Depreciation & Amortization in LBO
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In the context of a LBO, D&A comes into play as it affects levered free cash flows. More D&A means a lower EBT (pre-tax income), which results in less cash paid for taxes, and ultimately higher Levered FCFs. Depreciation is simply an allocation of costs.
In financial modeling, CapEx always translates into subsequent D&A. So if CapEx were to remain at steady levels, then D&A will likely remain at steady levels (with the exception of differing depreciation schedules like straight-line, accelerated MACRS, etc). D&A always follows CapEx.
As for the purpose of identifying a good LBO candidate - you want to look at CapEx more so than D&A. Why? it is the true cash outflows as a result of a requirement to invest in CapEx. The cash saved from the D&A is a more minor change to cash flows than actual capex spending, and again, D&A comes from Capex anyways. If a PE sponsor were to take on a company, then they may decide that it does not have as high of a capex requirement going forward as it current does, and will lower CapEx - which is the true cash outflow from purchasing LT assets. because we care about future cash flows and because D&A follows CapEx, so when identifying a good LBO candidate, you want to look at what cash outflows will actually come from future capex.
EDIT-this paragraph is not entirely true, see next commentSo the only way that companies can have large D&A but low CapEx (aside from depreciation schedules - MACRS would have a relatively larger D&A in the earlier years relative to CapEx), is if a company changes from a high to a lower Capex requirement.
Good response on the interplay between D&A and capex, agree with focus on capex vs. tax shield etc.
However, the last paragraph is not quite correct - purchase structure can have a meaningful impact on tax deductible amortization, which has nothing to do with capex. When a transaction is classified as an asset purchase (either due to being an asset purchase, 338(h)(10) election, LLC purchase, etc.), the buyer gets to step up the basis of the assets purchased, and get tax deductible amortization over the next 10 years. This incremental tax shield can be a value driver in LBOs and a sponsor's ability to pay.
This was very insightful thank you both. Love to see more educational stuff like this on the site
totally agree def need to get more threads like these. they are fun to learn and explain.
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