Why do we assume all FCF is used to pay down debt in a LBO? What if a company wants to use FCF for other purposes?
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First of all you don’t always assume all FCF is used to pay off debt. It depends on type of loans ,etc. Some are bullet for example, so they are not amortising. Secondly, FCF is call Free Cash Flow because it already accounted for key investments in the business such as working capital and capex.
Because (big assumption) paying off debt is likely the lowest ROI use of cash for a sponsor. Pay off $1 debt with FCF, create $1 equity value. Dollar for dollar value creation.
If you’re using that FCF for something else, say funding an add-on that you’re buying for 12x when platform is worth 16x… that dollar spent for equity value created ratio is much higher. $1 spent = ($1.33 Enterprise Value created / (equity/total cap) = equity value created).
Thats the simple answer.
aren't you making an argument for why not to assume FCF is being used to pay off debt?
No, I’m making the case for assuming the simplest use of cash that you know you always have the option of doing. Unless you have some specific use of cash already lined up, you would assume the highest certainty value creation lever - which is to pay down debt. That’s a button that is always available to push.
If you had an add-on already teed up, you obviously wouldn’t be modeling that you use that cash to pay down debt.
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