Working Capital considerations in LBO
Can someone answer (or point me to a comprehensive resource) on the below:
- how do GPs assess working capital in the context of LBO?
- what are things to look for (positive indicators)?
- what are things to watch out for (red flags)?
- what do certain trends and components of WC indicate for LBO candidate?
- how does it affect returns (IRR & MOIC)?
- is change in working capital or absolute amount of WC or WC as % of sales most important, and why?
- Bonus: examples of PE deals where WC had a significant impact?
Thanks!
@Tamara_S
I would really appreciate your input as I have seen your responses throughout the forum and you seem very knowledgeable. Thank you!
Just saw this.
When screening for LBOs, I don't look at WC at all - only use EBITDA less CAPEX as a proxy for cash generation unless I know that WC is a large producer or consumer of cash.
Implicitly, from the company's business model you already know whether or not their position is weak from a WC perspective. For example, I can't think of worse place to be than being a supplier to Wal-Mart (or the likes ) and wait for 180 days to get paid.
Equally, there are great businesses that are well-positioned from a WC perspective. Apart from Wal-Mart itself, companies that come to mind is private education and anything where customers prepay and don't have much propensity to switch.
When the time comes to analyze WC, I look at WC as % sales more than anything. I then look at how this metric can be improved.
If I have an EBITDA of 100, debt service of 40, maintenance CAPEX of 10, and WC % of 30% and next year's sales of 100. So, my cash is 20. If I can drive WC% from 30% to 20% of sales, then my cash generation will be 30. In other words, I can improve my cash generation by 50%. These opportunities for WC improvement are far more important to me than any absolute numbers.
Thank you - very insightful!
following
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Following as well
Definition First let's define it. Often you see a distinction between trade working capital (inventory + receivable - payables) that is sort of growing with the business and total working capital (trade working capital +/- other current assets/liabilities except cash/debt related items) with some (semi)fixed items in it).
Working capital is relevant because of many reasons, let's look at four:
source/use of cash when growing If you have a positive working capital, the business needs cash to grow apart from capex (to buy extra inventory, because you get more debtors, etc). If you have negative working capital you actually retrieve cash out of W/C when growing (supermarket pays suppliers after 60 or 90 days, but sells to consumers for cash within a few days for instance). If you model in growth in your LBO, you need to make sure you make sufficient cash to fund this.
working capital seasonality Some businesses have large swings in working capital through seasonality. If you look at a farm, they buy inventory at some point and they harvest at some point, so inventory shows huge swings. Retailers take on extra inventory before Christmas and sell out during Christmas (convert inventory in cash). This is relevant because you need liquidity when your W/C grows. This is often resolved with a revolving credit line with the bank (but you need to make sure it's in place when you need it and need to estimate the quantum).
settle w/c level at close of transaction When buying a business and establishing the net debt to get to equity value for seller, you want to make sure you get a business that has sufficient working capital. If you buy a retailer just after Christmas, inventory will be extremely low and due to the high cash generation during Christmas, net debt will be low (inventory converted into cash). However just after Christmas, the company needs to buy new inventory again to fill the store with new stuff to sell. This will result in a high need for cash. At close of transaction you make sure there is a level of working capital in the business that matches the year average OR you deduct an amount from the price you pay to sellers to make up for the difference.
source of cash when inefficient Most PEs will take a good look at the w/c items and see if they can optimise during the holding period. If you can sustainably reduce inventory or stretch payments, you can extract the freed up cash as a dividend. Many PE owned companies start paying suppliers later, reduce inventory or optimise billing. This can generate very nice returns for the PE.
Thank you, this is fantastic. Two follow-up questions:
Other working capital could include all sorts of lump sum items that might not grow in a linear way with the business, but you do need to forecast it. Trade working capital in addition is interesting as it shows the cash conversion cycle of the business (how long from buying raw materials to receiving cash). To conclude: you need to forecast total working capital (including trade working capital).
I've seen many questions about 'minimum cash balance' and it's bull shit unless you have physical cash in a register. You don't need cash on your account to run a business if you have a revolving credit facility that is 0 at least once a year. If it is actual cash in a cash register, treat it like working capital and forecast it.
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