Attributes of a good Leveraged Buyout “LBO” Target Company...

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Attributes of a good Leveraged Buyout “LBO” Target Company: The South African Private

Equity’s Perspective

A Thesis

presented to

The Graduate School of Business

University of Cape Town

in partial fulfilment

of the requirements for the

Masters of Business Administration Degree

by

Manabane Rachidi

December 2010

Supervisor: Prof Francois Toerien

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Acknowledgements

This thesis is not confidential. It may be used freely by the Graduate School of Business.

I wish to thank Prof Francois Toerien the head of Finance Section at the School of management

studies (UCT) firstly for agreeing to help and to supervise this study. Secondly for his valuable

input and never failing to draw my attention to shortcoming areas of this report. Lastly his ever

evident enthusiasm for the topic and I do so hope I have done his faith justice.

To all the private equity professionals that afforded time for my interviews and for all their value

adding insight. I do so hope this research makes a meaningful contribution to your work and

industry as a whole.

I certify that except as noted above the thesis is my own work and all references used are accurately

reported.

Signed:

Manabane Rachidi

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Attributes of a „good‟ Leveraged Buyout “LBO” Target Company: The South African

Private Equity‟s Perspective

ABSTRACT

The aim of this research is to determine and analyse the important attributes of what the South

African Private Equity Industry considers to be the make-up of „good‟ “Leveraged Buyout (LBO)”

target-company. The report identifies LBO motivations from prior studies, conducted mainly in

other markets which may have relevance to the local industry. As a way of carrying out the study,

perspectives from the private equity industry using semi structured interviews were captured, and to

a limited degree contrasted against the industry lenders‟ views. The purpose of the research was not

to prove causality, but rather to determine and highlight the South African industry‟s consensus

regarding important attributes considerable for an LBO target company.

The research study finds that in order of priority strong and partner-able management, steady and

predictable cash flow, viable exit strategy and strong market position is the make-up of the ranking.

Therefore in order of significance this ranking describes the valued attributes about or of an entity

that is suitable for an LBO type investment. In contrast the feedback from the lenders indicated that

priority is towards cash flows and/or the cash flow generative capability of an LBO target company.

Lastly the lenders also indicated that, reputation (therefore track record in the industry) of the

private equity firm is a factor in the debt funding decision of an LBO transaction. The above

findings are to a large extent consistent with the available literature.

KEYWORDS:

Leverage Buyout (LBO), Leverage, Gearing, Cash Flows, Target Company,

Private Equity, Returns

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CONTENTS

ACKNOWLEDGEMENTS ........................................................................................................................................................ 2

LIST OF FIGURES ............................................................................................................................................................ 6

1 INTRODUCTION .......................................................................................7

1.1 RESEARCH AREA AND PROBLEM ............................................................................................... 7

1.2 RESEARCH QUESTIONS AND SCOPE .......................................................................................... 11

1.3 RESEARCH ASSUMPTIONS AND ETHICS ................................................................................... 12

2 LITERARTURE REVIEW ....................................................................... 14

2.1 DISCUSSION ............................................................................................................................ 14

2.2 CONCLUSION ........................................................................................................................... 19

3 RESEARCH METHODOLOGY .............................................................. 21

3.1 RESEARCH APPROACH AND STRATEGY .................................................................................... 21

3.2 RESEARCH DESIGN, DATA COLLECTION METHODS AND RESEARCH INSTRUMENTS ................... 22

3.3 SAMPLING ............................................................................................................................... 24

3.4 DATA ANALYSIS METHODS ...................................................................................................... 26

4 RESEARCH FINDINGS, ANALYSIS AND DISCUSSION ..................... 28

4.1 RESEARCH FINDINGS .............................................................................................................. 28

4.1.1 DEMOGRAPHICS OF RESPONDENTS ....................................................................................................................... 28

4.2 RESEARCH ANALYSIS AND DISCUSSION .................................................................................. 32

4.2.1 STRONG AND PARTNER-ABLE MANAGEMENT ...................................................................................................... 32

4.2.2 STEADY AND PREDICTABLE CASH FLOW .............................................................................................................. 37

4.2.3 VIABLE EXIT STRATEGY ...................................................................................................................................... 40

4.2.4 STRONG MARKET POSITION ................................................................................................................................. 42

4.3 RESEARCH LIMITATIONS ......................................................................................................... 49

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5 RESEARCH CONCLUSIONS .................................................................. 50

6 FUTURE RESEARCH DIRECTIONS ..................................................... 54

REFERENCES .................................................................................................................................. 55

APPENDICES ................................................................................................................................... 60

APPENDIX 1 - PROCESS OF THE LBO STRUCTURE ............................................................................... 60

APPENDIX 2 – COVER EMAIL .............................................................................................................. 63

APPENDIX 3 – NON DISCLOSURE ........................................................................................................ 64

APPENDIX 5 – SA TOTAL FUNDS UNDER MANAGEMENT PER CATEGORIES ......................................... 67

APPENDIX 6 – INTERVIEW QUESTIONS - PE ........................................................................................ 68

APPENDIX 7 – STEP BY STEP PROCESS OF THE DATA ENGINEERING...................................................... 71

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LIST OF FIGURES

Figure 1 : Size of International Private Equity Markets (USD bn) Relative to GDP ....................... 8

Figure 2 : Broad Sense and Narrow Sense Private Equity Definitions .......................................... 9

Figure 3 : Participants of the LBO Transaction .......................................................................... 9

Figure 4 : Structure of a Typical Private Equity Fund .............................................................. 15

Figure 5 : Break down of respondents between captive and independent funds ........................... 28

Figure 6 : The respondents / Interviewees, their titles and years of private equity experience ....... 29

Figure 7 : Important Attributes of 'Good' LBO target ............................................................... 30

Figure 8 : Breakdown of important LBO target attributes between captives and Independents ...... 31

Figure 9 : Proportions of ranking for 'Good' Management Attribute .......................................... 32

Figure 10 : Frequency of management change ........................................................................ 36

Figure 11 : Proportions of ranking for C/F .............................................................................. 38

Figure 12 : Proportions of ranking for Exit ............................................................................. 40

Figure 13 : Proportions of ranking ......................................................................................... 42

Figure 14 :Least Important Ranked ........................................................................................ 45

Figure 15 : Lender's View ..................................................................................................... 47

Figure 16 : Does PE reputation matter? .................................................................................. 48

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1 INTRODUCTION

1.1 Research Area and problem

This research is based within the parameters of the South African private equity industry and more

specifically the leverage buyout (LBO) investment type transaction structure. Within these

boundaries the study focuses on the target company of a private equity firm, wherein the LBO

investment structure is being considered. Therefore this study is positioned at the due diligence

phase of the LBO transaction process, and the primary focus is the attributes of the target company.

In setting out the research and problem area(s), as well as the relevance and/or importance thereof,

this section will begin by outlining the macroeconomic contribution of the private equity industry

as a whole. Secondly a detailed description of the private equity model will follow, as well as the

main private equity investment structure, the LBO. From hence the section will close by outlining

an appropriate and or ideal target company via its attributes, by that formulating the findings of this

study.

Macroeconomic Impact of Private Equity

According to the DBSA‟s survey, over the three year period from 2005/6 to 2008/9 private equity

backed companies in South Africa have achieved an annual world-wide employment growth rate of

9%, (this versus the 4% recorded by JSE listed businesses) (DBSA, 2009). In addition the study

found that pre-tax profit of private equity backed companies increased by 16% per annum versus

14% for JSE businesses. This provides proof of how private equity impacts on social and the

broader local economy. Therefore the industry (private equity industry) adds value beyond just the

cash effect to develop portfolio business wherein invested. “Private equity investments have

considerable impacts in terms of productivity, skills development and job creation, as it includes the

transfer and exchange of know-how and not only the flow of capital” (SAVCA, 2009). Hence

hereby is justification, on a broader macroeconomic level, why private equity and its related

transaction structures such as the LBO deserve the attention of this and many other research studies.

In addition relative to other industries the size and growth of the local South African industry

provides another reason for the deserving attention. Contrary to the previous decade, when the vast

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majority of funds, over 77% were focused on North America, in 2009 the proportion had come

down to 37% (SAVCA, 2009). This is evidence that the market share of the rest of the world

including South Africa is growing at a rapid pace. In terms of total funds under management

relative to GDP, South Africa‟s private equity industry at 3.0% is below USA but higher than the

global average of 2.7%, and higher than the European average of 2.6% as illustrated in the figure

below (SAVCA, 2009).

Figure 1 : Size of International Private Equity Markets (USD bn) Relative to GDP

What is Private Equity?

“The term „private equity‟ refers to shareholders capital invested in private companies, as

distinguished from publicly listed companies” (SAVCA, 2009). Generally private equity financing

will assist an enterprise from increasing its working capital base during expansionary times,

developing new technologies or products to grow and remain competitive, making acquisitions of

other businesses and more commonly to buying out certain shareholders to restructure the

ownership and management of businesses (SAVCA, 2009). Private equity is also known as the

buyout fund on the basis that it makes acquisitions of companies with substantial portion of

borrowed funds, the leveraged buyout “LBO” transaction.

However there are many forms of private equity. Ogden (2002) referred to a broad sense and

narrow sense private equity definition as illustrated in the figure below.

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Venture Capital Development Capital Transmission Capital

R&D

Start-Up

Growth Capital

Buyout

Mezzanine/ BridgePrivate Equity(Broad Sense)

Private Equity(Narrow Sense)

Exit

Turnaround Investments

Figure 2 : Broad Sense and Narrow Sense Private Equity Definitions

On the other hand Pratt (1981) provides another definition that categorizes the types of private

equity activities in terms of elaborate stages of corporate development from seed funding to LBO

and/or managements buy out(s) (MBO).

The Leverage Buyout Transaction

The LBO structure, as depicted below, involves three main parties, the private equity firm, the

lender and the focus for this study, the target company.

