Immersion Learning

Identifying & Pitching an LBO Deal

by Brandon Mallette, MBA ‘14 (5/19/13)
Brandon Mallette, MBA ‘14

As the spring semester and Investment Banking Immersion were coming to a close, we were given the opportunity to pitch an idea to an investment committee made up of our peers. At this point in the immersion, we had already covered LBO’s, IPO’s, M&A transactions, as well as debt and follow-on offerings.  Needless to say, we discussed a lot of material and I had a range of business opportunities to pitch to the committee.

Considering that I will be spending my summer in Leveraged Finance, my team chose to recommend an LBO transaction. However, given that the equity markets have done very well recently, finding a suitable candidate for an LBO proved to be rather difficult. When taking a company private a financial sponsor looks to pay for the target with as much debt as reasonably possible in an attempt to limit the amount of equity they have the fund the deal with. Due to the recent upswing in the stock market though, many of the candidates my group looked at proved too expensive for an LBO (required a substantial equity check) and resulted in an unsatisfactory internal rate of return (IRR).

After weeding out dozens of companies that appeared unsuitable for an LBO, we finally came across American Eagle Outfitters (AEO). At first glance, AEO looked like a strong LBO candidate. Throughout the immersion, we learned several key attributes that make a firm an attractive LBO target. First, the company should have stable cash flows since the sponsor will need to pay down debt over time. Second, firms that are able to expand their margins and grow EBITDA are attractive since this would result in a higher valuation at exit assuming the same entry and exit multiples. Third, companies with little or no debt are attractive since sponsors are able to utilize more debt financing in the LBO deal. Lastly, since a private equity firm has to offer a premium to take a company private, firms that are undervalued relative to the market are attractive candidates as well.

American Eagle definitely displayed all these attributes. Over the past three years, net income grew at an 11 percent compounded annual growth rate (CAGR) and EBITDA grew at an 8 percent CAGR. In addition, the firm currently had no debt outstanding that needed to be paid back before levering up the company. Finally, AEO’s stock price hadn't moved significantly over the past year, so a sponsor would be able to offer a substantial premium to the current share price and still garner an attractive IRR.

Coming into the semester, I didn’t know much about the mechanics of an LBO or how to identify potential candidates. However, during the course of the immersion we were taught how to build out an LBO model that sweeps free cash flow to pay down debt and determines a sponsor’s IRR under various assumptions. Furthermore, we learned what factors make a company a suitable target for a leveraged buyout. With this knowledge in hand, I believe my internship in the Leveraged Finance group this summer will be easier since I have already modeled and reviewed several LBO deals.  The practical experience that the IB immersion afforded me certainly gives me a leg up heading into the summer, and is the exact reason why I came to Johnson for my MBA in the first place.