I've heard that high capex reduces returns significantly in an lbo model. I was wondering what the true impact of increasing capex is. If you increase capex, wouldn't you also be increasing D&A which increases EBITDA and, as a result, your exit valuation. If you increase capex, are your returns really lower?
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if you increase capex significantly, you will decrease the amount of debt you will be able to paydown, thus altering your capital structure to have more debt and less equity at time of exit. less equity value can change returns quite a bit.
yeah, lowers your cash flow. can't pay back debt fast. lower irr. caveat that i'm not currently working and have been out of school for a while.
Generally this is true since CapEx is a cash drain. But it is largely dependent on how accretive (for lack of a better word) said CapEx is.
For example, I was working on a deal where CapEx was 20% of revenue... which extremely high, even for a 30% EBITDA margin business.
But the LBO was based on an 8.0x acquisition multiple and the CapEx was comprised of about 3% of revenue was maintenance capex and the remaining 17% was used for acquisitions where the targets were being acquired at 5x-ish multiples... which means your instantly creating equity value.
Lets look at this example...
Total Debt: $1.7B Total EV: $2.4B (assumed 8x multiple) Revenue: $1B EBITDA: $300M CapEx: $200M Growth CapEx: $145
If we're acquiring 145M EV company at a 5x multiple, we're acquiring $29M of EBITDA.
If we would have saved that $145 capex and used it to paydown debt... our EV would still be $2.4B but our Debt would have been $1.555B which results in an equity value of $845M.
Alternately, if we used $145M capex to acquire $29M of EBITDA... our PF EBITDA is $329M and our debt is still the same but out EV becomes $329 x 8.0x multiple... resulting in an EV of $2.6B, less $1.7B debt and we have $900M equitty value.
Therefore its more accretive to pursue those acquisition opportunities so long as the above criteria is true.
Now obviously you acquire at 5.0x and sell at 8.0x for a variety of reasons... and you're hoping that you realize such margin expansion by integrating the businesses effectively such that the 8.0x multiple is justified for your whole business. There are considerations that come into play here... namely, how long it will take you to get to the run-rate level of operations in the acquired business and possibly cost to acheive synergies post-acquisition.
The moral of the story is... maintenance vs. growth capex is one of the most important aspects of an LBO to understand especially if its a capex and/or growth heavy business and number two that high capex isn't always bad for IRR.
Thanks Marcus, SB for you.
Actually one point people are missing is that the higher the capex, more likely it will blow out your fixed charge coverage ratio thus requiring you to lower the debt and increase the equity, which will cause your IRRs to go decline. It is not just leave more debt on the balance sheet, because more then likely there will be a senior piece that will be amortizing.
What happens if in only 1 year Capex significantly increases?
Chunky CapEx like that could breach covenants which lowers the debt quantum (how much leverage you can use) and thus depresses returns. Could be solved using a revolver structure to cover cash shortfalls in that year.
The root of this question isn't so much in the value creation that can come from acquisitions where there's multiple arbitrage... In the typical CAPEX sense, and the simplest way to think about this, is that yes capex is going to decrease the amount of debt you will be able to paydown. Further, yes you are right about the D&A, but that is over an extended period of time. You may purchase an asset now with a useful life of 10 years... The capex will ding you instantly for the full amount whereas the D&A is only an incremental addback worth 10% of the capex because of the useful life. This timing difference explains why the D&A does not fully make up for the capex drain. Unless this capex is going into something that produces strong returns it will likely lower your IRR
Thanks a lot!
im sorry d&a is just a tax shield even if it were immediately expensable. the timing is a totally secondary piece.
Do you care about how much cash you can put in your pocket or how much EBITDA you can record in an MD&A?
Look at the substance of it, not BS accounting and non-GAAP measures. Maintenance capex is a recurring expense like COGS or opex
Lots of unnecessary info here. Equity owners are entitled to all the business’s cash left over after paying off your debt (i.e. net debt). When you spend money on capex, cash leaves the business, thereby reducing the amount left for equity.
Ceteris paribus, less cash left means lower returns; you hope that this is offset by the capex allowing you to stay in business at current earnings levels (maintenance capex) and by it increasing future earnings (growth capex)
Increasing D&A in a vacuum doesn’t increase EBITDA. With no other changes it would make EBIT lower but get back to the same EBITDA
LMAO yes thank you. Lot of red herrings in this thread.
Would you depreciate maintenance Capex when making a waterfall?
Although you segment capex into growth and acquisition just for the sake of seeing it, there's no difference in terms of depreciating it. Growth vs maint. capex in the same year depreciates in the same way. So just model depreciation using mid-year convention as usual.
Also yeah, increasing D&A does not make EBITDA increase. This is a classic tricky interview question where people think bottom-up build from net income as EBITDA = EBIT + DA. The reality is you're supposed to think of carving costs from sales as EBIT = EBITDA - DA, where EBITDA is fixed and the EBIT ends up falling with incremental DA.
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