Figure 3 : Participants of the LBO Transaction

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An LBO is the purchase of a company using significant debt, whereby the target company‟s cash

flows are used to support the loan repayments. Management participation is integral to the

alignment of incentives in the equity of the new company, usually a combination of personal cash

investment and stock option compensation (Blaydon & Wainwright, 2006).

LBOs are according to Opler & Titman (1993), motivated by one of the following categories:

1. Incentive realignment, i.e. gains from operating improvements resulting from realignment

of management and shareholder interested.

2. Favourable inside information, i.e. gains from acquiring undervalued assets,

3. Stakeholder wealth transfer, i.e. gains from employee layoffs, union-busting or raising the

risk of pre-existing debt, and

4. Tax savings, i.e. tax reductions from increasing leverage and stepping up asset base.

For a detail process of how an LBO is structured see appendix 1 – Process of the LBO Structure

This research takes another approach to the study of LBO motivations and focuses on the target

company (therefore the private equity target). The approach seeks to identify the important

attributes with which a target company can be evaluated against in order to determine its suitability

as an LBO investment. The study differs from vast existing literature around the LBO topic,

notably Opler & Titman‟s (1993) closely related study as well as Kaplan (1989b), Muscarella &

Vetsuypens (1990) and Smith (1990), which infer motives for LBO transactions. These however

have focused on observing changes in the firm‟s operations (particularly but not limited to the

before-tax cash flows) post the LBO transaction. More specifically in Opler & Titman (1993) their

approach involved testing whether or not firms that do LBOs differ from those that do not in ways

that are consistent with theories of the sources of gains from LBO type transactions.

Secondly unlike many of the studies completed this study intends to find consensus from the

industry on the standard attributes that are worth looking into when investing via an LBO structure.

So it is positioned at the due diligence phase of an LBO investment process. Lehn & Poulsen

(1989) previously, narrowly tackled this issue, but found evidence that supported Jensen (1986) that

firms with high free cash flow are most likely to go private and thus provide for ideal LBO targets.

Later Lehn, Jeffrey, & Annette, (1990) conducted the study with a wider set of variables than Lehn

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& Poulsen (1989) and found that dual class recapitalization firms have greater growth opportunities

and thus make for better LBO investments. However a potential weakness in previous studies, has

been their over emphasis on quantitative measures. Therefore not accounting for the qualitative

elements (views and opinions of industry practitioners) worth considering in a LBO scenario as a

whole and as related to the target company, which is the basis of this study.

Thirdly this study is particularly focused and tailor made for the South African industry. All

existing studies are based in the Western context and thus a different geographical dimension is

added. Particularly since on a general level South Africa presents various dynamics and contrasts to

its Western counterparts.

Lastly this study is based on the views of the professionals in the industry, as well as those of

lending parties. The views of the lenders were deliberately added and are sought after as they

present another dimension from an important stakeholder in leverage buyout transactions.

By its nature this type of research is explorative and seeks new insights (Saunders, Lewis, &

Thornhill, 2000). Furthermore by the time of conducting this research it was envisaged that both

private equity players and lenders to the industry will have keen interest in its findings. More

importantly it should serve as a standard bench mark to all private equity professionals regarding

how a LBO target is viewed and analysed.

Following this introduction the report will adhere to the following structure: Chapter 2 will cover

the literature review conducted with regards to the area of study. Subsequently Chapter 3 will

follow, detailing the methodology used for the research, followed by Chapter 4 which will draw on

the findings of the research. Chapter 5 concludes and Chapter 6 indicates areas for further study.

1.2 Research questions and scope

The following questions formed the focus of enquiry when considering the overall research topic.

Thus the collection of data and all analysis herewith undertaken has been focussed on specific

topics, the results of which endeavours to answer the following research questions:

Primary question:

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What are the attributes of a good LBO target, from South Africa‟s Private Equity Industry

point of view?

The above research question addresses an important question, and attempts to advance the

frontiers of knowledge regarding what industry players should „check list‟ in their consideration

for an LBO target investment (Bryman & Bell, 2007).

Secondary questions:

How do does this ranked list weigh up against that of the other important parties to the LBO

structure, namely the lenders?

Does the source of private equity funds (therefore Captive versus Independent) reveal

anything about the choice of attributes?

What is the impact of large gearing on the LBO target companies and more importantly

whereas related to the private equity shareholder?

1.3 Research Assumptions and Ethics

It is assumed that the researcher‟s perspective and assumptions will have an influence on the

conducting of this research, this also includes but not limited to the interpretation of the findings

and the theory that emerges from the research. Further more it is important to note that the

academic research in South African LBO under private equity context is limited, and of the private

equity literature that is available most is based on developed markets.

The most important requirement to enable success of this research is the quality and

representativeness of the private equity industry. In total 28 requests for interviews were sent out to

private equity houses and 13 ended up being interviewed. In essence this equates to a 46% response

rate. Based on this outcome it is assumed that this response rate provides sufficient input data to

enable credible conclusions to be drawn. To add to that the obtained responses were assumed to

have common elements. However where this was not the case, the need for further in depth analysis

or understanding was highlighted, that also provided value adding discussions.

Other Assumptions include:

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The assumption that private equity firms‟ view regarding attributes of a good LBO target

will mirror that of their employees. So the interviewees of this study who are employees of

private equity firms are good representatives of the general views of their firms.

Assumption that a good target is understood to be the one that ultimately warrants an

investment mandate

South African private equity firms are engaging and will continue to have great interest in

LBO investments

Private equity employees interviewed have adequate exposure to LBO transactions and/or

have adequate experience of targeting investment potentials with a LBO structure in mind.

The research will be conducted in compliance with the UCT/GSB research guidelines. The

proposed research has no intended potential harm for the survey participants from the private equity

industry and/or the companies of the information used. Despite the challenges of openness and

transparency as well as accessibility of information no methods of coercion will be utilised.

There is an ethical obligation to process and analyse the data independently, accurately and without

influence or bias towards the results in any way or the other. All selection and ranking has taken

place in line with principles outlined within the methodology and any required deviations from the

principles have been fully disclosed.

A detailed covering email, included in the appendix 2, provides the research background and formal

request for participation. In addition signed non-disclosure agreements (included as appendix 3)

were included as part of the requests sent out. However most importantly all responses included as

part of this report are on the basis of anonymity, and all demographics will only be presented in

aggregate form. The main purpose of this study is not to single out responses, but where it is so, no

names and or references that allow names to be deduced will be included. All in all the research‟s

primary interest is in identifying commonality among the response themes.

The actual interview session were conducted in a formal manner and prior to interview questions

participants were again taken through an introductory session that outlined the intended objectives

of the study and reiterated the confidential nature of the content to be shared. By way of preparation

questions were also sent to confirmed respondents in advance.

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2 LITERATURE REVIEW

2.1 Discussion

The literature review discussion to follow will begin by explaining private equity, therefore the

structure and/or the model, narrowing off with the South African private equity industry. Secondly

the leverage buyout investment structured is briefly explored. Including but not limited to the

positive and negative aspects and impacts of the LBO structure.

Lastly the section is set on reviewing the theoretical perspective and previous research findings

regarding the problem at hand. While this study has characterised itself as determining the

attributes of an „ideal‟ potential LBO target, this essentially follows in the same lines as what vast

previous studies have termed, motivations for leverage buyout transactions. In the end the attributes

of a target company become the basis of why an LBO investment is motivated and thus completed.

2.1.1 Private Equity

“Private equity is not quoted on a public exchange. Private equity consists of investors and funds

that make investments directly into private companies or conduct buyouts of public companies that

result in a delisting of public equity. Capital for private equity is raised from retail and institutional

investors, and can be used to fund new technologies, expand working capital within an owned

company, make acquisitions, or to strengthen a balance sheet.” (Investopedia)

See appendix 4 for the fundamental difference between private equity and quoted equity as outlined

by Gilligan & Wright (2010).

Private Equity funds are designed to be “self – liquidating” that meaning that they are structured to

dissolve after ten to fifteen years. This imposes a healthy discipline that forces private equity

investors to take the necessary-but-painful step of terminating underperforming firms (investments)

in their portfolios (Lerner, 1997). These investments will typically realise value in the form of

capital gains through a sale to, or merger with, a competitor in the same sector, sale to another

private equity investor, or by eventual flotation on the stock market within the ten to fifteen year

period (The Center for International Securities and Derivatives Markets (CISDM), 2006). The

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objective of the private equity fund is to invest in equity risk capital in a portfolio of companies

which are identified and researched by the private equity fund manager. By their nature these funds

are primarily designed to generate capital profits from the sale of investments rather than the

income from dividends, fees and interest payments. Below is a structure of a typical private equity

fund adopted from (Gilligan & Wright, 2010).

Figure 4 : Structure of a Typical Private Equity Fund

Prowse (1998) found that the fund manager‟s fee ranges between 1.5% - 2.5% of asset and extra

interest of performance during the investment period. The performance and/or track record is

measured by the returns of investments generated (Internal Rate of Return – IRR). This stems from

the company‟s cash flow (i.e. return) the generation of which is in stages, and follows a J curve

effect based on the quantum of value added by the private equity.

Private Equity Value Add – Financial engineering vs. Operational efficiencies

Talmor (2006) believes that private equity‟s source of return are largely inconsistent with the

accepted academic paradigms: Firstly multiple arbitrage flies in the face of market efficiency

theories. Secondly profit from de-leveraging is just financial engineering and runs counter to

theories of capital structure.

On the other hand operational improvements as a private equity value add to its portfolio

companies, violates the fundamental tenet of separation of ownership and management. However

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on the contrary, believers of the private equity model like Jensen (1986), buy into the notion that

private equity firms apply financial, governance and operational engineering to their portfolio

companies, and, in so doing, improve firm operations and create economic value. While both the

arguments of Jensen (1986) and Talmor (2006) present merits, given recent developments in the

global financial services alternative assets have attracted a lot of attention. As a result it is certainly

more plausible that the era of multiple arbitrages is fading. Hence LBO as a structure will no longer

be a significant source of value, by investors just waiting for the debt pay down. As a matter of fact

more effort will need to be exerted on company operational performances, such that assets will

sweat and liquidity will suffer, therefore increasing default risks.

