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Private Equity Investment Criteria

Street of Walls Private Equity Training


A PE investor must evaluate several factors in order to determine whether any given investment opportunity is
a good one (and is appropriate for the PE firm). Research is needed in order to understand a companys
financials, market position, industry trends, and debt financing available. In the following pages, well discuss
how to assess an investment opportunity and conduct due diligence for all types of investments. While every
company has its different nuances, this chapter will give you a general framework of how to analyze an
investment opportunity and the various considerations involved.
CRITERIA FOR GOOD LBO CANDIDATES
A good LBO candidate typically has the following characteristics:
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Strong market position and sustainable competitive advantages: This may seem obvious, but
strong LBO candidates include companies that are market leaders with sustainable business models.
This can be characterized by high barriers to entry, high switching costs, and strong customer
relationships.
Multiple avenues of growth: It is always helpful to have a balanced and diverse growth strategy, so
that a companys success is not completely reliant on one driver. This could include growth through the
introduction of new products, increasing in the number of locations, new customers, increasing the
penetration of current customers (upselling products), exploring adjacent industries, and expanding
into new geographies, among other possibilities.
Stable, recurring cash flows: Due to the reliance on high leverage, PE firms must find companies
with stable and recurring cash flows in order to have sufficient cash flow to service all of its debt
requirements. This requires to have relatively low exposure to seasonal fluctuations in cash flows, as
well as low sensitivity to cyclical fluctuations (i.e., relatively immune to economic downturns and/or
commodity prices).
Low capital expenditure requirements: Companies with low maintenance capital expenditure
requirements provide management more flexibility in terms of how it can allocate the companys capital
and run its operations: investing in growth capital expenditures, making bolt-on acquisitions, growth in
its core operations, or give back capital to its shareholders in the form of a dividend. Capital-intensive
businesses will typically generate lower valuations from private equity firms since there is less
available capital (after interest expense), and there is increased financial risk in the deal.
Favorable industry trends: Private equity firms are continually searching for companies that are wellpositioned to benefit from attractive industry trends, since it results in above market growth and
provides stronger equity return potential as well as stronger downside protection for the investment.
Examples include increasing automation, changing customer habits, adoption of a disruptive
technology, digitalization, changing demographics, increasing regulation, etc.
Strong management team: A strong management team is crucial to success as private equity firms
will provide strategic guidance but will almost exclusively rely on management to execute their
operating strategy. If a company does not have a strong management team, the private equity firm
must have a replacement ready before even seriously contemplating the investment.
Multiple areas to create value: In addition to the characteristics above, a good LBO target candidate
will also have multiple areas where the PE firm can create additional value. Examples include selling
underperforming assets, increasing the efficiency of operations, pricing optimization, organizational
structure, and diversifying the customer base.

AREAS OF DUE DILIGENCE


A crucial part of the investment process is the due diligence performed on the company. Think of it like an
investigation process for a potential investment: PE firms will perform very detailed due diligence in order to
ensure that they are making a sound investment. This process is crucial to the success of the investment, and
the financial sponsor must look at all critical aspects of the target company: commercial, financial, and legal.
The vast majority of the time is spent on commercial due diligence while the financial and legal areas are more
confirmatory in nature. PE firms rely on consultants for their expertise and advice for portions of the due
diligence process, but ultimately the investment decision is the firms responsibility. This section provides
questions and topics that are often evaluated while looking at an investment opportunity.

Commercial due diligence includes understanding the companys value proposition, market position,
historical performance, and industry trends in order to assess the targets ability to achieve its forecasted
projections.
Sample due diligence questions include:
Competitive Landscape and Market Position: It is important to understand how sustainable the targets
business model is and where it is positioned relative to its competitors.

What is your competitive advantage (e.g. product offering, technology, price, premium brand,
distribution capabilities, geographic presence, fully-integrated solution, etc.)? Is this a disruptive
business model (i.e., one that changes the landscape of how business is done in this space in some
way)?

What are the barriers to entry into the business? What are the costs of switching to a competitors
product?

Where does the company fit in the industry value chain? How has the industry changed over the last 5
years? How do you expect that to change over the next 5 years?

