This blog is an extension of our blog on Dell’s Leveraged Buyout.
In the previous article, we discussed the importance of LBO with a hypothetical example on how a financial institution benefited in two different scenarios from a purchasing out a company. But to find these kinds of benefits from an LBO, there are some perquisites which make a good LBO. The list is endless but there are some important factors which are mentioned here:
1. Clean Balance Sheet with little/no debt: A company with a small amount of debt can become an LBO candidate since the acquiring company gets room to raise debt or leverage it without taking the burden of the candidate’s debt.
2. Steady and predictable cash flow: The acquirer needs to forecast the future cash flows as he raises a huge amount of debt to buy the target company and plans to pay a substantial amount of this debt using the cash flows of the target company before making an exit.
3. Divestible Assets: The acquirer looks for non-core or non-operating assets that can be divested to pay off the debt.
4. Viable exit opportunity: An institution always looks at any transaction from the perspective of generating returns on it; this applies to an LBO model too. The investor will look for a hassle free exit opportunity.
These are some of the many important factors that an investor considers to find a good candidate for an LBO. You can more learn about this through our video on what makes a good LBO by downloading it from here!
Finding an LBO candidate
Finding the perfect LBO candidate is a tough task from the universe of equities and requires a great amount of data to be collected and analyzed to fit the perfect match. To give a brief idea on how to search for a company from such a huge universe can be understood by taking an exercise. We extract the data of nearly 700 well known companies in the US & Europe in the form of Market Cap, Enterprise value and the Free Cash flow to the firm.
Data of well known companies in the US & Europe
Analyzing the data
With the above data we analyze some important ratios to carry on our search for the right LBO candidate. Ratios such as Equity/Enterprise are used to understand the depth of leverage a company is currently positioned at. The higher the ratio, the lower the company is leveraged on its balance sheet. Similarly important valuation matrix such as EV/EBIDTA and EV/Free cash flow are calculated and help in judging the right company for taking over.
Once we have the figures for the multiples calculated we sort out the companies which have a positive EV/Free cash flow but less than a multiple of 4. Also as discussed previously in the first paragraph above the factors to be considered to get a good LBO candidate can be implemented in a better way in this small exercise.
Out of the given data, we search for companies which have positive EV/Free cash flow, an Equity/Enterprise value of more than 100% and a high enterprise value, which can be seen in the above figure highlighted. In this case we extracted the information based on the criteria and was able to find healthy companies to fit for the LBO and thus selected the Dell model since it matches all criteria.
You can learn about analyzing the information from the data and also on selecting the best LBO candidate with the help of the video (why Dell) by downloading it from here.
There will be more blogs on the same topic. So stay tuned for more!