2.1.2 The theories around LBO

Dominant themes from the literature are gathered below to prompt this study towards the critical

issues around the LBO topic.

LBO incentives management to generate cash flows

When companies undergo a LBO, increased management ownership and high financial leverage

associated with the buyout provide strong incentives for managers to generate higher cash flows

through improved operating performances (Jensen, 1989).

Cash flows drive the value of LBO

LBO‟s are likely to be particularly valuable for companies with a strong cash-flow-generating

capacity and limited profitable growth opportunities. Kaplan (1989a), Lichtenberg and Siegel

(1990), and Baker and Wruck (1989) provide evidence supporting this proposition.

There is a positive relationship between debt and management discipline

“The high financial leverage also limits managers‟ ability to undertake wasteful investments

because free cash flow is committed to debt service. The substantial management equity ownership

ensures that managers do not meet debt payments through short-term cash-flow improvement at the

expense of long-term” (Palepu, 1990).

2.1.3 Motivations for Leverage Buyouts (LBO)

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For the most part, in the past, the benefit derived from the interest tax shield, introduced by the

Modigliani & Miller (1963) theories, justified the appeal of leveraging, from a fund managers

perspective. However since then numerous writers have referred to other benefits and the appealing

characteristics of LBO in particular.

Firstly Olsen (2003) presented a number of appealing characteristics of leveraging buyouts, which

included; tax advantages associated with debt financing. In support prior writings by Kaplan

(1989b) and Marais, Katherine, & Abbie (1989) all agreed that tax savings were a source of gains.

Secondly Gagliano, (2004) distinguished a successful LBO, as whereby equity holders‟ receipt of

very high returns as a result of locked debt holder‟s fixed returns. Thereafter the equity holders

receive all the benefits from any capital gains. Thus, financial buyers invest in highly leveraged

companies seeking to generate large equity returns. In a typical private equity LBO transaction, the

private equity firm agrees to buy a company and if that company is public, the private equity firm

typically pays a premium of 15 to 50 percent over the current stock price Kaplan, (1989b) and

Bargeron, Schlingemann, Stulz, & Zutter, (2007).The buyout is typically financed with anywhere

from 60 to 90 percent debt – hence the term, leveraged buyout (Stromberg, 2008).

Thirdly a study by Lehn & Poulsen, (1989) augments Jensen‟s (1986) findings that the target

company‟s cash flow is sufficient inducement for fund managers to want to buy out via high

leverage. The cashflow argument is particularly relevant, to making an LBO target attractive, as it

directly addresses the issue of meeting the high finance costs inherent in the life of a post LBO

transaction structure. In their writing Lehn & Poulsen, (1989) make references to LBO‟s and

company financial distress. In particular firms with lower cash flows have higher financial distress

costs and are also burdened with higher expectations of cash flow growth when considered for LBO

(Lehn & Poulsen, 1989).

Lastly Opler & Titman, (1993) extends the cash flow discussion further by agreeing that, firms that

attracted LBOs have relatively high cash flow but also added that these firms are characterized by

unfavorable investment opportunities (low Tobin's q). This is what is termed the financial distress

hypothesis also consistent with the free cash flow theory (Jensen, 1986). The Tobin‟s q as noted by

Opler & Titman, (1993) is a proxy variable for the cost of taking on debt, insofar as high „q‟ firms

typically have less collateralizable assets and greater growth opportunities. In their study that was

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set on investigating the determinates of LBO activity by comparing firms that have implemented

LBOs to those that have not, Opler & Titman, (1993) found that ideal LBO targets have product

uniqueness, collateral and growth, less cash flow volatility and a limited degree of information

asymmetry between managers and shareholders. Opler & Titman, (1993) concluded that

informational asymmetry increases the chances that a firm is undervalued. This creates

opportunities for individuals with superior information such as management to initiate management

buyouts „MBOs‟, thus induces LBO‟s.

2.1.4 Attributes of a good leverage buyouts (LBO)

In this regard based on prior experience Olsen (2003) provides a criteria list for a good LBO

candidate;

steady and predictable cash flow,

clean balance sheet with little debt,

strong, defensible market position,

limited working capital requirements,

minimal future capital requirements,

heavy asset base for loan collateral,

divestible assets,

strong management team,

viable exit strategy,

synergy opportunities and

potential for expense reduction.

According to Olsen (2003) firms with high expected costs of financial distress are less likely to do

LBOs. This for instance includes those companies with high research and development

expenditures (Opler and Titman, 1993).

In summary a good LBO target will have a strong balance sheet, therefore fixed assets and limited

gearing, profitable and cash generative operations –therefore limited capital expenditure (capex)

and manageable working capital as well as a viable exit – either by outright sale to a strategic

buyer, or even another financial buyer or Initial Public Offering and/or Recapitalization (Gagliano,

2004).

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2.1.6 LBO structure: default risk, the burden and benefit of debt

A general criticism for LBO by Fox & Marcus, (1992) takes the stance that leveraged buyouts

(LBOs) are controversial, as they have ethical problems and redistribution issues. To add another

prominent LBO criticism is that it increases corporate default risk. The debt in leveraged buyouts

often includes a junior, unsecured portion that is financed by either high yield bonds or “mezzanine

debt” (that is, debt which is subordinated to the senior debt) (Demiroglu & James, 2007). So in

actual fact LBO structures burden the company with finance costs obligations. That said a study by

Stromberg, (2008) has proven that only a trivial fraction of LBO firms end up bankrupt. Assuming

an average holding period of six years, this study found that annual default rate of LBO‟s worked

out on average to be 1.2% per year. However the positive side about leverage is the pressure it

creates on managers not to be wasteful (Jensen, 1986). This pressure reduces the “free cash flow”

problems described in Jensen, (1986). However a fine balance is required between achieving

leverage levels that ensure efficiency and those that can tip the insolvency scale.

All in all a good debt market and bond market capitalisation provide enablers for LBO‟s and result

in positive and significant influence on investment growth. Results from Abor et.al (2010)‟s study

point to the fact that emerging markets should therefore focus on developing their financial

superstructure further to enhance the performance of the financial markets and investment growth.

2.2 Conclusion

In conclusion it is quite clear that the „curtain is beginning to come down‟ on financial engineering

based value creation by the private equity industry. Thus the future for private equity value-add lies

in operational improvements.

Nevertheless prior writing on the LBO topic has lead to three main and recurring theories. Firstly

LBO is a good management incentive tool; it provides for managers to participate in equity and

focuses them on cash generation. Secondly there is positive relationship between debt and

discipline. Lastly the combination of cash and low growth opportunities equates to an ideal LBO

candidate. All in all the overall strong themes are management and cash flow.

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The notion of tax shield as a motivating benefit has been widely written about, but the significance

of this still remains untested. Finally even though default risk remains relevant for LBO structured

investments literature has indicated that only a handful of LBO structures have ended in default

(Stromberg, 2008).

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3 RESEARCH METHODOLOGY

3.1 Research approach and strategy

The research methodology is dictated by the nature of this study‟s question(s). The objective of this

research is to provide insight into understanding into the important attributes of a LBO target

company, and in so doing, aid in developing theory around this topic. Hence the inductive research

approach is fitting, whereby the approach results in theory that will be the output of the research by

a process of drawing generalisable inferences from the observations (Bryman & Bell, 2007, p.14).

Therefore the study will draw a conclusion from one or more of the evidence obtained. This

conclusion(s) will explain the facts, and the facts will be used to support the conclusion (Cooper &

Schindler, 1998, p.31). In that regard this study will not be deductive in approach and hence the

researcher will not deduce a hypothesis based on available theory and subjects it to empirical

scrutiny (Bryman & Bell, 2007, p.11).

Further more the research strategy of this study is qualitative. This qualitative research will be used

to enable the researcher to gain new insights about attributes of LBO targets and to develop theories

about this phenomenon (Peshkin, 1993).

By studying these phenomena in all of its complexity, data will be continuously collected and

analysed, resulting in a continuous reflective theory (Leedy & Ormond, 2005, p.133). Furthermore

the benefits and/or purposes of qualitative research is to; describe how things are, gain new insight

into this particular phenomenon and/or discover the problems that exist (Leedy & Ormond, 2005).

On the other hand Bryman & Bell (2007) highlights some limitations of qualitative research

namely; the issue of subjectivity, „un-replicability‟, transparency and the problem of generalisation.

As part of addressing these, deliberately the semi-structured interviews were recorded and a

prescribed methodology presided over the process.

According to Bryman & Bell (2007, p.28), the qualitative research strategy has epistemological and

ontological considerations. There are various epistemological positions positivism, realism and

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interpretivism. This study‟s epistemological orientation will be of interpretivism, which “rejects the

practices and norms of the natural scientific model and of positivism in particular in the emphasis

on the ways in which individuals interpret their social world” (Bryman & Bell, 2007, p.28).

Therefore understanding of the participants forms the basis of the analysis as well.

As with regards to considering the ontology two key positions are available, namely; objectivism

and constructionism. This study‟s ontological orientation will be of constructionism, therefore the

social phenomena and the meanings thereof continue to be altered by the relevant social actors.

All in all this is a combined interpretivist and constructionist stance, which also coincides with

qualitative research characteristics (Bryman & Bell, 2007).

3.2 Research design, data collection methods and research instruments

The choice of a research design, framework for the collection and analysis of data reflects decisions

about the priority being given to a range of dimensions of the research process (Bryman & Bell,

2007, p 40). The survey that will take place will take more of a cross-sectional design. The content

hereby will be collected via semi-structured interviews seeking to assess the view points of the

private equity industry at a given point in time. Furthermore the ranking is used in order to

distinctively categorize the different responses received. This is also used by Jones (2009) whereby

the inclusion of rankings within his survey is particularly used to enable variation between

responses to be explicitly indentified. The ranking is based on previously identified LBO attributes

from the literature review.

