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AXIAL FOR CEOS

THE COMPLETE GUIDE TO

LEVERAGED BUYOUTS

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THE COMPLETE GUIDE TO LEVERAGED BUYOUTS

Table of Contents
Private Equity Firm Structures........................................................................................................ 4
Understanding PE Fundraising................................................................................................... 4
Evaluating PE Funds..........................................................................................................................5
Leveraged Buyouts................................................................................................................................. 6
THE 10 STEP PROCESS
Step 1: Sourcing................................................................................................................................. 6
Step 2: Screening................................................................................................................................7
Step 3: Non-Disclosure Agreement...........................................................................................8
Step 4: Due Diligence...................................................................................................................... 9
Step 5: Indication of Interest.......................................................................................................11
Step 6: Letter of Intent..................................................................................................................12
Step 7: Negotiation......................................................................................................................... 13
Step 8: Acquisition...........................................................................................................................14
Step 9: Management (TOC)........................................................................................................14
Step 10: Exit........................................................................................................................................16
Preparing for LBO Discussions......................................................................................................18

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Private equity firms


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are categorized
into several buckets. You may hear a given fund referred to as a buyout fund,
growth equity fund or venture capital fund and this should give you a clue about
what type of investment a company could make in your company. In this guide,
well introduce you to leveraged buyouts and walk you through a 10 step process
that will give you a better understanding of what to expect and how to prepare
when considering the sale of your business through this type of transaction. First,
though, well take a closer look at how private equity (PE) firms are structured
and how they operate so you can ask the right questions during the initial phases
of the M&A process.

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Private Equity Firm Structures :4

UNDERSTANDING PE FUNDRAISING
To understand how PE firms impact the businesses they buy and grow, its important
to understand how firms raise the capital they eventually invest. PE funds are made up
of limited partners (LPs) and general partners (GPs). LPs are the outside investors that
provide capital to the fund. GPs are the professional investors who manage the firm and
deploy the capital.
Here are some key terms you need to understand in terms of how LPs and GPs
interact:
In a committed capital fund, the LPs have signed a formal partnership agreement
and are legally committed to provide capital. LPs do not typically transfer the capital
at the time of signing the agreement. Rather, most GPs make capital calls on a
quarterly basis or as needed.
This capital call is a formal notification from the GP to the LPs that a specific amount
of money is to be transferred to the PE firm within a certain time period, usually 30
days.
The difference between the total committed amount and the capital called to-date is
known a the LPs undrawn obligation. In other words, the LP makes a commitment
to provide funds, but doesnt actually give money until the times the GP calls for it.
The LPs undrawn obligation is the amount committed but as yet unpaid during the
duration of the fund.

WHAT HAPPENS IF It may seem risky for the GPs to be counting on funds they dont actually have, but its very
AN LP DEFAULTS unusual for an LP to default on a capital call for several reasons:
ON A CAPITAL CALL? Financial consequences. A default may require an LP to forfeit all or some of their
interest in the fund or sell their interest to a third party or other non-defaulting LP at a
significant discount.
Damaged relationships. Leaving obligations unfulfilled will likely have negative impact
on the relationship with affected GPs. The defaulting LP will likely not be able to invest
in any subsequent funds raised by that particular manager.
Impacted reputation. They are also unlikely to be able to invest in the most attractive
THE SELLER SERIES funds raised by the best managers as other GPs will likely be hesitant to work with them.
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EVALUATING PE FUNDS :5
As a business owner/entrepreneur looking to sell or raise capital from a PE firm, you
probably are not going to know who the LPs are in a committed capital fund. The
factors you do need to know are:
1. Total Fund Size. The total fund size gives you an indication of whether the
fund is an appropriate size for acquiring your company. If your firm is worth
$20 million to $30 million, it would not make much sense to approach a firm
managing a $5 billion fund. On the other hand, if your company is worth $400-
$600 million, you shouldnt approach a firm with a $100 million fund. Middle
market PE funds will generally make 5-10 investments with any one fund. Any
fewer than 5 and they risk having the overall fund performance be too highly
concentrated. Any more than 10 creates significant management challenges.
That said, it may make sense for a large fund to look at a small company if it is
making an add-on acquisition (i.e. one of the funds portfolio companies making
an acquisition). In that case, though, the transaction is more like selling to a
strategic buyer than a financial buyer.
2. Fund Dry Powder. This refers to a funds total size less any capital the
firm has already deployed. Its an indicator of whether the fund has the ability
to write the check to invest in or acquire your company. PE firms usually will
not deploy 100% of their capital. A portion, typically 20%, is held back to pay
management fees. Other portions are retained to support add-on acquisitions
and provide additional growth capital or other support to existing portfolio
companies. Firms do sometimes have the ability to draw on additional third
party capital sources or raise funds, but knowing how much dry powder they
have gives you a clear picture of whether they are in a position to close a deal.
Funds will do their due diligence when considering buying or investing in your
business. Do the same when approaching or considering them.

