What Makes a Good LBO Candidate? The Complete Checklist
Learn the key characteristics PE firms look for in LBO targets. Understand cash flow, growth, market position, and improvement potential.
"What makes a good LBO candidate?" is one of the most common PE interview questions. It tests whether you understand how PE firms think about investments. Here's your complete guide.
The Core Characteristics
The Ideal LBO Candidate Has:
- Stable, predictable cash flows
- Low capital expenditure requirements
- Strong market position
- Opportunities for improvement
- Defensible competitive moat
- Strong or replaceable management
- Clear exit path
1. Stable, Predictable Cash Flows
This is the most important criterion. LBOs use significant debt, and debt requires reliable cash flows to:
- Pay interest expenses
- Make mandatory principal payments
- Optional paydowns to delever faster
Pro Tip
What creates stable cash flows?
- Recurring revenue (subscriptions, contracts, repeat customers)
- Diverse customer base (no single customer >10-15%)
- Non-cyclical industry (or counter-cyclical)
- Essential products/services (customers can't easily stop buying)
- High switching costs (customers are sticky)
Warning
Red flags for cash flow:
- High customer concentration
- Cyclical industry without downside protection
- Project-based revenue with no backlog
- Commodity exposure without hedging
2. Low Capital Expenditure Requirements
Every dollar spent on CapEx is a dollar that can't go toward debt paydown.
CapEx Considerations
| Term | Definition | Note |
|---|---|---|
| Maintenance CapEx | Required to sustain current operations | Unavoidable |
| Growth CapEx | Investment in expansion | Optional, drives growth |
| CapEx % of Revenue | Lower is better for LBOs | <5% is ideal |
| Asset-light models | Software, services, franchises | Excellent LBO candidates |
Good: Software companies, business services, franchises
Challenging: Manufacturing, airlines, utilities (capital intensive)
3. Strong Market Position
Market leaders have pricing power and can better withstand economic downturns.
Market Position Indicators
| Term | Definition |
|---|---|
| #1 or #2 Market Share | Dominance provides leverage with customers/suppliers |
| Pricing Power | Ability to raise prices without losing customers |
| Brand Recognition | Reduces customer acquisition costs |
| Scale Advantages | Cost benefits from being larger than competitors |
4. Opportunities for Improvement
PE firms don't just buy good companies—they look for companies they can make better.
Value Creation Levers
Revenue Growth:
- New product launches
- Geographic expansion
- Sales force optimization
- Cross-selling opportunities
Margin Improvement:
- Operational efficiency (lean manufacturing, automation)
- Procurement savings
- Overhead reduction
- Better pricing strategy
Strategic Initiatives:
- Add-on acquisitions (buy-and-build)
- Divest non-core assets
- Digital transformation
5. Defensible Competitive Moat
The company needs to protect its position during the 5+ year hold period.
Types of Moats
| Term | Definition | Note |
|---|---|---|
| High Switching Costs | Customers face pain if they leave | Software, specialized services |
| Network Effects | Value increases with more users | Marketplaces, platforms |
| Regulatory Barriers | Licenses, permits, approvals required | Healthcare, financial services |
| Economies of Scale | Size creates cost advantage | Distribution, manufacturing |
| Brand/Reputation | Trust built over time | Consumer products |
6. Strong or Replaceable Management
PE firms need either:
- A strong management team they can back and incentivize, OR
- The ability to bring in new leadership to execute the value creation plan
Pro Tip
Management considerations:
- Track record of execution
- Alignment of incentives (equity rollover)
- Depth of team (not just CEO-dependent)
- Openness to change and improvement
7. Clear Exit Path
PE firms must eventually sell. Good candidates have multiple exit options:
Exit Options
| Term | Definition | Note |
|---|---|---|
| Strategic Sale | Sell to corporate buyer | Often highest price |
| Secondary Buyout | Sell to another PE firm | Most common exit |
| IPO | Public market listing | Requires scale and growth |
| Recapitalization | Dividend recap to return capital | Partial exit |
Interview Questions
Key Takeaways
Key Takeaway
- Cash flows are king - Without stable cash flows, the LBO doesn't work
- Low CapEx = more cash for debt paydown
- Market position provides pricing power and resilience
- Improvement potential drives returns beyond just deleveraging
- Multiple exit paths reduce risk