The data for this study will be field-based (Private Equity Industry). The actual data collected will

be via semi – structured interviews with industry players (Associates and Principals). The data

collected will include the perspectives and voices of the industry.

The interviews were structured to minimize the researchers input. To this regard close ended

questions included demographic information, while the open ended offered participants opportunity

to provide in-depth details. The actual interview process closely follows the following guidelines

(Jones, 2009):

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Interview questionnaire preparation:

1. Questions will be identified in advance – no leading questions

2. Consideration of participant‟s background and potential influence on answers

3. Interviewees are intended to be representative of the group

4. Location chosen with suitability in mind

Each of the 28 available private equity houses were contacted

Only 13 confirmed.

5. Get written permission

30-60 minute Interview

6. Focus on actual rather than the hypothetical

7. Don‟t put words people‟s mouth

8. Reward responses of verbalism

9. Minimize reactions

10. Ensure of hardware

The interview questions themselves were sent to the respondents in advance for preparation sake.

Also the respondents were expected by the beginning of the interview to come prepared with their

ranked choices, the attributes that make a good LBO target. In this way the interview was structured

to focus on the reasons for the respondents‟ choices made and ranking thereof. (Appendix 6 -

Interview Questions) The interviews were tailor made to suit the respective audience(s), i.e private

equity houses and the debt houses. Similarly as done in Jones‟s (2009) study, the questions were

used as a basis for the interviews, but consistent with a semi structured interview format,

interviewees were encouraged to discuss freely, around the questions. Accordingly in some

instances for the sake of clarity the researcher was prompted by the interviewee‟s feedback to probe

for further information.

The process then continues with a transcribing exercise, which allows for the content to be checked

and cross referenced. Following that the ranking were given scores, consolidated so to yield a

combined ranking of the groups‟ responses.

If attribute ranked 1st = 4points

If attribute ranked 2st

= 3points

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If attribute ranked 3st= 2points

If attribute ranked 4st= 1points

The total per element/attribute determines the final score which then determines the position of that

attribute. Furthermore these totals were converted to % to be able to graph and present the findings

in graphical point.

3.3 Sampling

In sampling the local private equity industry the focus was on eliminating potential sampling bias,

therefore a selection restricted to only a narrow group (non-representative group) of market

participants. Therefore in so doing avoid the risk of potentially only being exposed to a small subset

of the issues facing the industry as a whole (Lerner et al. 2005 p 90).

In a similar manner Lerner et al (2005) and Lingelbach (2008) also chose to target different groups

in their studies. Thus to cover the two targeted groups for this study, private equity houses and debt

providers, the researcher identified and contacted the following potential participant groups:

1) Members of private equity firms registered as full members of the SAVCA website

2) Debt houses that have particular focus on servicing the private equity industry

The South African context provides at least two previous instances Van Deventer & Mlambo

(2008) and Jones (2009), where SAVCA was used as a source for target respondents. The SAVCA

database was used in conjunction with internet (company internet sites). In addition the actual

process of identifying individuals in each firm to take part was assisted by the fact that the

researcher is in the field and was able to use existing networks to target specific individuals. This

was done on the basis of rank and experience in the private equity industry.

In terms of the debt providers these were as recommended by the private equity houses engaged.

However all in all the sampling of this study provides an instance of convenience sampling, as the

SAVCA database was chosen out of convenience and the fact that it provides full contact details of

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its members. Another characteristic of this study‟s sampling is non probability sampling technique,

as some units in the population are more likely to be selected than others. (Bryman & Bell, 2007)

However a number of stumbling blocks are anticipated; firstly the issue of non response anticipated

and to counter that at minimum two interview requests targeting principals and senior associates per

organisation will be sent out. Secondly invariably decisions about sample size represent a

compromise between the constraints of time and cost, the need for precision and a variety of further

considerations. (Bryman & Bell, 2007, p194) Thirdly the lack of transparency in qualitative

research is related to sampling (Bryman & Bell, 2007, p.497).

Bryman & Bell (2007) state that reliability, replication and validity must be considered when

evaluating business and management research. Reliability therefore is the study repeatable?

Replication - therefore the ease of replicating the study. Validity - therefore the integrity of the

conclusions that are generated from a piece of research. However, the relevance of applying

reliability and validity to qualitative research is questionable. LeCompte & Goetz (1982) relate

reliability to qualitative research as external reliability or the degree, to which a study can be

replicated, and internal reliability or the consistency of observations between two or more

observers. Similarly internal validity or the degree to which a match exists between the researcher‟s

observations and the theoretical ideas they develop, and external validity or the degree to which

findings can be generalized across social settings (LeCompte & Goetz, 1982).

Given that this study is qualitative and specifically limited to the South African context, herein are

potential issues in terms of replication. Due to varying geographies having specific and unique

characteristics. Nevertheless reasonable replicability would require an accurate replication of the

methodology outlined in this study. Furthermore and on the basis that this is a qualitative study the

concepts of validity and reliability are substituted by trustworthiness and authenticity. This

substitution is proposed by Cuba & Lincoln (1994) because reliability and validity are concepts that

more easily applied to quantitative rather than qualitative studies.

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3.4 Data analysis methods

The responses to the first part of the interview, which constitute the closed ended questions allowed

for the generation of simple analytics of the responses. The analysis of the open ended questions

focused on presenting the findings of the ranking questions pictorially as done in Jones (2009).

This was done to aid comparison as well as to present the proportion of respondents indicating

specific answers to the other closed questions.

As per Leedy and Ormrod (p, 142, 2010) the data analysis for a grounded theory study begins

almost immediately, at which point the researcher develops categories to classify the data.

Subsequent data collection is aimed in essence at learning as much as possible and at finding any

disconfirming evidence that may suggest revisions in the categories identified or in

interrelationships among them (Leedy and Ormrod, p.142, 2010). This essentially is the constant

comparative method, as it involves a data process of moving back and forth between data collection

and data analysis (Leedy and Ormrod, p, 143, 2010).

Ultimately the presentation below is the result of the interviews conducted. The point of the study is

not to prove causality or to establish significance and/or otherwise of opinions between the groups

(Jones, 2009). Rather this research is aimed at capturing as broad a set of views as possible within

the private equity industry and debt providers of the private equity industry. In the end the results

of interview represented a combination of perspectives. From hence the focus was on highlighting

the areas of consensus and divergences.

The steps which are highlighted by Corbin (2008) towards strict sense of coding presented too

structured a process to the point that they limited the flexibility of the researcher. This one

drawback was also identified by Charmaz (2000). Furthermore based on the intentions of the study

statistical analysis of the results was not appropriate in this instance.

In summation just as with Jones (2009) and some adoptions from Corbin (2008) the interview

sessions lasted between 30 – 60 minutes,

Each interview was recorded

In conjunction detailed notes were taken

Notes were then amalgamated with the recorded content to form final data

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Data then scrutinised for commonalities in categories and themes

Data then examined for sub-categories as well

Followed by further development of each category regarding conditions, context, strategies

and consequences thereof

Develop a story that describes the attributes of a „good‟ LBO target, from combination of

category themes and interrelationships

Then finally the theory in a visual model

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4 RESEARCH FINDINGS, ANALYSIS AND DISCUSSION

4.1 Research Findings

This study sought to establish and asses the factors considered, by the South African private equity

industry, good attributes of a potential LBO target. The findings below represent the results of the

interview surveys conducted on the industry. The following sections include the research findings,

analysis and discussion thereof.

4.1.1 Demographics of respondents

Out of the 28 private equity houses contacted, a total of 13 responses were received. This represents

a 46% response rate. The respondents were either from captive (46%), therefore managers who

manage on balance sheet funded funds by a parent company, or independent funds (54%), which

manage funds on behalf of third parties (SAVCA, 2009). Here below is an illustration of the

breakdown of respondents between captive and independent funds.

Independents54%

Captives46%

Break down of respondents between captive and independent funds

Figure 5 : Break down of respondents between captive and independent funds

The quality of information obtained out of the interviews was of a high standard and as anticipated

provided a lot of content and insight. This was largely assisted by the high level of private equity

experience, of the interviewees, that formed the basis of the respondents‟ feedback.

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0

5

10

15

20

Years Experience

Years Experience

Figure 6 : The respondents / Interviewees, their titles and years of private equity experience

The average private equity experience of the sample respondents was 7 years, made up of 62%

principals/associate principals and 38% associates.

4.1.2 Results of Interview feedback

Based on the feedback of the interviewees the following findings as represented by the graph below

were made. (See Appendix 7 for step by step derivation of the data – graph)

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0%

5%

10%

15%

20%

25%

30%

Important attributes of a ‘good’ LBO target

Figure 7 : Important Attributes of 'Good' LBO target

The four most important attributes of a „good‟ LBO target company were identified and ranked, in

order of importance (priority), by the South African industry as follows;

1. Strong and partner-able management

2. Steady and predictable cash flow

3. Viable exit strategy

4. Strong market position

The mean line (red dotted line) indicates where the average lies. Evidently the four most important

attributes stand well above the average line and the rest of the choices made. This is evidence of

existing high consensus achieved in the results.

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Furthermore captives are compared to independents in the below graph. While from both groups

the list of attributes did not change, the order of priority differed (captives versus independents).

Notably the captives prioritised steady predictable cash flow above strong partner-able management

unlike in the combined results and the independents results. As shown in the graph below.

0%

5%

10%

15%

20%

25%

30%

35%

Breakdown of important LBO target attributes between captives and Independents

Independents

Captives

Figure 8 : Breakdown of important LBO target attributes between captives and Independents

The section to follow will provide in-depth analysis of the findings above, as well as a discussion

with regards thereof.