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Leveraged Buyouts :6

When a PE firm purchases a controlling share in a company using


outside capital, they have completed a leveraged buyout (LBO). As
the name implies, the use of financial leverage, or debt, is one of the
primary elements that distinguishes an LBO from a traditional acquisition
executed with cash or stock. Weve just gone through the structure and
role of LPs and GPs, and what you need to consider as the seller. Now,
here is the 10 step process the PE firm will follow as the buyer in the LBO:
1 STEP 1: SOURCING
Before a fund ever talks to a seller, before any negotiation happens, they look
at the entire universe of deal opportunities for something that seems worthy
of investment and their next six years. They comb the landscape searching for
enterprises with certain core traits, researching, weighing (and recording in acute
detail) investment risks and benefits, gathering data to inform their next move.
They turn to several channels in this process. First, theyll reach out to personal
contacts including peers at other funds, investment bankers in the sector, and
company executives with whom they have cultivated relationships over many years.
Then, they will use dealmaking tools like Axial and LinkedIn to substantively improve
sourcing scale and reach. Finally, they will utilize databases such as Capital IQ,
Factset, and Bloomberg to make sure they are up to speed on all things happening
in the market and not missing something the competition might know.
The ability to source comprehensively will be the biggest driver of the funds LBO
returns. In order to deliver a strong internal rate of return (IRR), a fund needs to
be able to buy at a fair price and provide profits to the business. Because most
transactions are auction processes, multiple capital providers - each with strong
capabilities - are all bidding on the same asset, making competition steep. As a
result, funds that have identified efficient sourcing channels are able to access more
opportunities and better, proprietary deals that end up delivering huge dividends.

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2 STEP 2: SCREENING
The skill with which a fund is able to identify the right target is arguably the second
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most influential factor on performance, next to its ability to source at scale. The goal
of the screening process is to narrow the potential targets identified during sourcing
to a shortlist of high-value opportunities and agree on a single target to pursue.
Though every fund will approach screening a bit differently, a typical process takes
The goal of from several days to several weeks. During this time, the fund will construct a
the screening comprehensive view of a company by following this generally accepted process:
process is to
narrow the 1. Collect Public Info from Company. Firms start with whatever information
potential targets the company has made publicly available. This may include anything on the
identified website, press releases, shareholder presentations, customer pamphlets,
during sourcing ownership change announcements, and any financial figures the management
to a shortlist team has released. If they found out about the opportunity via a teaser from
of high-value an investment bank, they will consider the business and financial data disclosed
opportunities there as well.
and agree on a 2. Find Third Party Info. Next, theyll comb the landscape for anything that may
single target to shed light on the core foundation and health of the business. This includes third
pursue. party news mentions, independent profiles on the business and its leadership
team, customer testimonials, customer complaints; basically anything they can
find on search engines and beyond.
3. Assess the industry. Then theyll undertake a thorough assessment of the
industry in which the company plays.

