Capital Expenditure (Capex), which simply means expenditure on assets with long lives, is a big deal for private equity. Firstly, because it reduces cash flow. Secondly, because it reduces cash flow. Thirdly, okay, okay… I don’t want to harp on about cash flow, but I do want to talk about the importance of capital expenditure in private equity deals. The following list goes a little further:
- The P&L statement doesn’t show expenditure on capital assets. This is because capital assets are capitalised to the balance sheet and only expensed to the P&L as they deteriorate (or insofar that accounting standards say when and by how much they deteriorate). The implication of this is that analysis of the P&L statement won’t show the capital requirements of the business and hence, the business’s real value. For example, you may be considering a great business that has EBIT of $1m, but if the business requires $2m of capital expenditure (capex) just to keep operating each year (fixing machines, buying new equipment, etc.), then it’s not such a great business. You can get an estimate of capex by looking at depreciation on the P&L, but this is fraught with risk.
- Even the balance sheet doesn’t make the capex picture any clearer. You can calculate the difference in assets between one year and the next, but all you get is a single number skewed by many variables. For example, if the company sold a large asset, this would underestimate real capital expenditure (capex). Also, if the company only invests in capex every three years, an analysis of only the last year may show the business has no capex requirement, which would be wrong. The same goes for the Cash Flow Statement, which shows a single item for investment in plant, property and equipment; it’s only a single number.
- Most importantly, capex reduces cash flow. This has implications for valuations and debt reduction. As aforementioned, capex doesn’t make it to the P&L statement. That means any valuation based on EBITDA won’t account for it. Even a valuation on EBIT will only somewhat account for it if you consider depreciation to be a good proxy for future capital expenditure (capex), which it rarely is. But, the big problem is that if FCF is negative due to high capex requirements, you won’t be able to pay off debt. And, you may not be able to meet debt repayments, which would quickly lead to insolvency.
So, the message is really to make sure you consider capital expenditure (capex) in all transactions. You need to see the detailed budgets of the business and understand how capex affects cash flow, what capex is required to keep the business operating as per usual, and what plans show for one-off items in the near future. Then, you may be able to get a better picture of maintainable earnings and hence value. Above all, don’t be fooled by EBITDA figures.