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4.2 Research Analysis and Discussion

4.2.1 Strong and partner-able management

Strong management team definitely came out the strongest of the attributes selected. Out of the 13

interviewees 38% (5 out of 13) rated it the most important and another 38% prioritised it second on

their list. The graph depicts the proportion of people per the ranking made for good management as

an attribute.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

15%

8%

38%

38%

Proportions of ranking for 'Good' Management Attribute

No Choice 4th 3rd 2nd 1st

Figure 9 : Proportions of ranking for 'Good' Management Attribute

One other theme that is clearly evident from the interview feedback is that, of the respondents that

ranked management 1st and 2

nd none of them were at the associate level, all were either holding

principal or associate principal roles. While literature was not able to provide concrete reasoning

behind this, it is concluded based on the descriptions of private equity roles and responsibilities that

associates are less likely to appreciate the role and or the work of portfolio company

management(s). This because for the most part the board representation on behalf of private equity

firms on portfolio companies is mostly a responsibility carried out by principals and associate

principals in the private equity firm. As a result the associates are left to do much of the technical

and modelling exercises. The end result being that associates get limited face time with the

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management of portfolio companies, and hence tend to have limited appreciation for the role they

(portfolio company management) play this may somewhat, explain the ranking results.

This section will briefly explain the term „good management‟, there after move into the discussion

around the benefit of good management in an LBO transaction. Following that the negative impacts

of LBO and management are explored, and then the section rounds off with a potentially

contentious debate about whether, management is relevant as an attribute, in the first place.

What is good management?

Palepu, Healy and Bernard (2004) and Palepu (1990) provide us with a inverse answer to the above

question by outlining what does not constitute a good manager from the practical view of a private

equity investor:

Management that is not cost conscious and thus have high ratios of general & administrative

expenses and overheads to sales in comparison to competitors in the industry

Lacking focus and making significant investments in unrelated business areas

Not focussed on performance as measured by cash generation

Poorly incentivised, therefore weak linkages between management compensation and firm‟s

performance

All in all Palepu, Healy and Bernard (2004) describe these as value-eroding characteristics of

management. In addition Wang and Hanson, (2009) characterizes working experience and

professional knowledge as relevant, good management characteristics. Further to add, one of the

private equity respondent‟s company website, described good management as “management that is

partner-able”

The benefit(s) of good management in an LBO transaction

Some of the vivid comments from the interviews about good management were as follows:

“without a good captain even the best of ships will have no direction” and “in the end you need

good people who you can trust your money with...”. There have been studies in the past regarding

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management in relation to private equity in general. One such study is of Bloom et al (2007) who

found that management scores are highest for private equity owned firms. One possible

explanation for this is that private equity firms only buy well managed firms, therefore good

management is such an important factor that private equity is forced to be good “cherry pickers” of

companies who have good management. The other consideration is that private equity is able to

incentivise management to be good, via appropriate performance based incentives.

Jacobs Andersson, (2005) included strong management in the top three of his six primary LBO

investment criteria of private equity in Scandinavia. This view is strongly supported by Wang and

Hanson, (2009) who in their master‟s thesis study found that a qualified management team is a

crucial factor for a successful LBO, that because manager‟s diligence positively affects a

company‟s financial performance. To link this to an evident theme from the interviews, the

interviews revealed that to sustain the cash flows needed for the high debt obligations that are

inherent in LBO structures performing management teams are required. So good management is

beneficial in an LBO structure because they drive performance and efficiencies that realise the

needed cash to finance the LBO debt.

Management performance and the derivation thereof has been widely documented, particularly with

regards to private equity buyout funds. Opler and Tim (1993) on the other hand, attribute incentive-

intensive operating environments as positive influences of management performance. On the other

hand Morck, Shleifer and Vishny, (1988) presented evidence that firm performance is positively

related to ownership concentration and ownership of management. This is where management

buyout current shareholders in partnership with a private equity firm (buyout or management

buyout MBO) and as one respondent put it, “management with „skin‟ in the game”. This provides

great confidence in the merits of the transaction for the private equity partner. Management as an

insider will be privy to a more accurate picture regarding the future prospects of the company as per

theories around, information asymmetry.

The concept informational asymmetry between shareholders and management raises another issue

inherent in LBOs, the issue of agency theory from The Theory of the Firm. Jensen and Meckling

(2000) according to this theory pointed out that failure to maximize the value of the firm is still

consistent with efficiency. The debt of an LBO transaction plays its part in curbing the impacts of

agency theory. As so eloquently put by two of the interviewers when a company is geared there is

very little cash to „squander‟ as its mostly used to service the debt. In that regard the private equity

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manager also minimises on agency costs such as the monitoring expenditures, which according to

Jensen and Meckling (2000) include efforts on the part of the private equity firm to control; the

behaviour of the agent through budget restrictions, compensation policies and operating rules.

Therefore it is very easy to understand what Jensen and Meckling (2000) meant when they said, the

impact of debt in addressing the agency theory provides valid reasons why debt was relied upon as

a source of capital even before debt financing offered any tax advantage relative to equity.

By way of rounding off the benefits of a good management appears to be more required by the

South African private equity than western countries, particularly USA. This is due to the fact that

developments of the local private equity stills lags behind that of the developed markets.

Particularly when it comes to operational involvement in the portfolio companies. So the South

African industry still relies more on their company‟s encumbered managements and most often just

adds value by financial engineering. Hence they depend more on management quality for the

success of their LBO transactions. For instance from our interviews only 3 out of 13 interviewee

had knowledge of a „100 day plan‟. This is contrary to developments in the USA where recent

newspaper reports indicated that private equity firms are bolstering their operational resources. For

instance ex operational CEO (since February 2010) AG Lafley of Procter and Gamble has joined

Clayton, Dubilier & Rice LLC Private Equity as a special partner, advising the firm and its

companies on management issues ranging from product innovation to global expansion. This is in

addition to others such as John F. Welch Jr., the former General Electric Co. CEO, and Edward

Liddy, the ex-CEO of insurer Allstate Corp.

Does management quality of a target company really matter?

This topic brings attention to a specific point discussed at length in some of the interviews. That

good management in the portfolio companies is a private equity imperative, but not necessarily an

entry criterion. This is because as with buyouts the significant private equity shareholder is able to

effect a change management process once on the board. However the South African industry has

not presented some of the aggressive change management actions as seen in the United States of

America. As pointed out by one of the interviewees the local industry has a reputation to protect.

Though all the interviewees were in agreement that opportunities for buyouts do exist locally, the

acknowledged fact was also the difficulty of unearthing them and the close network that guards

these potential pipelines of deals. Hence it is necessary for private equity houses in the local

environment to appear partner-able rather than hostile to management and current owners of South

http://online.wsj.com/public/quotes/main.html?type=djn&symbol=GE

http://topics.wsj.com/person/l/edward-liddy/172

http://topics.wsj.com/person/l/edward-liddy/172

http://online.wsj.com/public/quotes/main.html?type=djn&symbol=ALL

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African business. This is very different to USA and UK environments where there is large

concentration of business and where respectively 68% and 74% of all private equity buy out deals

entail changes to management whether it is at the start of the investment, during and/or both as

illustrated below (Ernest and Young, 2006).

USA (74%) Europe ( 68% )

39% 38%

13%5%

22%25%

Frequency of management change by private equity

Start Start and During During

Figure 10 : Frequency of management change

To extend this further the need to protect reputation appears to be less of a concern with

independent funds. One of the interviewees mentioned that in most cases the shortage of skills and

therefore the lack of replacements for encumbered management in potential portfolio companies is

a major South African change management hindrance. Therefore instead most cases management is

incentivised to increase alignment with the private equity firm‟s objectives. On the other hand the

captives involved in this study were banks, which inevitably have a business that relies on

creditability and reputation; therefore assumedly captives should value their reputation more than

independent funds.

The cons of LBO on management

This section focuses primarily on the myopic behaviour of management‟s tendency to be over

consumed by the debt obligation(s). Therefore the terms and covenants of the debts, which

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naturally have a short term outlook, at the expense of long term growth objectives of the firm. This

argument is carried in more depth in the steady and predictable cash section to follow

Overall this section managed to uncover mostly congruencies and in some places diversions of

findings among the authors and in relation to this study‟s findings. Firstly there seems to be

widespread consensus on the importance of good management as an attribute but some differences

in the prioritization thereof (ranks) between this study and reviewed literature. Secondly the benefit

of good management in LBO structures is that they will produce the required performances that

will yield debt servicing cashflows. But also debt has proven to have its own benefits of minimizing

agency costs. Lastly some diversions regarding the level of involvement with local private equity

versus that of the west and the frequency of change management. However there is merit in the

argument for both reputation and skills shortage under the South African context as probable

constraints that are not so compelling in the west.

4.2.2 Steady and predictable cash flow

Steady and predictable cash received the lowest standard deviations in the rankings and featured in

all the ranking except for one interviewee. As depicted by the graph below.

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0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

8%

23%

23%

31%

Proportions of ranking for Steady and predictable C/F


Figure 11 : Proportions of ranking for C/F

What is steady and predictable cashflows?

Steady cash flows in many ways infer that the company has the ability to generate cash flows that

are consistent and sustainable. This speaks directly to the fundamentals of a business and

performance thereof. One of the recurring reasons for the prioritization of steady and predictable

cash flows and even above viable exit strategy for an LBO is that a cash generative business is

generally attractive and the attractiveness thereof is assumed will attract interest from potential

buyers.

The relevance of cashflows to LBO

Free cash flow and the capability of a company to generate thereof is particularly relevant to LBO

transaction above all else because as mentioned previously, it ensures that debt will be serviced. As

mentioned by one of the interviewees the ideal geared company will pay its debt in the shortest

possible time and avoid bullet type debt terms. In this way the company maximises by using a

cheaper means of financing, debt. As per the Pecking Order Theory and minimising on financial

distress costs as previously discussed in the literature.

