A leveraged buyout, or “LBO,” is the acquisition of a public or private company with a significant amount of borrowed funds. Key characteristics to look for when searching for a potential LBO candidate include:

–          Mature industry and/or company: Stock price of the public target company is trading at a lower multiple to free cash flow as compared to a new and high growth industry or company.

–          Clean balance sheet with no or low amount of outstanding debt: Need the ability to be able to use debt as part of the acquisition consideration or “leverage” as the name suggests. A company with no debt and high free cash flow may be a great candidate given the fact that you can buy the company with senior debt and use the free cash flows of the company to pay the principal and interest due.

–          Strong management team and potential cost-cutting measures: Management is able to run and create a more efficient company with same cash generating characteristics. PE firms might decide to get rid of the old management team and hire a new team that has a successful track record of building great businesses in the respective industry.

–          Low working capital requirement and steady cash flows: Looking for stable and recurring cash flows that can be used to pay down debt over the years before exit, thus increasing the equity/total assets ratio of the company.

–          Low future capital expenditure requirements: Same reason as low working capital requirements.

–          Feasible exit options: One question you might ask is if there have been any historical LBO or IPO precedents in the relative industry as your LBO target candidate. Will you be able to sell this business at the same or higher entry multiple that you originally paid for the company?

–          Strong competitive advantages and market position: Overall, company is in a great position to keep generating steady cash flows and keep position in its markets.

–          Possibility of selling some underperforming or non-core assets: Company can sell assets to raise cash to pay off outstanding debt. Note that these assets should not represent a significant contributor to company’s current cash flow. The spin-off of these non-core assets may increase your market multiples because your business going-forward may be compared to a new set of public peers.