Business Risk, Financial Risk and Attractive LBO Candidates

As the time grows closer to our Acquisition Finance course in Amsterdam, I find myself thinking of the relation between business risk and financial risk.  Business risk, of course, is the volatility in a firms pretax cash flows. Simply put, some firms have more stable business environments over time - without even considering how the firm is financed. Business risk is often measured as the variability of EBIT or EBITDA, although I've also seen the variability of sales used as a measure.  A utility like Trans Canada Corporate (TRP), for example, has much lower business risk than say, Dunkin Donuts (DNKN).

One of the basic concepts of capital structure is that business risk and financial risk should be inversely related.  A company with less business risk can afford (tolerate) more financial risk.  This concept for business should not surprise us - the same holds for individuals.  Imagine you and I are otherwise identical, making the same average income, etc  The only difference is that I earn my income by commission while yours is fixed.  It is not hard to see who can tolerate the most debt.

All of this relates nicely to LBOs.  When considering candidates we look for strong, stable companies with predictable cash flows to cover the increased leverage we will add to the capital structure.  In more detail, we would consider the balance sheet, the income statement, the company itself, the business cycle of the industry and any synergies.  For an LBO, it is also important to consider the exit strategy.

Let's consider these in just a bit more detail.  First, the balance sheet.  Good LBO candidates are those with low debt but high debt capacity and possibly non-essential assets or divisions than be divested to free up cash.

Now - the income statement.  Steady, predictable cash flows are important (i.e., the low business risk).   In addition, investors in LBOs such as KKR are interested in strong management teams.  This is important since private equity investors typically don't want to run the company's themselves.   They do want a strong managerial team that they can motivate with a carrot (high personal equity) and stick (high personal debt to buy the equity) approach.  Companies with low capital requirements and strong strategic positions in their industry are also desirable.

Possibilities for synergies are always desirable.  In an LBO this typically this includes paring expenses, or combining various firms (i.e., rollups) to create economies of scale.

The exit strategy is also important. A typical time horizon is 5-7 years.  Without a good exit plan, a relatively short term and lucrative investment can quickly turn into a less desirable or even disastrous investment.

A concept related to many of these items is the stage of business cycle for the industry.  One problem to avoid is the 'catch a falling knife' syndrome which occurs when investors purchase a company with declining cash flows.

Other considerations are important as well, but these are top of the line (or should I say bottom line) items.  We'll have more to say in Amsterdam and in future posts.

All the best,

Ralph