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In addition each company needs free cash flow to support new profitable projects as per Wang and

Hanson (2009). This also introduces a related theme that developed during the interviews and

previously documented by Andrews, (1987) Reich, (1989) and Fox & Marcus (1992) that LBOs

have a tendency to focus private equity portfolio company management on short term strategies of

their businesses. This is primary due to two reasons. Firstly the shareholder private equity has

inherent short term views as they look to exit mostly via a listing in 3-5 years time Fox & Marcus

(1992). Secondly the management of these companies are so often consumed by the obligation to

service the debt at even the expense of long term growth strategies. An example of this is where

management of companies neglect R&D investment(s) as pointed out by Wright et al (2000), in his

study that found that R&D investment and intensity tended to decline in companies post LBOs.

However as a counter and a fair balance to the argument, 70% (9 of the respondents) of the

interviewees put forth the argument that, private equity companies will always have a growth

strategy in place for their portfolio companies. Further more they pointed out that this plan is

designed to factor and consider both expansionary strategies and the ability for the company to

service the debt. One respondent put it so clearly by saying that in the end the determining factor is

the highest potential benefit, therefore the incremental return on capex and/or growth related

expenditures versus the levering that potential debt will have on the Internal Rate Return (IRR). All

in all it therefore all depends on the quality of a firm‟s investment opportunity set.

But is it only cash flow?

As a matter of fact it is the combination cashflow and low Tobin‟s q that is relevant, and again the

issue of agency theory is also applicable here.

There are a number of documented literatures including Lang & Litzenberger (1989) and Opler &

Sheridan (1993) regarding Tobin‟s q as the measure for a firm‟s investment opportunities. As

matter of fact Opler & Sheridan (1993) found that firms that initiate LBO‟s can be characterised as

having a combination of unfavourable investment opportunities (therefore low Tobin‟s q) and

relatively high cash flow. This is in line with the free cash flow theory.

In concluding this section we have discussed the following; firstly it‟s not so much the cash flow of

a company, but the capability to generate consistent and sustainable cash flow (in order to have this

the company is most likely to be in its mature state) that matters in an LBO target. In addition the

cash generative business has to be coupled with a low Tobin‟s q (therefore having real free cash

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flows), indicating the poor quality of investment opportunity set available and therefore ruling out

the argument of trading off growth for debt servicing. On the whole there is consensus as to the

importance of cash flows in the consideration process for an LBO target.

4.2.3 Viable exit strategy

Out of the 13 interviews 6 ranked exit as the least priority of the four choices made, as reflected in

the graph below. The sub sections to follow will briefly include an explanation around exits and the

importance thereof exits strategy at the LBO investment consideration stage, secondly the different

views around the importance of an exit strategy are explored in general and from a captive versus

independent funds‟ perspective.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

8%

46%

0%

23%

23%

Proportions of ranking for Viable exit strategy


Figure 12 : Proportions of ranking for Exit

The choice of exit is important to determine how return is to be gained from the given LBO

investment, and determined by the private equity manager in accordance with the (current or

expected) condition of the company (Povaly (2007). Exit options include listings (public offering of

shares on the public market), sales (merger and/or acquisitions by another company) and share

repurchases.

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Is exits strategy more compelling for independent funds?

Out of the 13 respondents only 3 prioritised exits above all other choices and notably all of these

were independent funds. Which immediately begged the question – does an exit strategy matter

more to third party fund managers than on balance sheet fund managers? On the basis that third

party fund commitments typically expire often according to a time schedule based on a use it or

loose it principle, once a maximum drawdown time period expires (SAVCA, 2009). In addition to

this it is the industry norm for independents to only start raising funds when 70%-80% of current

funds are spent. As one principal put it fund raising is on a vintage basis, therefore success of

previous funds will determine the fundability of your next fund. The combination of the above

factors make probable reasons as to why exists are more important to independents than captive

funds. However interestingly according to subsequent conversations with the captives respondents,

there should really be no difference. It merely becomes an issue of different type of investors.

According to the captives their parent company will have similar terms on the money that is

allocated to the private equity division. To take this further in the case of this study, the captive

funds are banks. These ultimately have depositors who are the ultimate owners of the funds and

further reason why effectively the balance sheet funding will have no lesser terms in comparison to

the independents.

How important is an exit strategy?

Out of those that had not prioritized an exit strategy in their choice, the emphasised reason is that,

the fundamentals of the business are the determining factor for buyer‟s interest. All in all a viable

exit strategy at the onset of the LBO transaction was not given significance. This is some what

different to Wainwright and Groeninger (2003) strong stance from their study, that private equity

only invests in portfolio companies that have a clear exit sense at the beginning. Several GPs

indicated that they need to see at least three clear buyers at the outset to believe that an M&A exit

approach is viable (Wainwright and Groeninger, 2003). Notably one of the interviewee explained

that the value of the LBO investment is derived from the exit. Hence the importance to work

backwards in prioritising these attributes starting with exit as most important. “Through an exit,

investors realize returns …” Exits essentially allows the company receives to an infusion of capital

and/or a new strategic direction from a new partner.

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So the connotation for exit in private equity terms refers to exit via a listing (IPO). But in fact many

other options are available such as sales to trade and/or financial buyers. The exit strategy at the

onset is important as it directly impacts on the expected return to be earned. In addition there

appears to be some merit in the argument that independent funds are more concerned about exits

than their captive counterparts, based on the nature of the source of funds. However in reality this

argument is limited by the fact that captives have indicated to be subjected to similar funding terms

from their parent company investors. In the end as per the findings „exits‟ might not be as important

relatively, because given good business fundamentals selling the business will sort itself out.

4.2.4 Strong market position

Notably there were a large number of interviewees that did not have this attribute in the top four

ranking, 38% in total (5 out of 13).

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

38%

8%

46%

0%8%

Proportions of ranking for Strong market position


Figure 13 : Proportions of ranking

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This section explores the meaning of market dominance and related links to the cash flows of a

business. Further on elements and characteristics that provide strong market positioning are finally

outlined.

The strength of any company‟s position in its industry directly speaks to the dominance within the

industry, therefore the competitive advantage and the barriers of trading in the industry (Porter,

1979).

The common theme reiterated in all the interviews was that strong market position leads to good

performance i.e. revenue growth. Wang and Hanson, (2009) also alluded to the conclusion that cash

flow of any entity begin at the topline. Therefore on that basis we conclude that strong market

position should go hand in hand with cash flow of the firm. However as the interviews indicated

management is vital in making sure the market positioning is translated into cash value and not just

top line growth that is eroded by cost inefficiencies.

In specific instances the strength of companies will be derived from unique products. However

literature by Titman & Wessels (1998) as well as Opler & Sheridan (1991) agree that several

proxies for product uniqueness are negatively related to leverage ratios. These proxies include:

1. research and development divided by sales,

2. selling expenses to sales and

3. dummy variable for firms in the machinery and equipment industries. Titman & Wessels

(1998)

The third proxy indicates that, the strength of the market position also depends on the relative asset

base in the industry. In some instances large capital intensive companies keep out competition

through required initial capital outlays. These trade barriers limit new entrants and competition. All

in all an LBO capital intensive target company provides an advantage, the collateral factor, as

pointed out by one of the interviewees. The references about significance of collateral is also made

by Galai & Masulis, (1976), Jensen & Meckling, (1976) and Myers, (1977) who show that

collateral makes creditors less vulnerable in the above sense. This is because equity holders of

levered firms have incentives to invest sub-optimally to expropriate debt providers (Opler and

Sheridan, 1991). However there was also some lack of consensus on the importance of collateral.

One of the interviews minimized the collateral and/or asset intensive requirement in LBO

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transactions by illustrating the many intellectual property (IP) based companies and services

companies transactions such as Tourvest LBO in 2009 with Old Mutual (SAVCA, 2009).

In conclusion prior writing has elaborated on strong market position as a competitive advantage,

more specifically a potential protective barrier to competition. The link between strong market

position and cash flow is also distinctively made. Hence as a way of deduction an inherent link is

possible between market position and cash flows, ranked second.

From henceforth this chapter proceeds with the following sections; firstly the attributes that were

not prioritised (ranked) from the interviews are briefly explored. Followed by a limited secondary

study that provides perspectives of debt providers and finally focus on of the secondary research

questions about whether private equity companies have a checklist against which a typical LBO

opportunity is measured against.

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4.2.5 Least important ranked

0%

1%

1%

2%

2%

3%

3%

4%

4%

5%

Low Enterprise Value/ EBITDA

multiple

Large amount of tangible assets for

loan Collateral

Potential for expense reduction

Minimal future capital

requirements

Limited working capital

requirements

Clean balance sheet with little debt

Least Important attributes of a ‘good’ LBO target

Figure 14 : Least Important Ranked Attributes

The mean average of the lowest ranked attributes is 2%, versus the 10% of the mean average of the

highest ranked attributes.

The most commentary from the least ranked attributes was about the clean balance sheet with little

debt attribute. Most (over 70%) of the interviewees indicated that the advantage of minimal debt is

somewhat limited, under LBO context. Infact the primary benefit of introducing the debt is that the

private equity player is able to negotiate their own terms. However for the private equity investor

whether debt is existing or introduced during the time of investment the net effect is a reduced

equity cheque. See illustrated example below:

At T-1 :

If one assumes the following 2 companies with R1000 Enterprise Value (EV – Equity +

Debt) company A with no debt and Co B with 60% leverage of R 600.

Therefore effectively Co A has R 1000 equity and Co B has R 400 equity (NAV)

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Lastly the assumption is that both companies have a EBITDA of R200 and can only be

leveraged up to 3x EBITDA therefore maximum debt of both companies can only be R600.

i.e Co B is fully leveraged.

A ] EV = 1000

Debt = 600

Equity = 400

B} EV = 1000

EV = 1000Debt = 0

Equity = 1000

EV = 1000Debt = 600

Equity = 400

Debt = 600

Equity = 400

T-1

T+1

At T-1 :

A 100% leverage buyout is done on both companies

Since there is maximum debt Co B will require an equity cheque of R400 for 100% of the

business

Co A can be levered up to R600 first, and then an equity cheque of R400 is required for

100% of the company.

