Rethinking Asset Intensity in Search Fund Acquisitions

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The vast majority of Search Funds seek to acquire businesses that are both “asset-light” and “capital-light”. That is, companies that don’t have a large base of tangible assets that need to be added to, refurbished, or replaced to either maintain operations or pursue growth. All else being equal, this makes perfect sense: EBITDA is only so useful if a large percentage of it gets consumed by required capital expenditures in any given year.

That said, I don’t believe that the mere presence of capex should necessarily disqualify a company from consideration. In this post, we’ll begin by exploring several situations in which capex can be a tolerable part of any given deal, and we’ll conclude by discussing how buyers should adjust their approach to valuation based on the asset intensity of the target company in question.

Not all Capex is Created Equal

To suggest that all capex is necessarily “bad” is to drastically oversimplify the matter. Though all else being equal, buyers would prefer as much of EBITDA as possible to convert into free cash flow, consider the following:

(1) Strategic vs. “Routine” Capex: Some capital expenditures provide companies with a meaningful source of competitive differentiation, or entry barriers that protect them against newly formed competitors (consider an equipment rental company with the largest breadth and depth of inventory in the industry). Some expenditures obviously provide nothing of the sort (consider the need to replace a component of a manufacturing line simply because it’s reached the end of its useful life)

(2) Growth vs. Maintenance Capex: All else being equal, growth capex is preferable to maintenance capex (spending money to grow is one thing – the need to spend money simply to maintain existing operations is another thing entirely).

(3) ROI and Payback Variance: Capital expenditures differ materially across payback periods and ROI: Whereas some expenditures produce little to no ROI, and/or take a very long time to pay for themselves (if they ever do), others present much more sensible investment opportunities.

(4) Episodic vs. Recurring Capex: Some capital expenditures are regular and predictable (which generally erode free cash flow), whereas others are more episodic, discretionary, and/or one-time in nature: In one of Mineola’s portfolio companies (an equipment rental business that serves the construction industry), we benefited materially from a previous owner who decided to spend a lot of money upgrading the fleet, only to sell the company ~12-24 months later. Though historical free cash flow generation didn’t look great on paper, as buyers we benefited from ~15-20 years’ worth of future rental income without having to incur the large upfront cash outlays that would otherwise be required to obtain such a benefit.

EBITDA Multiples & Asset-Intensive Businesses

Before we discuss how to contextualize valuations for asset-intensive companies, it’s likely worth exploring the widely-used EBITDA multiple: Why is this the primary metric used by acquirors in the lower middle-market, and under what circumstances is it actually a useful shorthand?

While the exact origins of the term “EBITDA” are unclear (at least to me), a very early proponent of the idea was John Malone (nicknamed the “Cable Cowboy”), who ran cable company TCI between 1973 and 1999. Because the nature of his business was such that it had large upfront capital expenditures (from laying cable infrastructure), heavy depreciation charges, and significant interest costs (from high leverage), he often trumpeted EBITDA as a better reflection of a company’s “cash-earning power” than net income.

An EBITDA multiple, therefore, can act as a rough proxy for the following:

• The “Inverse Yield” of an Investment: Acquiring a company at 5x EBITDA suggests an approximate 20% yield on an investment (= 1 / 20%). Said another way: Assuming that EBITDA is a rough proxy for free cash flow, and assuming that EBITDA stays roughly flat during the hold period, investors can theoretically distribute EBITDA to themselves every year and earn a 20% yield on their investment. Optimists will point to the fact that this ignores the additional returns that could come from growth, multiple expansion at exit, and/or the use of leverage.

• The (Approximate) Payback Period of an Investment: Using the same logic, one can  think about EBITDA as a rough approximation of an investment’s payback period: Again, assuming that EBITDA is a rough proxy for free cash flow, and assuming that EBITDA stays at least flat during the hold period, then a 5x EBITDA multiple suggests that the buyer’s initial investment could theoretically pay for itself in 5 years.

The concept of EBITDA (and, by extension, the concept of EBITDA multiples) certainly has its skeptics, however. Warren Buffett summarized his stance on the matter nicely when he said the following:

“Trumpeting EBITDA is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense-a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?”

Charlie Munger, as he often did, summarized his thoughts much more succinctly than his partner when he famously said: “Every time you see the word EBITDA, you should substitute the word bullshit earnings“.

Clearly, EBITDA is a much less useful shorthand (and, as a result, EBITDA multiples are less useful approximations of value) in situations where EBITDA is not a reasonable approximation of cash flow. These include situations where the company in question:

• Has a large base of tangible assets; and/or
• Incurs a lot of capital expenditures; and/or
• Is working capital intensive (long cash conversion cycles, large inventory balances, slow collections, etc.); and/or
• Operates in a high tax jurisdiction

In situations like these, buyers are likely better served by situating their valuations in the context of multiples of:

• EBIT; or
• EBITDA minus maintenance capex; or
• EBITDA minus total capex; or
• Free cash flow

Doing so will still provide buyers with an approximation of the potential yield of their investment (absent growth, leverage, and/or multiple expansion) and its potential payback period, but the calculations will utilize a number that better reflects the economic reality of the target company in question.

In Sum: Judging Capex in Context

While most searchers understandably prefer asset-light, capex-light businesses, that bias can sometimes obscure otherwise attractive targets. If, under the right circumstances, we’re willing to underwrite deals that have customer concentration, key-person risk, or dated technology stacks, why can’t we also consider businesses that are slightly more asset-intensive than we would otherwise prefer?

As any experienced buyer knows, there is no such thing as a company or an investment opportunity that is without its imperfections. Though most buyers acknowledge this at an intellectual level, at a practical level many still struggle with the extent to which they should adhere to their “checklists” of desired company and industry characteristics.

I think Guy Spier put it best (when talking about the extent to which buyers should adhere to “checklists”) when he said: “The point is not to let them become a straitjacket, but to have them guide my behavior in a generally healthier direction“.

In this case, instead of discarding capex-heavy businesses out of hand, smart buyers should consider digging deeper to understand what the capex actually buys them.

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