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A Look At Buyout

By: Danielle Silva

The buyout industry has garnered a great deal of attention from the media recently, courtesy of Republican presidential nominee Mitt Romney. He has received a good deal of negative press for the buyouts he engineered earlier in his career. Investors and individuals involved in the alternative investment industry, however, know that many of the claims made by the media regarding how private equity funds operate are misleading.

Buyout strategies call for managers to acquire a majority stake in companies or buy them outright. These funds focus on mature companies, whereas venture capital funds invest in young companies or startups. Buyout funds finance deals with about 60% to 90% debt, which is why these transactions are often times referred to as leveraged buyouts (LBOs). Funds from investors are used to cover the remaining portion of the purchase price. Funds hold on to companies for an average of approximately six years.

A mid-market buyout fund recently explained to BHA analysts what it looks for when evaluating companies. It noted that companies must have three characteristics before it will begin serious due diligence. First, companies must be part of an attractive industry and one that is not cyclical. Some popular sectors include energy, healthcare, and natural resources. Second, they must have a favorable business model-one with recurring revenue and predictable revenue streams. Third, companies cannot rely too heavily on one customer. If one customer makes up a large percentage of a company's revenue, then purchasing the company may prove to be too risky.

Other buyout managers stress different criteria. For example, they might favor companies that have high gross margins, which usually indicate that they are able to charge a premium. Such companies are generally providing goods or services that are difficult to replicate, which adds a great deal of value for the customer. It also means favorable competitive dynamics, which some managers look for. When products or services can be copied, companies can be forced to lower their prices or be at risk of losing market share.

There are various reasons that private companies seek the investment of buyout funds or sell to them outright. The business owner may have taken on personal financial risk and need to reduce his debt. Or a company may have grown significantly, and the owner would rather focus on making the product and selling it rather than on operations. Still in other cases, the owner may want to sell for the simple reason that he would like to retire.

The one thing all buyout managers consider going in is how they will exit the investment. The fund must ensure that they are getting a good price for the company. If the fund pays too high a premium when it acquires a company, it will make it much more difficult to get the targeted return on investment (NYSE:ROI).

It is expected that buyout funds will continue to experience the same amount of success in fundraising in 2012 as they did in 2011. The M&A environment in 2012 is predicted to be robust and thus the buyout managers should have a good amount of deal flow this year. This deal flow is expected to be driven by an increase in strategic acquisitions fueled by high levels of cash on corporate balance sheets. Furthermore, the combination of low interest rates and low levels of speculative grade credit defaults should provide sufficient liquidity for funds seeking access to the leveraged loan market.