Conclusion: In the end, in principle it does not really matter whether, the private equity

firm introduces debt or not the net effect is that minimum equity is put in for a firm that is

much higher in value (EV). This is inline with the MM theory that states that the total value

is the value of all its sources of funding. Therefore the total cash flows a company makes for

all investors (debt holders and shareholders) are the same regardless of capital structure.

http://moneyterms.co.uk/cash_flow/

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Changing the capital structure does not change the total cash flows. Therefore the total

value of the assets that give ownership of these cash flows should not change (Modigliani-

Miller, 1976).

4.2.6 Debt houses‟ perspective

0%

5%

10%

15%

20%

25%

30%

35%

40%

Debt Houses' Important attributes of a ‘good’ LBO target

Figure 15 : Lender's View

According to Mester (1992) and Smith & Warner (1979) LBO firms rely on bank debt because

concentrated ownership makes bank loans easier to renegotiate than with listed company which

have wide shareholdings. In addition Gilson, et al (1990) argued that the ease of renegotiation aid in

lowering financial distress costs. The feedback from interviews done with the providers of debt

adds an interesting dimension to the attributes considered for an LBO investment. The lenders

highlighted cash flows as the most important attribute. As vividly illustrated by one of the

interviewee there are in essence two main things to consider in funding a typical LBO transaction.

Firstly the repayment ability of the target company. This is the debt quantum determinant that the

entity is able to withstand and is largely focused on the Debt to EBITDA ratio (EBITDA is

representative of the cash of the company), then there is the consideration of the inherent risk, this

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will involve the nature of assets and the business plan. The outcome of which can also have some

impact on the debt quantum, already discussed.

Notably reputation of the private equity firm also featured as a prioritised attribute from the

lender‟s perspective.

Does reputation of the private equity firm matter?

Given the results from the interviews with lenders the private equity firms were asked follow up

telephonic questions regarding, whether they considered the reputation of their firm as an important

factor in securing leverage funding LBO investments.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

14%

57%

29%

Does PE reputation matter in LBO financing?

Not Certain NO YES

Figure 16 : Does PE reputation matter?

From the results above private equity firms did not necessarily think their reputation is an important

factor in securing LBO debt funding. However from the small sample of this study (only two

lenders) the conclusion from findings can be made that reputation of the private equity matters.

Reputation generally refers to the track record and the general prior performance of the fund

manager. Demiroglu & James (2009) also completed a study on this topic, the reputation of

acquiring private equity groups (PEGs) and their relatedness to financing structures of leveraged

buyouts (LBOs). The study found that reputable private equity firms secure more favourable debt

funding. Thus narrower bank and institutional loan spreads, longer loan maturities, and rely more

on institutional loans (Demiroglu & James, 2009).

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4.3 Research Limitations

According to Bryman & Bell (2007), qualitative research has the following limitations:

Subjectivity - therefore findings are reliant on researchers unsystematic impressions about

significant levels

Replication – it is thus hard to refute or confirm a research findings

Generalisation – the sample are general and small and non representative

Transparency – it is difficult to decipher what the researcher actually did and how they

arrived at the conclusion

To add to this the population of the study is not homogenous and hence analysis, interpretation and

applicability of the research are difficult (Muriithia et al, 2003). This lends itself from the fact that

non probability sampling has the danger of introducing bias, from choosing of categories of the

population (Aarker, 2001, p. 26).

The study was limited in its attempt to cross-sections of the respondents between private equity

practitioners and debt providers of the industry because of the poor response rate from the debt

providers. Therefore there is a need to increase the lenders sample. Furthermore amongst the

private equity practitioners the sample needed more broadness to allow significant representation of

the different private equity types based on the source of funding beyond just captive and

independent. Therefore instead captives government, captives financial services and captives other

(SAVCA Survey, 2009).

Furthermore the biggest limitation on the interview process was time. Firstly the constraints of time

provided for solicited interviews to be accepted and confirmed. Secondly the time availed by each

practitioner for the conduct of the interview sessions were limited as generally the session were

scheduled in diaries amidst very active and tight time commitments. Lastly the provision of follow

up questionnaire could only be secured as a telephonic interview.

Finally the study on the whole is deliberately limited to the South African Private Equity Industry,

and is thus geographically biased.

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5 RESEARCH CONCLUSIONS

This is a private equity research, based within the parameter(s) of the South African industry, and

more specifically refers to the leverage buyout (LBO) investment structure. The study has a

particular focus on the private equity target company. Therefore as a result it is positioned at the

due diligence phase(s) of the LBO transaction process.

The study is set out to determine and analyse the important attributes of a „good‟ LBO target

company, this particularly from the South African private equity practitioners‟ perspective. The

findings of this report will also sufficiently serve as recommendations to the local industry, at

minimum to be considered during targeting of an LBO investment.

As the study has outlined there are essentially three main players (private equity, lenders and target-

company) in an LBO structure as depicted below:

The primary aim of the study is to gather opinions from the local private equity industry and to a

limited extend contrast this with opinions from debt funders of LBO transactions. From thus some

interesting discussions have emerged. The result and summary of which is included herein the

answers to the revisited research questions below.

The local private equity industry has grown rapidly over the years. Studies and surveys mentioned

in this research study have proven that this industry (private equity) is making significant local

Private

Equity

Target

Company

Lenders

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macroeconomic contributions. Hence the decision to focus this study on the private equity industry

has some noble intensions, and is aimed at furthering the industry, and indirectly contributing to its

success, and that of the macro economy at large. In particular this study intends to add value by

improving the local success rate of LBO transactions. By providing the industry practitioners with

consensus around a list (ranked) of attributes for a good LBO target, should aid their choices for

suitable LBO investment targets.

The study‟s approach began with a comprehensive review of previous literature, to determine

attributes that previous writers have highlighted in the past. From hence practitioners of the

industry were interviewed to determine a consolidated view(s) that represents the South African

industry (i.e. the consensus view).

The research set out to answer a number of questions as set out previously in this report:

Firstly what are the attributes of a good LBO target, from the South African Private Equity

Industry‟s point of view?

The literature review conducted in chapter 3 highlighted prior work conducted into the LBO

structure and which outlines various motivations for LBOs. These range from the benefit of tax

savings to the positive impacts of debt on management behavior and solving shareholder issues, to

be explored below.

The results of the feedback from the local industry indicated that the four most important attributes

of an LBO target company are as follows:

1. Strong and partner-able management


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3. Viable exit strategy

4. Strong market position

Notably prior writings also make extensive mention of both strong management and cash flow

attributes.

How does the ranked list weigh up against that of the other important parties to the LBO

structure, i.e. the lenders?

Contrary to the findings of private equity results, the lenders indicated that they prioritized the

following attributes in their debt funding decisions:


2. Debt/ EBITDA multiple

3. Reputation of private equity firm

4. Minimal future capital requirements

The main difference between private equity results and that of the lenders is that lenders prioritized

cash flows above all attributes, and not management.

Another contrary juncture between the two parties is the focus and/or consideration placed on the

reputation of the private equity firm, by the debt providers (lenders). The lenders prioritized

reputation (third) of the private equity firm as part of consideration made in funding an LBO

transaction. This is reasoned that naturally, as parties to the deal, lenders have a interest in ensuring

that funded LBO‟s succeed, reputation reflects track record, and indicates potential. However in

contrast and a vital point of divergence the local private equity players did not consider reputation

to be a factor in their LBO transactions.

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Does the type i.e the source of private equity funds (Captive versus Independent) reveal

anything about the choice of attributes?

From the feedback obtained the differences between captive and independent funds are limited.

Notably there is differing prioritization of the „exit‟ attribute. However this might just be as a result

of third party funds placing more pressure on the private equity manger for a definitive exit strategy

at the onset of all investments, including LBO‟s. However in many ways both types of funds are

subjected to terms by their different investors (source of funding).

What is the impact of large gearing on the LBO target companies and more importantly

whereas related to the private equity shareholder?

The dominant themes that came out of the literature regarding both positive and negative impacts of

debt were validated by the private equity industry‟s interview feedback.

The positive element(s) of debt is in reference to its impact on management discipline. Whereby

literature talks to and about debt decreasing agency costs (monitoring costs). The negative elements

include the risk of default and the related costs of distress from large debts. All of these were

reiterated by the feedback of the local industry interview.

An important juncture of difference is however as related to the tax shield, while literature has

talked to this extensively as a benefit and a potential motivation for LBO the local industry only

perceive the tax shield as a by-product of the overall LBO, and not necessarily a benefit that

solemnly justifies a transaction.

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6. FUTURE RESEARCH DIRECTIONS

The findings of this study have also highlighted the need for other possible future studies in this

area. Firstly a more comprehensive study between private equity debt providers and private equity

houses, as attempted in this study, would be meaningful. Therefore to look specifically and to

outline the consensus and divergences of views regarding valued attributes of LBO target

companies.

Secondly there is a need for research around the assessment and analysis of failed historic local

leveraged buy outs (specifically with the intention to determine causality). According to Palepu

(1990) the three reasons why buyout(s) might fail are:

(1) Flawed structure of the LBO

(2) Poor post LBO management

(3) General economic conditions

Thirdly, this study has found that the South African private equity industry has limited portfolio

company change management activity versus their USA counterparts. Thus a future study that

looks into the nature of these activities, so current private equity firm‟s involvement in their

portfolio company investments, would be beneficial. Also but not limited to an analysis into the

reasons why the South African private equity industry is so conservative in applying change

management to LBO and other type structure portfolio companies.

Lastly, on the basis that private equity reputation is a factor of consideration in the financing of

LBOs by lenders, and as written about by Demiroglu and James (2010), a worthwhile study would

be to see the determinants of a private equity firm‟s reputation, especially in the South African

context.

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APPENDICES

Appendix 1 - Process of the LBO Structure

Below is a process of the LBO transaction structure as detailed by (PE simplified)

Fig : Participants of the leveraged buyout transaction

There are two sides to every corporate transaction: those acting with or for the purchaser,

and those acting with or for the owners of the target company (the target), the shareholders.

o On the purchaser‟s side is the private equity fund that intends to invest in the

transaction

o And the bankers who will lend in support of the deal and their respective advisers.

