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)
A PE firm is evaluating two potential LBO targets with similar EBITDA. Company A has 80% recurring subscription revenue with diverse customers. Company B has higher margins but 40% of revenue from one customer. Which is the better LBO candidate?
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 operations | Unavoidable |
| Growth CapEx | Investment in expansion | Optional |
| CapEx % of Revenue | Lower is better | <5% ideal |
| Asset-light Models | Software, services, franchises | Excellent targets |
Good: Software companies, business services, franchises
Challenging: Manufacturing, airlines, utilities (capital intensive)
3. Strong Market Position
Market Position Indicators
| Term | Definition |
|---|---|
| #1 or #2 Market Share | Dominance provides leverage |
| Pricing Power | Ability to raise prices |
| Brand Recognition | Reduces customer acquisition costs |
| Scale Advantages | Cost benefits from size |
4. Opportunities for Improvement
PE firms don't just buy good companies—they look for companies they can make better.
A PE firm acquires a regional healthcare services company. Which value creation lever is MOST likely to generate returns over a 5-year hold?
Value Creation Levers
Revenue Growth: New products, geographic expansion, sales optimization, cross-selling
Margin Improvement: Operational efficiency, procurement savings, overhead reduction, pricing strategy
Strategic Initiatives: Add-on acquisitions (buy-and-build), divest non-core assets, digital transformation
5. Defensible Competitive Moat
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 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
7. Clear Exit Path
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 |
Special Case: Tech Companies
Would a high-growth SaaS company growing 50% annually but burning $20M/year be a good traditional LBO candidate?
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
Continue Learning
- LBO Explained Simply — Full mechanics of leveraged buyouts
- 3 Drivers of LBO Returns — EBITDA, leverage, and multiples
- Top 20 PE Interview Questions — Complete PE interview prep
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