Who are your main competitors? From whom have you been gaining/losing market share? What firm is
the biggest threat to your company? What is the biggest share gain opportunity?

What is the market landscape (e.g. oligopoly, fragmented market, first-mover, etc.)? How saturated is
the market?
Industry Growth/Addressable Market: When evaluating the industry, it is crucial to understand the market
environment and the external factors affecting the business.

What is the historical growth of the market? What is the projected growth of the market over the next 5
years? How mature is the industry?

What is the total addressable market? What segments of the industry are growing faster than others?

Describe the key macroeconomic drivers of the business. What are the trends?

Have there been any significant changes to the industry landscape (e.g. disruptive new entrants,
consolidation, vertical/horizontal integration, demand/supply imbalance, etc.)?

What are the regulatory concerns and how can it adversely affect the business?
Customer Base/Suppliers: This entails understanding the stickiness of customers and the companys reliance
on suppliers.

How many customers do you have? What is the concentration of your top 50 customers?

What is the typical contract length of a customer relationship? What is a typical renewal rate? What
percentage of customers have multiple products?

Who are the key decision makers for the customers? What are the buying dynamics? How long is the
entire sales process?

Please describe your most recent customer wins and losses. What were the main reasons?

How many suppliers do you have? What is the concentration of your top suppliers? How large of a
customer are you to them? What is the average length of the relationship? How often are your supply
contracts renegotiated?

If you receive price increases from your suppliers, are you able to pass it through to your customers?
Capital Requirements of the Business: A good understanding of the total capital needed to run the operations of
a business is needed, especially during difficult times.

How capital intensive is the business? What percentage of capital expenditures is growth capital vs.
replacement/maintenance capital? How has that trended over the last 5 years? What kind of lead-time
is needed (i.e. time from purchase order to delivery) when making a purchase order? How large of a
deposit is customary for new purchases?

How cyclical is the business? Are there any severe seasonal changes in demand? What are the
factors? How much visibility do you have in expected sales?

What percentage of the COGS cost structure is fixed vs. variable? What is the breakdown of operating
expenses?

What is the normal working level of cash to run the business for a year?

At what manufacturing capacity is the company running right now? How quickly and to what extent can
it be reduced if demand falls?

What would be your biggest concern in a downside scenario?

Financial Performance (Historical & Projected): This analysis provides a deeper look into the companys
historical performance in order to understand how realistic the companys forecasted projections are.

Provide a comparison of the historical performance to the management budgets for the last 5 years.
Describe the methodology behind the budget and the reasons for beating/missing the budget.

What are the key performance indicators (KPIs) the management uses to monitor the business?
Describe the trends in these indicators.

Break out your organic growth over the last 5 years (not including the impact from acquisitions).

Provide your 5-year financial model and describe the key drivers in your projections.

Growth: Please describe key assumptions. How does it compare to expected market growth?
Where will it come from (increase in price, increase in volume, increase in market share, new
products, acquisitions, etc.)?

Margins: Please describe key assumptions. Why (for example) do you expect margins to
increase so significantly compared to historical performance? Where will it come from
(operating leverage, cost efficiencies, higher margins on products, revenue/cost mix, etc.)?

KPIs: Describe key assumptions. How do they compare to the industry average and/or your
main competitors?

What are the primary risks to this forecast (new product introduction, successful expansion
into new geography, customer concentration, sufficient hiring of employees, R&D resources,
etc.)?
Financial due diligence confirms that all the financial information provided is accurate and helps PE firms
understand some of the unique dynamics of the company from a financial reporting perspective. The firms
typically hire accountants and/or auditors to review the financials, operations, customers, markets, and tax
issues in detail. This is usually referred to as transaction advisory services.
The main areas of financial due diligence include:
Quality of earnings: The PE firms need to confirm the historical earnings of the company excluding nonrecurring costs/expenses, as this will affect the valuation of the company. Consequently, they hire accountants
to ensure that the information the company provides is accurate. Accountants review the companys historical
performance to understand the targets actual EBITDA, adjusted for non-recurring costs. Adjusted EBITDA is
critical because that is what will drive the companys valuation (Adjusted EBITDA EBITDA multiple =
Purchase Price). These adjustment types include management adjustments, business-related adjustments,
and pro forma adjustments.

