July 29, 2014

4 Things Private Equity Firms Look For Before Acquisition

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So what IS a private equity firm, anyways?

You've probably heard a lot more about private equity -- or "PE" for short -- in the news recently, as a number of well-known companies have been snapped up by PE firms over the last few years.

Lululemon is a well-known, troubled brand that has been tied to private equity rumors.

So what do these PE firms do, and why are they buying all these companies? Well, the goal of a PE firm is the same as any other company - to make money. To do this, PE firms buy a (typically) majority position in a company, leverage their networks and resources to help make the target more successful, and then ultimately resell the company (or take it public) for a profit -- usually after 3 to 7 years. This process can be likened to someone buying a classic car, restoring it, and then banking the proceeds when they sell it.

Paying for an acquisition with its profits -- the "leveraged buyout"

A leveraged buyout, or LBO, is a tool that PE firms use to (a) juice returns, and (b) limit the amount of money they need to put down to buy a company.

When a private equity firm buys a company through an LBO, it's a lot like you buying a house with a mortgage. By taking out a loan to buy your house, you're able to buy a much more expensive home, but you only have to put down a small amount of money (well, relatively small) up front. This is exactly what an LBO is. PE firms borrow money from banks to buy a company, and then use the company's profits to pay down the debt over time. This strategy allows the PE firm to generate a greater return and limits the amount of money they have at risk.

What does a good acquisition target look like?

This is a very subjective question, as each private equity firm has their own investment strategy based on their thesis for the economy, the industry, and the company. In addition, PE firms have their own investment styles as well. Some like to buy companies that are undervalued, some like ones that seem overlooked, and others will target those that appear to be run inefficiently.

That being said, the traditional acquisition candidate will have the following characteristics:

1. Operates in a non cyclical industry - Since a PE firm will own a company over a number of years, they like to buy companies that aren't especially volatile. It's difficult for a PE firm to exit their position, and they don't want to have to wait and wait for the economy to rebound before they can finally sell -- ever tried to sell a house in a down economy?

2. Low capital expenditures - If a company requires continuous reinvestment to be successful, it's extremely difficult for the PE firm to make any money. Therefore, PE firms like to buy companies that require very little additional investment. To follow the real estate analogy, if your house is beautiful, but clearly falling apart and increasingly in need of repair, it's not a PE-kind of house.

Ironically, Harrah's Casino was a private equity "bet" that didn't work.

3. Steady and reliable cash flows - This is probably the most important investment criteria. Since a PE firm will typically LBO a company, they need a target to have reliable cash flows to meet their required interest payments. If they were to miss a debt payment, the PE firm could lose their ownership in the company and the bank could take it over (one more time with the house -- this would be like if you stopped paying your mortgage, a.k.a., "bad").

4. Strong management team - If a PE firm doesn't have their own team to replace the current management, they'll need to make sure that they believe the guys running the ship are the right ones for the job. This is important because PE firms don't typically jump in and run the companies they buy. They're investors, not operators.

So at a very high level, now you pretty much understand how private equity works. Any questions?