I'm looking at something similar, focused on practising LBO skills.
My comment, given the above caveat, is that it doesn't look like you've considered the current ownership and governance of the business. Some owners and boards may be less willing to sell the business than others.
Well, you are right. Some owners are indeed more willing to sale than others. Unfortunately "willingness to sale" is difficult to measure because only data accessible to me are balance sheets, income statements, real estate ownership, corporate ownership structure. Qui sit omnis id voluptas. At dignissimos aut harum quia eum cumque ex. Ut eligendi ut repellendus qui non.
Velit autem corporis ipsam repellat numquam et. Delectus alias reiciendis alias quo veritatis facilis. Consectetur veniam earum quisquam illo dignissimos et quia dolor. Recusandae id vero non doloribus. Earum maxime commodi vel occaecati distinctio cum quia accusantium. Companies with a lot of debt have much less margin for error as miscalculation and poor execution may drive a company into distress. Picking the right kind of stable cash flows is also challenging.
Newspaper companies may have generated plenty of revenue in the past but they have been completely eroded now by digital technology giants such as Google. Likewise, as we can see with Sears or JC Penney, cash cow department stores have become liquidation stories or threats. Having a well reasoned view and having a plan B for adverse circumstances is key.
Many scenarios will have to be run too — if you purchase an airline and plan on exiting in 5 years, what if there is a recession and your EBITDA drops while multiples contract in a risk off environment? Are you able to stave off bankruptcy in a stressed economy? When asked for some ways to value a company, investment bankers accept the leveraged buyout as one of them. For the green finance student, this may be confusing because the LBO models that they are tasked with building in school are generally for figuring out an IRR.
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. Both the points provide comfort to its potential buyers and financers because of its predictable cash flows. A strong asset base serves as collateral against the loan and gives the lenders greater comfort and assurance of the debt repayment. It increases the chances of acquiring a higher bank loan for the borrower.
Strong asset base also signifies that the market, in which the target operates, has a higher barrier to entry because of the higher capital investment required and hence, lower new entrants.
However, if a candidate does not have a strong asset base but demonstrates the capability to generate stable predictable future cash flows, it can still be an attractive one for the sponsor. Profitable outstanding sales growth generates cash flows for debt repayment, while also offering an opportunity to enhance the EBITDA and Enterprise Value during the investment horizon, thus further enhancing its potential returns.
Higher growth trajectory also gives them speedy and better exit options, especially when the target is designated as an eventual IPO exit. Candidates that offer sponsors the opportunities to save cost through operational efficiencies prove to be a strong candidate as well. These cost saving measures can be lowering of overhead costs, downsizing, streamlining of processes, headcount reduction, rationalizing the supply chain, new MIS, etc.
The sponsor may also look for re-negotiations with partners like suppliers and customers. The successful implementation of all these measures creates substantial value to equity given an eventual exit. Hence, best LBO candidates tend to have lower capex needs. However, an LBO candidate with strong growth profile, high profit margins and sound business model will still be consider strong despite having high capex needs.
A proven talented management team is considered critical to the success of an LBO, given the need to operate under highly debt-laden capital structure with ambitious performance output. As such, leaders with prior LBO experience, implementing restructuring initiatives or integrating acquisitions are highly regarded by the sponsors.
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