Management adjustments are common when purchasing family-founded businesses where


compensation is very flexible. Adjustments include one-time or excess owner/executive compensation,
transaction costs, legal settlements, and personal expenses (like a private jet, accounting fees, etc.).

Business-related adjustments include accounting-related issues, such as accounting true-ups for


bonuses and reserves, inventory valuation, revenue recognition, accrual/reserve reversals, etc. These
adjustments also include lost customers and unsustainable margins or cost cuts.

Pro-forma adjustments occur when the company has made recent acquisitions or divestitures. They
are attempting to answer the following question: given the current business structure, what would
historical earnings have been, pro forma for the acquisitions/divestitures? This review includes
synergies (eliminated positions & facilities, scaled pricing, major customers, audit/tax fees, open
positions, known cost increases, etc.).
Debt and debt-like items: During the review, firms need to calculate the companys total debt-like items
outstanding, because it will impact the total amount given to the sellers (Total purchase price less debt = cash
given to sellers). All liabilities will be categorized as either working capital or debt, not both. Sellers have an
incentive to have lower debt & debt-like items, but buyers need to ensure that the amount of debt owed isnt
misrepresented. For example, capital expenditures may not be accurate because the company could have
ordered a lot of equipment but have yet to pay for the purchase, which results in a payment post-acquisition,
thus affecting the total cash available after the deal. In addition, debt-like items are often buried in accounts
payable and accrued expenses. Other common debt-like items can be found in deferred compensation, termed
accounts payable, shareholder payables, legal settlements, tax related liabilities, and liabilities associated with
certain cash transactions.
Normal working level of capital: The PE firm assumes that the company needs a normal level of working capital
to remain in business, and thus removes it from the purchase price. The accountant must identify adjustments
to reported working capital (this involves determining and reporting on the Quality of Operating Working

Capital), and assist with setting an operating working capital target. Beyond setting a working capital target for
the purchase price, the accountant must perform due diligence to understand the other unique dynamics of the
business model to optimize the operations during various economic cycles. This would require looking at the
characteristics of the companys cash flow, deferred revenue, orders, revenue recognition, and seasonality of
the business.
Tax structure: This process entails looking at the tax structure of the company and providing a detailed analysis
of the federal, state, local, and international tax situation (both historical and anticipated). Federal taxation
occurs at the national level and includes a review of tax assets, structure the company, step-up calculations,
compliance procedures, and identification of the potential tax liabilities. State and local taxation are based on
the location of the company. This entails a review of the payroll, use tax, and sales compliance procedures as
well as a high level assessment of potential tax liabilities. International taxation deals with the transfer pricing
as the company conducts business globally. This also refers to the tax structure of the company after the
acquisition. By looking closely at a companys tax structure, the analysis can provide insight into the best
methods and locations for tax compliance so that the company may maximize its net profit and minimize its tax
liabilities.
Information technology: IT issues can cause a significant block in a smooth transition if the systems are not
reviewed correctly and comprehensively. The smooth process of IT systems is crucial to conducting accurate
reviews of tax liabilities and accounting as well as maintaining historical financial records.
Human resources: HR plays an important role in due diligence because it affects payroll and that in turn affects
the taxes for which the company is responsible. State filing requirements and income regulations are based
partly on the location of the payroll.
Legal due diligence is mainly confirmatory. It is focused on confirming that the target company is not subject
to any future liabilities including regulatory issues, threatened or ongoing lawsuits, and unusual or onerous
contract provisions.
Corporate filings: This component of the legal due diligence process is to confirm that all corporate filings have
been filed correctly (corporate organization and documents) and to understand the legal organization of the
company, such as whether there are any strange corporate structures.
Material contracts: Prior to acquiring a company, it is important to look at past and current material contracts.
This includes the debt structure, acquisitions and other liabilities, and it may include key customer, partner or
supplier agreements.
Property, plant and equipment: It is important to consider the companys property, plant and equipment to study
its assets and liabilities. One example of this is a detailed review of key operating or capital leases.
Human resources: HR due diligence is another important area in legal due diligence, and it refers to the target
companys management team and employees. Any HR risks need to be captured in the valuation model. The
firm will look at employment terms/agreements, individual contracts, collectively bargained agreements, and
retention/severance agreements. In conjunction, a review of the management and employees are necessary.
The compensation structure is crucial to understanding the organizational and operational structure of the
company. This includes compensation for executives, and the possible severance required if they are to be
terminated during the deal. This also includes other salary and stock option plans to key employees.
Health and welfare plans: The target company will have various benefit plans set up, which must be evaluated
as the acquisition is taking place. The firm reviews the health benefit plans, retiree health plans, and retirement
plans to understand any regulations or legal issues surrounding the benefits.
Information technology: Reviewing the companys IT structure during legal due diligence is very important.
Assessing the companys information technology and related agreements can provide further insight into the
companys weaknesses and strengths. The review includes looking at software or hardware agreements with
external parties, contractually obligated product features or service level agreements, license agreements, and
other technology agreements.