J Who are the competitors? J How much do players typically spend


J What are their relative market on capital expenditures, working
shares? capital, the like?
J What differentiates this company? J What does the average accounts
J Who is the target consumer? receivable and accounts payable
J Are there product or service cycle look like?
substitutes? J Who are the upstream providers?
J What are the performance drivers? J How fast is the sector growing?
J What are the typical margins (e.g.,
gross margin, EBITDA margin, net
income margin, etc.)?

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4. Build Financial Model of Buyout. The model answers the key question: what :8
would the LBO look like if we were to execute it? It includes available (or often
assumed) financial projections, details on how much debt the transaction would
entail (3.75x EBITDA? 4.50x EBITDA?), how much they would pay, how long they
would hold it, how much value they plan on creating during the holding period
(usually 3 to 10 years), what they would do to create that value (reduce cost of
goods sold? grow topline?), how much they would sell it for on the exit date,
and what % return can be expected.
5. Aggregate Findings. Finally, the fund takes all this information and aggregate it
into a central document. Some are brief investment overviews while others are
longer, more comprehensive deal memos. A memo might include an overview
of the company, the competitors, and the industry, as well as a thorough
assessment of any associated risks and benefits.

3 STEP 3: NON-DISCLOSURE AGREEMENT


At this point, if the buyer (PE fund) decides that it wishes to move forward, theyll
want significantly more detail than what is publicly available or provided in the
teaser. To access this data, they and the seller (you) will sign a confidentiality
agreement also frequently referred to as a non-disclosure agreement (NDA). The
NDA is a legal document that protects any information shared by either party
throughout the transaction process from being disclosed to third parties.
The execution of the NDA officially kicks off the deal. Its the first point where
the potential investor is given access to information that couldnt be accessed by
any public party. Its also the first time the buyer and seller sit down at the table
to negotiate. In more complicated transactions, this is also the point where other
parties might begin to weigh in on negotiations. These may include investment
banks and legal counsel from both the buy- and sell- side.

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4 STEP 4: DUE DILIGENCE :9


A signed NDA kicks off the first of assuming all goes well many rounds of due
diligence. Due Diligence is the investigation of a targets business by the potential buyer.
This step involves the buyer, the seller, and if engaged, the buyer and sellers advisors.
Buyside deal teams typically start with an initial two to three week diligence round,
followed by a non-binding indication of interest, and then a much deeper diligence
round lasting two to six months that will precede the letter of intent (more on this later).
During this multistep process, the investor starts with a review of the sellers
confidential information memorandum (CIM).

A well prepared CIM will generally include a robust overview of:

J Business J Growth opportunities


J Operating history J Management team
J Industry dynamics J High level financials (ideally five
years of historicals plus five years of
J Competitive landscape
projections)
J Barriers to entry
J Discussion of the companys ability
J Core customer base to execute on said projections
J Go-to-market strategy J Summary of the auction process,
J Primary performance drivers proposed structure of the deal, and
expected timeline for expressions
J Scalability
of interest (bids)
J Assets (e.g., intellectual capital,
patents, facilities, etc.)

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The buyer will then set up meetings with the management team, site visits, supplier : 10
meetings, and customer and expert interviews, as appropriate.
The seller, sometimes aided by sell-side counsel, will usually set up a virtual data
room. Theyll upload the following types of information to this storage space:
Specific information requested by buyers.
Information that gives the buyer improved visibility but was too data heavy to
include in the teaser or CIM.
Product information that gives deeper insight or detail than the CIM.
Information that becomes available over the course of the deal process.
All else equal, the volume of information presented in the sellers data room will
increase with its size, the complexity of the transaction, and the number of potential
suitors involved in the process.
In most transactions, the due diligence process is a two-way conversation. While
the seller will usually kick off due diligence by circulating the CIM and giving
investors access to its data room, midway through buyers often email the targets
management team, investment bank, and legal counsel to request information.
The primary goal of diligence is to provide a comprehensive picture of the target,
communicate risks, answer any questions, and perhaps most importantly for
you present information that will frame the buyers thinking on operational
improvements.

