Module IV· Interview EssentialsIntermediate
Question
What is a typical 'red flag' on an LBO target and how would you flag it in an investment memo?
Answer
What
A red flag on an LBO target is a risk indicator that must be named explicitly in the investment memo and paired with a mitigation.
Top 5 red flags in the middle market
- Customer concentration: top 3 over 40% of revenue.
- EBITDA add-backs > 20%: suspicion of adjusted-EBITDA inflation.
- Pension deficit: DBO over 1.5x EBITDA, hard to de-risk.
- Litigation or patent disputes: ongoing proceedings with substantial exposure.
- Legacy IT: outdated ERP systems that require a $5–30m capex boost.
Deep diveShow more details
Other common red flags
| Red flag | Mitigation |
|---|---|
| Negative working-capital profile (inventory grows faster than revenue) | DSO/DIO tracking, sales-vs-WC trend |
| Labor-cost inflation (collective-bargaining settlements 4–6% p.a.) | pricing-power analysis, automation pipeline |
| Environmental legacy liabilities (old industrial sites) | specific indemnity in the SPA, environmental DD |
| Governance — family drama, unresolved succession | pre-closing family settlement, clear rollover vesting |
| ESG risks (union conflicts, questionable supply chains) | supply-chain due-diligence compliance setup, supplier audit |
Memo structure
In the investment memo, always a clear risk/mitigation table, quantified where possible (e.g. "litigation exposure $5–15m").
Pitch tip
In the interview, be able to think through ONE red flag from a real industry concretely — e.g. "automotive tier-2 concentration on a single major automaker as the main customer". Three-part answer: (1) which red flag, (2) mitigation in the SPA, (3) quantification of the residual risk.