They must negotiate between them a funding package to support the bid.

The bid will be made by a newly-formed company, usually referred to as „Newco‟, which

will be funded by the bank and the private equity fund.

On the target‟s side are the shareholders who are generally seeking to maximize the value

they receive from the sale.

o They will be represented by the management of the business or independent advisers

(or both) who will negotiate with the private equity fund acting on behalf of Newco.

o The role of the incumbent management of the business in any buy-out varies.

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They may be part of the group seeking to purchase the business and therefore

be aligned with the private equity fund. This is often termed an insider buy-

out, or more often simply a management buy-out or MBO.

Alternatively the private equity fund may be seeking to introduce new

management if they successfully acquire the business. This is an outsider

buy-out or management buy-in or MBI.

In some circumstances management find themselves acting as both vendor

and purchaser. For example, in a buy-out by a private equity fund of a

company that is already owned by another private equity fund, management

may on the one hand be vendors of their current shares, but also be

purchasers of shares in the company set up to acquire the target. This is a

secondary buy-out.

Where management has a conflict of interest the shareholders‟ interests are

typically represented by independent financial advisers and, in a quoted

company buy-out, the independent non-executive directors of the target.

The role and rewards of management are a key difference between a

corporate takeover and a management buy-out.

In a management buy-out, management will be expected to invest their own

money in the business acquiring the target and expect to have the risks and

rewards of a shareholder of that business, not an employee.

The new company („Newco‟) is established and raises funds to acquire the target company.

Fig: Outline structure of a leveraged buy-out

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Private equity funds use a combination of their own funds and bank debt to fund each

separate newco that acquires a company.

The debt is the so-called „leverage‟ or „gearing‟. The use of leverage increases the returns

for private equity investors from successful investments and creates financial risk in under-

performing investments: it amplifies the underlying investment return.

The limits on the amount of debt

o The amount of debt available to fund a buy-out is a function of the bank‟s estimation

of a company‟s ability to repay the capital amount and to pay the interest on the

capital, as well as the security available to the bank in the event that the company

cannot repay the loans.

o Using debt increases financial risk in businesses, and if a business does not generate

enough cash to repay the capital and interest, under-performance can lead to failure.

o A crucial skill of a private equity fund manager and a banker is to balance this

risk/reward equation when structuring a transaction.

The sources of cash to repay debt

o Cash can be generated in any business in a limited number of ways: from increased

profitability; more efficient uses of capital; reduced taxation; or from new capital

from outside lenders or investors. Any debt in a buy-out has to be serviced by either

profits or capital efficiency improvements. Capital efficiency might mean selling

assets that are under-performing or leasing assets rather than owning them.

o The body of academic evidence is weighted against the idea that buy-outs are

successful simply because of asset sales or reduced investment.

While the above presents a detailed buy out process, it is worth nothing that the process really

begins at the point where the private equity manager discovers a potential LBO target and based on

the attributes of that target company is motivate to make the investment.

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Appendix 2 – Cover Email

Hi [Name]

As talked over the phone here with the formal request:

As part of my MBA studies at the Graduate School of Business (UCT) I am conducting an Academic

Research Survey on the South African Private Equity Industry. More Specifically the "LBO" Leverage Buy

Out Investment Structure. In attempt to minimize your effort with this, the Survey is designed as an

Interview - 30min (but otherwise if more practical for you, it is acceptable to just fill in your responses and

email back) and all information to be shared will be opinion based, thus there will be no need to divulge

any confidential fund specific information and/or data. Nevertheless all information shared will be in strict

confidence and will only be included in my final report in an aggregated form. Therefore there will be no

mention of specific names and/or details of specific fund references. (Please find attached a signed UCT

Graduate School of Business’s Non Disclosure Letter as well). Please feel free to refer me to a colleague

should you not be in a position to afford the time.

The Questionnaire is divided into three parts; an Introduction (demographics section which is below), then

followed by as attached a multiple based question and lastly some further insight questions into the

choices made from the multiple choice questions.

I sincerely thank you in advance for taking the time out of your busy schedule to consider my request and

advancing academic research in the Private Equity industry. You and/or your colleague’s a contribution

will also mean that I can share with you the final report once completed, should you have any interest. My

timings are such that I need to have completed this data collection phase by 30th Nov 2010.

Kind Regards,

Manabane Rachidi

MBA (Modular) 2009/10 --------------------------------------------Mobile - 071 609 7196

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Appendix 3 – Non Disclosure

PRIVATE EQUITY RESEARCH

CONFIDENTIALITY AND USE OF INFORMATION

I understand that confidentiality and high ethical standards are important prerequisites for participation in the

Private Equity Value Add Research as a student of this University, and that this study involves confidential

material of a company (ies).

I undertake to abide by the following:

1.

To keep confidential, information gained about the company(ies), other than public and/or published

information, outside the classroom, or other than in academic discussion with staff at the Graduate School of

Business, and,

2.

Not to use information learned about the company (ies) for personal gain, directly or indirectly.

I acknowledge that these obligations continue after completion of the MBA course work.

DATE: 15 October 2010

NAME (PRINT): Manabane Rachidi SIGNATURE:

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Appendix 4 – Fundamental difference between private equity and quoted equity

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Appendix 5 – SA Total Funds under Management per categories

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Appendix 6 – Interview Questions - PE

University of Cape Town GSB MBA Research Project – Industry Survey

Topic: Attributes of a good “LBO” Leveraged Buyout Out Target Company: South

African Private Equity’s Perspective

The objective of this research project is to assess from a South African Private Equity perspective, the attributes of

what is considered a good target for an LBO structure investment. In this context, please provide the most

important and valued features for you, in a potential portfolio company, that makes for an ideal LBO transaction

structure.

Introduction: Demographics – This information will only appear in aggregate form in the final report and no names

or specific details will be included here from.

a. Name of Fund e. Employment Title b. Date of Close f. Qualification c. Size of Fund g. Years of PE Experience d. Estimate % spent

1. Choose/rank what you consider to be four of the most important attributes for a good/ ideal LBO target company?

Steady and predictable cash flow – To ensure that the LBO target firm is able to meet its interest payments for the debt it will take on. Steady and

predictable makes it easier to get a loan since there is less risk that the firm will not be able to meet interest payments.

Low Enterprise Value/EBITDA multiple - An indicator of how easily the cash flows will be able to cover the purchase price

Large amount of tangible assets for loan collateral - Tangible assets will help to obtain more low-interest financing. The more low-interest

financing the acquiring firm can get, the less cash will be necessary to repay the loans

Potential for expense reduction - Reducing expenses will increase margins and free up cash and allow for faster repayment of the debt

Minimal future capital requirements – No need to have to make large cash outlays to keep the company running and growing.

Limited working capital requirements - This is pretty much the same as the point above.

Clean balance sheet with little debt - This makes the deal less risky (lower leverage = less risk) and allows excess cash to go to the debt necessary for

the leveraged buyout.

Strong market position - A strong market position can ensure that the target company won't be squashed after the leveraged buyout goes through. Such a

position makes cash flows less risky.

Viable exit strategy - Without a good exit in site, the LBO probably won't (and shouldn't) happen.

Strong and partner-able management Other: 1. 2. 3. 4.

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a) Out of the four choices above which would constitute the most important? - Why? b) Out of the four choices above which would constitute the least important? - Why?

1. What provides the most enabler and stumbling block locally for LBO structuring?

2. How much of the decision to leverage is based on tax savings? I.e. Tax reductions from increasing leverage

finance costs that warrant a tax shield. Why is this Significant or not?

3. Post the LBO, does leverage, address theorized issues of too much liquidity, hence does it increase

management discipline? How and Why?

4. Based on your and / or your firm’s opinion does the local SA market present sufficient LBO opportunities for

the Private Equity Industry? Why?

5. What are you and/or your firm’s outlook for the local LBO market or opportunities?

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I will also be adding the following angles on which I would like to understand your opinions:

Tax shield saving as an incentive to do transactions

Industry influences on the ranking of attributes

Reputation of PE as a factor considered in the decision to finance

LBO debt obligation and tendencies to force Short term strategies

Views on Change of management on entrant of LBO structure

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Appendix 7 – Step by step process of the data engineering

Step 1 – Score the rankings

A B C D E F G H I J K L M

Steady and predictable cash flows 2 1 2 3 4 4 3 4 4 1 2 3

Low Enterprise Value/ EBITDA multiple 1

Large amount of tangible assets for loan Collateral 3

Potential for expense reduction 3 2

Minimal future capital requirements 2 1

Limited working capital requirements 1

Clean balance sheet with little debt 1 2

Strong market position 2 4 2 2 1 2 2 2

Viable exit strategy 3 4 1 1 1 3 1 4 1 3 4 1

Strong and partner-able management 4 3 3 4 2 4 3 3 4 3 4

Private Equity Fund

Step 2 – Calculate Totals and %‟s

Totals %

33 25%

1 1%

3 2%

5 4%

3 2%

1 1%

3 2%

17 13%

27 21%

37 28%

Step 3 – Ready for the Graph

Totals %

A B C D E F G H I J K L M

Steady and predictable cash flows 2 1 2 3 4 4 3 4 4 1 2 3 33 25%

Low Enterprise Value/ EBITDA multiple 1 1 1%

Large amount of tangible assets for loan Collateral 3 3 2%

Potential for expense reduction 3 2 5 4%

Minimal future capital requirements 2 1 3 2%

Limited working capital requirements 1 1 1%

Clean balance sheet with little debt 1 2 3 2%

Strong market position 2 4 2 2 1 2 2 2 17 13%

Viable exit strategy 3 4 1 1 1 3 1 4 1 3 4 1 27 21%

Strong and partner-able management 4 3 3 4 2 4 3 3 4 3 4 37 28%

Private Equity Fund

Step 4 - Graph

Attributes of a good Leveraged Buyout “LBO” Target Company...

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