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5 STEP 5: INDICATION OF INTEREST : 11


After a cursory round of DD, the seller gives its potential buyers a deadline by which
all interested parties must submit their indication of interest (IOI). An IOI is a first
round bid for business. Its a non-binding, generally conditional document that
reflects available data, moves buyers into a shortlist (as opposed to the shortlist
created by the buyers in Step 1), and moves them through to the second round.
There are four primary purposes of the IOI for the seller:
1. Provides higher participant quality because it asks buyers to demonstrate a
threshold level of commitment.
2. Sheds light on approximate valuation range for each buyer.
3. Narrows focus to only those buyers serious enough to complete the IOI.
4. Limits the number of parties to which the seller exposes internal data.
After the buyer provides its IOI, the seller can choose to either accept, negotiate, or
deny the buyers terms.

The following are typically outlined in an IOI:


J Approximate price range for the business in an absolute dollar amount (e.g.,
$15 $20 million) or multiple of EBITDA (e.g., 3.0 5.0x EBITDA)
J Details on available funds (i.e., cash and equity) and debt financing sources
J Potential transaction structure (e.g., cash vs. debt ratio, leverage tranches)
J Management retention plan
J Intended role of equity owner(s) after the deal has closed
J Key items needing further diligence
J Planned diligence timeline
J Expected timeframe to close

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6 STEP 6: LETTER OF INTENT


Assuming the seller and buyer agree on the terms of the IOI, the buyer enters the next
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round of bidding and begins an in-depth course of due diligence. This generally takes two
to six months. Because of the high time and resource commitment involved, the buyer will
usually negotiate and sign a letter of intent (LOI) with the seller after it has performed
some diligence, but before it completes full due diligence.
By definition, the LOI is the agreement that documents, in detail, the buyers intention to
execute the transaction and is substantively more thorough and legally declarative than
the IOI. In an LBO, an investor outlines his plan to buyout the business and discloses the
most important deal terms.
More importantly, it gives the buyer exclusivity, which is effectively the right to purchase
that business within a certain timeframe. Its now common for buyers to request an
exclusive negotiating period. This ensures that the seller is not shopping their deal to other
bidders while appearing to negotiate in good faith. Its particularly important because
buyers will frequently involve outside consultants and legal counsel to help with diligence at
substantial cost. Exclusivity clauses typically last between 30 and 120 days. The duration may
be up for debate but the presence of the clause will almost always be non-negotiable.

Such a contract typically includes:


J Details on the format of payment (cash, usually include a fee schedule that
stock, seller notes, earnouts, rollover protects the buyer from an owner
equity, or contingent pricing) withdrawal)
J Transaction structure specs defining the J Binding confidentiality terms that go
deal as a stock or asset purchase beyond the original NDA
J Updated estimate of closing date J Management compensation plans
detailing which current executives
J List of tasks that need to be completed
should be retained post-transaction,
by closing
their equity plans, and their
J Approvals needed by the buyer (e.g., employment terms
board of director vote) or seller (e.g.,
J Any additional areas of due diligence
permissions from regulatory agencies)
required by the buyer
J Binding period of exclusivity
J Summary of the buyers expected
J Binding break-up fees (deals greater escrow terms (if applicable)
than $500 million in aggregate value

