Why LBO Candidate Quality Matters
In leveraged buyouts (LBOs), private equity firms acquire companies using a combination of debt and equity. The target’s cash flows are then used to service debt and generate returns for the sponsor.
But not every company is suitable for an LBO. Since leverage magnifies both returns and risks, the quality of the candidate is crucial. A strong LBO candidate reduces downside risk and increases the probability of achieving attractive IRRs and MOIC multiples.
In interviews, you’ll often face questions like:
- “What makes a good LBO candidate?”
- “Would this company be a good LBO target, and why?”
Here’s a breakdown of the characteristics private equity firms look for.
Key Characteristics of a Strong LBO Candidate
1. Stable and Predictable Cash Flows
The most important requirement is reliable cash generation. Debt must be serviced consistently, and volatile earnings create repayment risk.
- Good candidates: Consumer staples, healthcare services, industrial distribution.
- Risky candidates: Highly cyclical industries (airlines, oil exploration), early-stage growth companies with negative cash flow.
2. Low Capital Expenditure (Capex) Needs
If a company must reinvest heavily just to maintain operations, less cash is available to pay down debt.
- Ideal: Asset-light businesses (software, business services).
- Challenging: Capital-intensive sectors (airlines, telecom infrastructure).
3. Strong Market Position and Competitive Advantages
A defensible market position reduces risk and improves exit prospects. Private equity firms look for:
- High barriers to entry
- Strong brand recognition
- Differentiated products or services
- Customer stickiness
This ensures the company remains profitable even in competitive environments.
4. Solid Management Team
PE firms rarely micromanage day-to-day operations. They rely on management to execute growth and efficiency initiatives. A strong, aligned leadership team increases the odds of success.
Sponsors often incentivize management with equity stakes, aligning their interests with investors.
5. Opportunities for Operational Improvements
Beyond stable cash flows, firms want upside potential. Common levers include:
- Margin expansion through cost reduction
- Pricing optimization
- Working capital management
- Bolt-on acquisitions
The ability to drive EBITDA growth enhances returns even without multiple expansion.
6. Clear Exit Opportunities
Private equity firms must eventually exit. Ideal candidates have multiple exit paths, such as:
- Strategic buyers
- Other financial sponsors
- IPO markets
A lack of logical buyers limits exit options and depresses valuations.
7. Favorable Industry Dynamics
A strong industry tailwind helps companies grow more easily. Characteristics include:
- Growing demand
- Consolidation opportunities
- Limited regulatory headwinds
For example, healthcare and technology services are often attractive, while industries facing disruption may be less appealing.
8. Reasonable Purchase Price
Even a strong company can be a poor LBO if purchased at too high a multiple. Overpaying leaves little room for returns, especially if exit multiples compress.
PE firms aim to find businesses with solid fundamentals at attractive valuations.
9. Strong Asset Base (Optional)
Having tangible assets (like real estate or equipment) provides collateral for lenders. While not required, it can make financing easier and cheaper.
Service-based businesses without significant assets can still be good LBO candidates if cash flow is reliable.
Putting It All Together: A Framework
When evaluating a company for LBO suitability, think of three categories:
1. Cash flow strength: Stable, predictable, with low reinvestment needs.
2. Value creation potential: Operational improvements, industry tailwinds, and growth opportunities.
3. Exit feasibility: Reasonable purchase price and multiple paths to exit.
If all three boxes are checked, the company is a strong candidate.
Real-World Examples
- Good Candidate: Dunkin’ Brands (2006) Acquired by Bain Capital and others, Dunkin’ had stable franchise-driven cash flows, strong brand recognition, low capex needs, and room for expansion.
- Challenging Candidate: WeWork (pre-IPO) Despite growth potential, WeWork had negative cash flows, high capital needs, and uncertain profitability—making it a poor LBO candidate.
- Typical Candidate: Dollar General (2007) KKR acquired Dollar General for $7.3 billion. The company offered predictable cash flows, resilience in downturns, and strong expansion opportunities.
Common Interview Approach
If asked “What makes a good LBO candidate?”, structure your answer:
1. Start with cash flows: “The most important factor is stable, predictable cash flow to service debt.”
2. Add low capex and industry stability: “Low reinvestment needs and non-cyclical industries are ideal.”
3. Highlight competitive positioning and management: “Strong market position and a capable management team increase success likelihood.”
4. Conclude with value creation and exit: “Opportunities for EBITDA growth and multiple exit options are key to generating attractive returns.”
This shows both conceptual understanding and structured thinking.
Key Takeaways
- Cash flow reliability is the #1 criterion.
- Low capex needs free up cash for debt repayment.
- Defensible market position protects profitability.
- Operational improvements provide upside.
- Multiple exit options reduce risk.
- Reasonable purchase price is critical—overpaying kills returns.
Conclusion
Not every company is LBO-ready. The best candidates combine stable cash flows, efficiency potential, and clear exit opportunities at reasonable valuations.
In interviews, focus on cash flow predictability, capital intensity, industry stability, and exit options. Pairing theory with real-world examples (like Dunkin’ or Dollar General) will demonstrate a strong grasp of what makes a good LBO candidate, setting you apart as someone who thinks like an investor.
Download on App Store