Prospecting for Private Equity Targets

The flood of cash has private equity investors surveying the full corporate landscape for buyout candidates—where will they shop next?

by Steve Rosenbush

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For investors and companies who may wish to go private, the rise of private equity offers an array of allures. A leveraged buyout can represent a healthy premium for shareholders. Company executives can shed many of the regulatory burdens public companies bear. Top managers also typically enjoy richer paychecks in the private market.

Those groups of private investors, using large amounts of borrowed money, buy companies with an eye toward improving them for sale. Indeed, private equity funds enjoyed a record year in 2006 (see BusinessWeek.com, 12/28/06, "Private Equity's Big Winners"). And they have assumed a place in nearly every potential deal when a company is in play.

The Right Numbers

So which companies are likely to be acquired? Private equity investors certainly won't tip their hands. But it's possible to field a list of likely targets, based on an analysis of industrial sectors and individual companies.

"Private equity firms like companies with stable cash flows, low debt levels, and cheap stock prices," says Scott Marchakitus, a Goldman Sachs Group (GS) credit analyst who covers media, telecom, and cable companies.

Private equity buyers generally seek targets with an internal rate of return (IRR) of 20% or more, according to Marchakitus. The IRR, which takes into account the present value of future profits, can be as low as 15% in some cases where noncore assets can be sold to raise cash.

Goldman chief sector strategist David Kostin and U.S. credit strategist Charles Himmelberg issued a report on Mar. 22 examining the appeal of 937 potential U.S. buyout targets. The study ranks the companies based on their IRR, using Goldman's proprietary methods. The credit analysts worked with equity analysts to understand the potential for cost cuts and asset sales, which can boost returns. The report identified some companies like Minnesota-based grocer SUPERVALU (SVU) with an IRR of more than 70%. It determined that pharmacy chain Rite Aid (RAD) has an IRR of more than 65%. That doesn't mean such companies will be acquired, but their financial profile and the nature of their business could arouse interest.

Tech Plays

To assess where the next private equity deal may occur, it helps to know a bit about how private equity firms operate. They typically buy companies at a low price and pile substantial debt, or "leverage," onto the acquisition target's balance sheet. Debt boosts a deal's return, because the borrowed cash can be returned to investors in the form of a dividend. Stable cash flows are necessary to pay down the additional debt. Companies with a battered stock price and slow-growth prospects are usually deemed suitable, as long as the enterprise sports stable cash flows. Some private equity investors focus less on such financial engineering and pay more attention to boosting return through changes in cost structure, operations, management, or strategy.

Certain industry sectors lend themselves to leveraged buyouts. Consumer products, retail, and health care often make good LBOs because revenues usually remain stable despite fluctuations in the economic cycle. Even when times are tough and people trim their spending, most of us still need to buy razor blades, shoes, and groceries and must visit the doctor. Potential retail buyouts include electronics retailer Circuit City Stores (CC) and health-care services company AmerisourceBergen (ABC). Goldman says its research indicates that both companies have IRRs well in excess of 70%.

Tech sectors such as software and IT services are increasingly popular with buyout firms, too, because their wares are business necessities in good times or bad. Tech firms also have turned themselves into service companies that win big contracts that can produce stable revenues for several years. Private equity buyers often win deals because the number of strategic buyers has been reduced over the years as companies such as Oracle (ORCL) acquired midsize to large companies, says Peter Falvey, co-founder and managing director of Revolution Partners, a tech-oriented investment bank.