The LOI is an important milestone in the successful sale of a company. While it doesnt
guarantee a closed deal, its a clear signal that the buyer has serious intentions.
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7 STEP 7: NEGOTIATION : 13
The negotiation process involves two primary parties the seller and buyer.
Depending on the deal, there may be several additional players the sellside
advisor (i.e., investment bank), sellside legal counsel, buyside advisor, buyside legal
counsel, and buyside lenders.
Players in Negotiation
Seller (you) The sellers primary goals are to complete the sale, maximize
its sale price, and secure a favorable buyer ( one that brings
specialized experience to the table and / or with which it has
a synergistic relationship). As a result, though its advisors are
almost always involved in negotiations (more below) the seller
has the final say in valuation conversations and bidder selection.
Buyer The buyers primary goals are to achieve a high IRR and a
strong money multiple, the two most common measures of
investment profitability. The three main considerations for
buyers are entry price, exit price, and leverage.
Sellside advisor The sellside advisors primary goals are to close the deal
and maximize sale price. During negotiations they will
provide support, counsel, and often represent the seller in
conversations with buyers.
Buyside advisor The buyside advisor is focused on helping the buyer find the
right investment, closing the deal, and building relationships
to support future business. They will create internal financial
models to check valuation, assign independent credit ratings to
the target, and validate the targets ability to service a certain
amount of debt.
Buyside lenders The buyside lenders are the capital providers that fund the
debt portion of a leveraged buyout (i.e., the revolver and term
loans). Their primary goal is to put their cash into investments
with a balance of decent risk and return characteristics. They
run their own due diligence, and often step in to negotiate debt
covenants aimed at mitigating borrower behaviors that might
increase default risk.

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8 STEP 8: ACQUISITION
This step begins the multi-year period in which the buyer owns, manages, and helps
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grow the acquired business. All the players that were involved in the negotiation
work together to execute the acquisition.
Here, the financing structure is reviewed and vetted, the bookrunning bank
syndicates the debt, lenders wire the funds, the new owner assumes official
management of the business and new directors - often including the fund partner
that led the LBO and certain experts the fund believes to be value additive - take
their seats on the Board of Directors.

9 STEP 9: MANAGEMENT (TOC)


The management phase is the longest and arguably most important part of the LBO
process. It begins when the buyer purchases the company and ends when its sold
to another owner or goes public.
In this multi-year period (usually three to ten years), the buyer who is now owner
improves the business in ways that create value. The three primary ways of doing
this are through earnings growth, debt paydown and multiple expansion.
1. Earnings growth means that the business is becoming more profitable. This
can be achieved by increasing the topline (i.e., organic growth), improving
the bottom line (i.e., higher efficiency), or cultivating inorganic growth (e.g.,
acquisitions). Frequently it entails a combination of the three.
2. Debt paydown involves increasing equity-to-debt ratio. It accomplishes this by
paying back borrowed funds and thereby reducing leverage. In other words, the
company is not only generating excess cash, but using that cash to reimburse
lenders that provided the capital to complete the buyout in the first place.
3. Multiple expansion means that the business is being sold for a higher earnings
multiple than that at which it was bought (i.e., the new buyer is paying more
for every dollar of earnings today than the original buyer did). The earnings
multiple is usually expressed as a multiple of EBITDA (e.g., 5.5x EBITDA) and is
covered in more detail in our article on why LBOs generate higher returns.
Multiple expansion is typically a product of improved growth opportunities,
increased company size, more efficient operations, favorable industry dynamics,
or a bull (i.e., strong) market.
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Value creation is not easy. Each of these three types requires thoughtful process, a : 15
surefire blueprint, and rigorous execution. To ensure successful value add, there are five
generally accepted steps to methodically managing an LBO candidate.
1. Determining potential. Here the owner defines the maximum value for the business.
This takes root during the first eight steps of the LBO process weve just outlined.
Most buyers will create three models during the full deal process: a downside case, a
base case, and an upside case. The latter two reflect how the business would perform
if management were to successfully implement some or all of the improvements. The
former will maintain a set of conservative - often very conservative - estimates.
2. Creating the game plan. The game plan is a comprehensive framework for how the
business can reach its performance targets. It outlines strategic goals, tactical initiatives,
necessary steps, teams involved, changes to be made, and the execution timeline.
3. Aligning stakeholders. The primary goal here is to direct leadership talent toward
activities that facilitate the greatest gains in earnings, margins, or cash output. The
principal mechanism for alignment is a reward structure that puts management and
owners on the same page. The arrangement should incentivize the companys leaders to:
embrace the game plan
tackle value additive activities, and
shoulder otherwise burdensome tasks.
The most effective reward structures will usually encourage leaders to be results-oriented,
proactive, and strategically nimble. The primary goal is to foster an environment that
is both metrics-driven and agile, such that management is motivated to both take on
efforts that drive the company in the right direction, and adjust course when there are
better tactics for achieving targets.
4. Laying the foundation. This is the process of creating a foundation for the business
in line with the game plan, and setting up necessary building blocks. It includes
structural changes, matching employees to fundamental initiatives, and securing
any necessary but currently unavailable resources. During this stage, the companys
performance typically accelerates and the owner will begin to track certain operating
indicators and iterate on the day-to-day game plan.
5. Optimizing financial efficiencies. This step focuses on improving the cash
efficiency of a company. It involves the thoughtful application of buyout economics
to the business. Specifically the owner will concentrate on two things:
1. Improving operating income
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THE COMPLETE GUIDE TO LEVERAGED BUYOUTS