Lawsuits/litigation/patents: A look at the companys lawsuits/litigation provides a summary of any pending


litigation, history of past litigations, and what may arise in the company, such as environmental, employment,
customer or worker compensation issues. Similarly, a careful review of the intellectual property (IP) will be
useful because the companys proprietary information can help raise its value. Valuable IP can include
patents/trademarks, domain names, trade secrets, and design rights that are exclusive to the company and
help drive its business. Regulatory issues can also come into play here. On example of this is the need to
review the possibility of asbestos liability for certain companies in some industries.
Environmental: Another crucial aspect of operations is to understand any potential liabilities the business is
exposed to in its environment while conducting the day-to-day processes, such as hazardous material or toxic
waste. Each business has specific types of environmental issues, and they will vary based on the industry.
CAPITAL STRUCTURE CONSIDERATIONS
Capital structure considerations are important for all private equity deals, but this is most relevant for LBOs,
because they rely heavily on leverage to produce attractive returns to equity investors. Leverage creates
investment risk, however, and choosing the optimal capital structure is therefore extremely important. The
optimal capital structure will also heavily influence how the target company runs its operations. Firms need to
weigh the pros and cons of the cost of the debt and the capital structures flexibility as well as how much debt is
suitable for the company.
The figure below illustrates a typical capital structure for an LBO transaction, and some of the key
characteristics and considerations for each tranche (slice) of the capital structure.

Senior debt: The largest component of an LBO companys capital structure typically is the senior debt
or bank debt (otherwise referred to as first lien or second lien). Senior debt has the lowest financial
cost and is the first in line in the capital structure to receive its money during the liquidation of the
company. In addition, senior debt is sometimes secured by the companys assets. However, the
tradeoff is that the company is typically burdened with strict maintenance covenants to protect the
senior/bank debt investors. Such covenants can include total leverage covenants and interest
coverage covenants. Also, senior debt typically requires annual principal payments (referred to as
amortization payments), which creates a burden on the company to generate sufficient cash flow from
its operations. Senior debt typically matures after 5-7 years and has a floating coupon (i.e., the interest
rate fluctuates based on an index such as LIBOR).

High yield debt or subordinated debt: This kind of debt typically represents 20% to 30% of the LBO
capital structure and has higher financial costs than senior debt. In contrast, high yield debt usually
has less restrictive covenants or limitations, a longer time to maturity, and no required amortization
payments. Subordinated debt typically matures after 6-8 years and has a fixed coupon or interest rate.
One restrictive characteristic of high yield debt is that it is often not pre-payable by the company for a
few years, so that high yield debt investors can lock-in their high interest rate for at least a couple
years. If a private equity firm is looking to raise additional debt within the first few years of investment
(e.g. for a bolt-on acquisition), it will typically avoid a high yield debt structure, because it would then
likely incur high prepayment penalties. This portion of the capital structure can also include some
combination of bridge financing, mezzanine financing, or quasi equity.

Equity: This represents 20%-50% of the total capital of an LBO investment and is the most junior
portion of the capital structure. In other words, common equity shareholders are paid last during a
liquidation of a company. Equity holders require the highest rate of return on investment
(approximately 20% to 40%) due to the high level of risk being taken by equity investors. For example,
the equity holders often will receive no value if the company defaults on its debt payments (i.e., the
entire equity investment will become worthless).