​Flipping LBOs - Selecting Profitable Flip Candidates

To those not familiar with the world of M&A (mergers & acquisitions) investment banking, a leveraged buyout (LBO) is a financial transaction in which the acquirer uses considerable leverage and as little equity as possible to purchase a target (e.g. a company --- see Nabisco). The buyer hopes that, under a new and improved management team, the cashflows generated by the company will be more than enough to compensate for the higher interest expense. After a determined period, the buyer seeks to exit the investment by selling the company again, paying off its creditors and pocketing a handsome profit.

This strategy is not much different to what home flippers use. Like private equity funds, venture capital and other “financial sponsors”, the flipper uses debt to boost its returns on equity. The borrower “exits” the investment by selling the property at the after-repair value (ARV) and pays off a hard money loan or refinances the property into a long term rental (similar to a cashflow generating company with an improved management team in place).

Bankers and financial sponsors have specific criteria to select strong LBO candidates, and fortunately we can extrapolate these criteria to select the best opportunities:

1. Strong Cash Flow Generation: The company’s debt holders are going to want their return on investment so it is important that the company has the potential to generate sufficient cashflow. In the same fashion, one can select a property that, given the scenario of a late exit, can be turned into a rental that generates strong cashflow. In order to do so, the repairs must seek to meet the taste of the market with the most stable demand.

2. Market Leaders: Financial sponsors seek to invest in companies that are market leaders. This leadership is based on many factors such as brand recognition, superior product or services, customer relationships, etc. Like so, one must find a property with the qualities of a market leader in the local real estate spectrum. The rehabber must take into account factors beyond price. Such factors include neighborhood popularity, safety, hazard areas, nearby parks and entertainment. The most beautiful rehab does not live in a vacuum and will never command a high ARV if the surroundings are not ideal.

3. Growth: Do you see growth potential in the property? Or is it in a mature market where people are not interested in moving in. You might see it as quick flip but you must also consider if the property would make a good long term investment for the next owner. Therefore, the property must not only meet your exit criteria but also the market’s.

4. Low Working Capital Requirements: LBOinvestors seek to buy companies with low maintenance CAPEX. The purpose of the acquisition is to optimize processes already in place to boost cashflows, not to reinvent the company. Similarly, the flipper must take on repairs that maximize ARV. Unfortunately, there is no guide or hard fast rule that determines which improvements are going to be accretive to price. Therefore, one must rely on experience to pick the right property and the right improvements to improve perceived market value.

5. Experienced Management Team: This is where YOU come in. LBO equity investors seek companies with great management teams in place because, in turn, it makes it easier for them to pitch the deal to financial backers. Your proven track record will help you open doors and secure the resources you require. Don’t have vast experience? Joint venture with more experienced contractors or simply work on other teams to get your network and track record started.

6. Strong Asset Base: LBO professionals prefer companies with large tangible assets because they can use them as collateral for their loans. In the same way, you can use your property as collateral. If your analysis is properly done and you pick the very best properties, you should be rewarded with a generous LTV from your lender. Furthermore, you can use other assets to over collateralized the loan and get the best pricing on the loan. Just one caveat, one should seek to develop a relationship with the lender because pricing is not the only input driving the profitability of the flip. Closing time, quick availability of funds and flexibility to restructure is paramount for opportunistic investments such as flips.

When looking at neglected houses for opportunity, the flip will only represent an attractive opportunity if the price and the financing terms are right.

Do you have a flip in mind? I’d love to chat about it!

Feel free to reach out!

Daniel