10 STEP 10: EXIT


This step marks the end of the ownership period. On average, the exit occurs five years after
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the original purchase of the company. It can range from between three and ten years.
The decision to exit is almost always a difficult balancing process. The current sale
prospects for the company have to be weighed against untapped opportunities to create
future value and incentives to exit before the IRR flattens.
Why is this? Because although good buyout candidates usually exhibit strong
performance beyond just five or even ten years, the downward pressure on IRR increases
with investment length, as returns are spread over more years.
For example, a good business can continue to generate additional cash-on-cash returns
while simultaneously reducing IRR. As a result, incremental value creation opportunities
usually need to be sizable in order to justify delaying an exit past a certain point.
Owners typically exit LBOs in one of four ways:
Strategic These occur when the company is sold to a corporation commonly
buyout referred to as a strategic buyer or strategic. This usually
happens because the corporation sees value in vertical integration
or the companys product portfolio, customers, intellectual
property, patents, brand, leadership or synergy potential.
These exits tend to offer the highest exit value because a
strategics synergies and lower cost of capital will be factored into
the dollar sum that its willing to pay to purchase the business.
Secondary Secondary buyouts occur when the company is sold to another
buyout financial sponsor. This usually requires a high degree of leverage
and a favorable cost of capital because the new buyer needs to be
able to achieve high returns a second time around with the same
business.
They are often an outcome of the original buyer electing to exit
within a certain timeframe to maintain high IRR, and therefore
occur predominantly with high performing businesses.
These exits typically come with less of a premium than a strategic
buyout given the absence of cost or revenue synergies and
generally more restrictive sponsor debt terms.

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Management MBOs occur when the existing management team purchases the
buyouts business back from the current owner.
(MBOs) This occurs in a very specific scenario: when the financial sponsor
wants an exit, members of the management team wish to make
the transition to owners, and there are no competitive bids from
buyers.
MBOs typically require substantive amounts of external financing
and will usually involve a combination of equity and debt funding
from the management team, third party capital providers, and
sometimes the sellers.
Initial public IPOs happen when the owner decides to sell in the public markets
offerings rather than to a private buyer. This involves going the process of
(IPOs) making the company a publicly traded entity.
Depending on the markets, an IPO may result in a lower or higher value than a
strategic or secondary buyout. IPOs almost always offer only a partial exit to the
owner. The complete exit comes in subsequent secondary offerings.

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Preparing for LBO : 18

Discussions
Use this overview of the LBO process as a tool to prepare for assessing partners,
providing proper information to frame your company, negotiating and closing
the sale of your business. Be prepared to outline or discuss your hard assets,
steady cash flows, market, capital expenditure requirements, non-core assets, any
risk of forced divestitures (for antitrust reasons), non-core corporate divisions,
management and succession plan (or lack thereof). Often, these elements will be
used as screeners for LBO candidates. Be up front as elements that might worry
you may actually make you an attractive candidate. Lack of a succession plan or
sub-par management, for instance, may be attractive to a PE firm that sees these as
easily fixable issues and, therefore, solid ROI.
There are over 2,800 private equity firms exist in the US alone, buying tens
of thousands of companies each year. The LBO is well-practiced among PE
professionals, and is now standard industry practice as a means by which to acquire
private companies.

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