The Next Buyout Stock?

Has the Golden Age of private equity come to a sudden end? Here are the numbers, according to data compiled by Bloomberg, a data and analytics provider: Announced leveraged buyouts (LBOs) in the first half of the year totaled $616 billion, but the pace of buyouts from June through the first week of August has slowed more than 33%. Now, it seems like it's all but come to a halt.

The reason for this slowdown is that debt markets will no longer absorb the huge amounts of debt required to finance LBOs on the same loose terms that prevailed until recently. As a result of this major risk reassessment, banks such as JPMorgan Chase (NYSE:JPM) and Credit Suisse (NYSE:CS) are carrying $400 billion of high-yield loans they're still hoping to sell into the fixed-income market.

Sharks need to keep moving
While I do expect the buyout pipeline to slow down measurably during the second half of the year compared with what we witnessed in the first, I also think the current freeze is temporary -- LBO companies are still flush with cash that needs to find a home (Dow Jones Private Equity Analyst estimates that LBO and corporate finance shops raised $108 billion in the first half of this year alone!). Naturally, investors are curious about which company will be snatched up once the private equity engine starts again. To try to answer that, take a step back and ask the following question: What types of companies do private equity companies tend to invest in?

These are four primary characteristics that private equity seeks in potential targets:

1. Steady and predictable cash flows
LBOs -- the L stands for leveraged -- are financed by large amounts of debt. Investors look for companies that will be able to make the associated interest payments by generating healthy, steady cash flows from their operations.

2. Clean balance sheet with little debt
Debt boosts the returns of private equity investor returns in an LBO. If a company already has a lot of debt on its balance sheet, it's not a viable candidate.

3. Strong, defensible market position
No surprise here! A defensible market position is attractive for two reasons: First, it's a key determinant of a company's ability to generate steady cash flows year in and year out. Second, companies with a defensible competitive position are most likely to compound their intrinsic values. Increases in intrinsic value are another source of LBO investor returns.

4. Minimum future capital requirements
Capital expenditures required to maintain the company's operations consume cash flow that could otherwise be allocated to other uses. In a company that has been taken private through an LBO, the priority is the paying interest or principal on the new debt. All other things being equal, companies with low maintenance capital expenditures can dedicate more cash to servicing that debt.

Private equity is pretty sharp
Do these four criteria sound familiar? If, like me, you're a value investor, they might as well be a mantra.

That's not a coincidence: Value investors believe in adopting the mindset of a control investor. After all, if you approach every stock purchase as if you were acquiring the entire company, you're going to look for these traits -- the hallmarks of superior companies -- above all else.

My "potential buyout" screen
To try to find potential buyout candidates, I created a stock screen based on criteria that try to capture the characteristics I discussed above:

• Free cash flow (FCF) margin greater than 12% over the trailing 12 months (TTM) and for 2004 through 2006
• Total debt-to-capital ratio less than 20%
• Capital expenditure-to-revenue ratio less than 5%

No investor worth his salt wants to overpay, even for a high-quality company, so I added a valuation criterion:

• Enterprise value-to-EBITDA less than 10 (EV/EBITDA is a valuation ratio widely used by LBO investors).

Here are four companies that showed up in my screen.

These aren't recommendations, but they might be worthy of further investigation (in fact, Federated Investors and Pfizer have been Motley Fool Inside Value picks for quite some time). Of course, you might be wondering why I bothered to leave Pfizer on the list. At more than $160 billion in market capitalization, it's much too large to be the object of a leveraged buyout.

Don't bet on buyouts
As an individual investor, you shouldn't be buying stocks in the hopes that they'll get bought out. While you'll get a nice short-term gain, you're also leaving future gains on the table. Remember: Private equity will only buy out a company if it thinks it can get gains far in excess of the buyout price.

So instead of trying to guess where private equity will be stepping next -- which is unlikely to prove financially rewarding -- focus on finding outstanding companies trading at bargain prices. That's what we do at the Inside Value service I just mentioned. You can take a look at all of our research and value recommendations by clicking here to join IV free for 30 days.

After all, if you find enough outstanding companies trading on the cheap, private equity will find you.

This article was first published on June 21, 2007. It has been updated.

Alex Dumortier, CFA, has a beneficial interest in Federated Investors. JPMorgan is an Income Investor recommendation. The Motley Fool has a disclosure policy.