Private equity firms have become an important player in the acquisition market. These private investment groups offer to buy a target firm, often with the cooperation of management and then take the firm private. Private equity buyouts rose from just 2 percent of U.S. merger and acquisition activity in 2000 to 15 percent as of December 2005. Private equity buyers tend to finance a significant portion of the acquisition with debt.

a. What types of firms would make ideal candidates for a private equity buyout? Why?

b. How might the buyout firm add sufficient value to the target to justify a high buyout premium?

SOLUTION

Ideal private equity firmware those that

• Generate relatively stable cash flows to repay the debt used to fund the private equity acquisition.
• Have relatively low tax shields prior to the buyout, so that the acquisition can create new value through interest tax shields.
• Have assets in place, versus growth options or intangible assets. If acquired firms have high growth opportunities, any financial distress due to high leverage will probably reduce their ability to fund the new opportunities. Acquired firms with intangible assets (such as star research personnel) will also be affected by financial distress since these highly valued assets can leave, whereas assets in place cannot.

b.   The acquirer might provide opportunities for better management of the firm's operations. The buyout debt imposes fiscal discipline on a firm's managers and employees. The firm is required to make large debt payments on a regular basis; otherwise the firm could be in default and taken over by its creditors. Management and employees alike would probably lose their jobs. In order to make debt payments, management and employees are forced to eliminate any wasted expenditures, reduce the firm's cost structure, and increase the firm's efficiency.