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Private Equity Investment Criteria | Street Of Walls 1/29/20, 11:28 AM
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Private Equity Investment Criteria | Street Of Walls 1/29/20, 11:28 AM
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.
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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?
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Private Equity Investment Criteria | Street Of Walls 1/29/20, 11:28 AM
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.”
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Debt and debt-like items: During the review, firms need to calculate the
company’s 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 isn’t 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
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Private Equity Investment Criteria | Street Of Walls 1/29/20, 11:28 AM
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 company’s 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.
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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.
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Private Equity Investment Criteria | Street Of Walls 1/29/20, 11:28 AM
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 structure’s flexibility as well
as how much debt is suitable for the company.
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