Two companies with identical EBITDA can return very different equity: the difference is how much of it turns into cash that repays debt.
Cash conversion is EBITDA less capital expenditure less the increase in working capital, divided by EBITDA. On an illustrative buyout of a company with 20.0 of EBITDA, levered 5.0 times, 80 per cent conversion against 60 per cent adds 27.6 of exit equity on a 100 cheque, 2.9 points of IRR, with exactly the same EBITDA. The difference is debt: one company repays 47.6 over five years, the other 20.0.
Worked in full in The Private Equity Operating Partner by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Two illustrative portfolio companies are bought on identical terms and grow EBITDA at the same 8 per cent a year. They differ only in how much of that EBITDA they keep. All free cash flow after interest and tax repays debt. Depreciation is set equal to maintenance capex for the tax line. Figures in millions.
| Input | Value |
|---|---|
| Entry EBITDA | 20.0 |
| Entry and exit multiple | 10.0x |
| Enterprise value | 200 |
| Debt at 5.0x EBITDA | 100 |
| Equity | 100 |
| Interest rate | 8% |
| Tax rate | 25% |
| EBITDA growth, per year | 8% |
| Hold, years | 5 |
Operating cash conversion = (EBITDA − maintenance capex − growth capex − increase in net working capital) / EBITDA
Free cash flow conversion = (EBITDA − capex − increase in NWC − cash interest − cash tax) / EBITDA
In Excel, with EBITDA in row 5, capex in rows 6 and 7 and the NWC change in row 8: =(D5-D6-D7-D8)/D5, copied across.
| Line | Company A | Company B |
|---|---|---|
| EBITDA | 21.60 | 21.60 |
| Maintenance capex (10% / 12%) | 2.16 | 2.59 |
| Growth capex (5% / 10%) | 1.08 | 2.16 |
| Increase in working capital (5% / 18%) | 1.08 | 3.89 |
| Operating cash flow | 17.28 | 12.96 |
| Operating cash conversion | 80% | 60% |
| Cash interest | 8.00 | 8.00 |
| Cash tax | 2.86 | 2.75 |
| Free cash flow to repay debt | 6.42 | 2.21 |
| Free cash flow conversion | 30% | 10% |
A 20-point gap in operating conversion becomes a threefold gap in the cash that actually reaches the lenders, because interest and tax are almost the same for both and come off the top. That is the leverage in a leveraged buyout working on cash, not on value.
Both companies exit at 29.4 of EBITDA and 10.0 times, so both have an enterprise value of 293.9. The equity is the enterprise value less what is left of the debt.
| Line | 80% conversion | 60% conversion |
|---|---|---|
| Exit enterprise value | 293.9 | 293.9 |
| Debt repaid over the hold | 47.6 | 20.0 |
| Net debt at exit | 52.4 | 80.0 |
| Exit equity | 241.5 | 213.8 |
| MOIC | 2.41x | 2.14x |
| IRR | 19.3% | 16.4% |
The weaker converter returns 27.6 less equity, 0.28 turns of money and 2.9 points of IRR. To close the gap through earnings it would need 32.1 of exit EBITDA instead of 29.4: 9.4 per cent more EBITDA, roughly an extra year of growth, to make up for cash it did not collect.
In a value creation bridge this whole effect lands in the deleveraging bucket, not in EBITDA growth. An operating partner who lifts conversion by tightening working capital or capex discipline has created value that the standard bridge credits to the capital structure.
Holding capex at 15 per cent of EBITDA and varying only the working capital absorbed:
| Conversion | Net debt at exit | Exit equity | MOIC | IRR |
|---|---|---|---|---|
| 50% | 94.9 | 199.0 | 1.99x | 14.8% |
| 60% | 80.7 | 213.1 | 2.13x | 16.3% |
| 70% | 66.6 | 227.3 | 2.27x | 17.8% |
| 80% | 52.4 | 241.5 | 2.41x | 19.3% |
| 90% | 38.2 | 255.6 | 2.56x | 20.6% |
Each 10 points of conversion is worth about 14 of exit equity here, or 14 per cent of the entry cheque. The 60 per cent row differs slightly from Company B because B's higher maintenance capex also lowers its tax.
The usual error is reporting conversion on a single year, or on EBITDA before adjustments while the cash reflects the costs behind them. A company that defers capex for a year shows 90 per cent conversion and then 60. A company that adds back recurring restructuring costs to EBITDA inflates the denominator while the cash outflow stays in the numerator, so conversion falls and nobody can say why. Measure conversion over a rolling three or four years, on the same EBITDA definition as the leverage covenant, and split growth capex from maintenance so that investing for growth is not mistaken for poor cash discipline.
Divide EBITDA less capex and the working capital increase by EBITDA, then follow the cash into the debt balance. Here 20 points of conversion are worth 27.6 of exit equity on identical EBITDA. The book's Vireo bridge, which shows where that cash lands, is built in the free workbook for this book. For the working capital lever on its own, see how much cash reducing DSO releases, and for the full deal mechanics, the LBO model template.
It depends on capital intensity, so compare a company with its own history and peers rather than with a universal figure. As an illustration, a business spending 10 per cent of EBITDA on maintenance capex, 5 on growth capex and 5 on working capital converts 80 per cent; one at 12, 10 and 18 converts 60.
Report both. Operating conversion, before interest and tax, measures the business and is what an operating partner can move. Free cash flow conversion, after both, measures what repays debt. In the illustrative year one, 80 per cent operating conversion becomes 30 per cent after 8.00 of interest and 2.86 of tax.
Price it as the extra exit EBITDA needed to reach the same equity. In the illustrative case the 60 per cent converter needs 32.1 of exit EBITDA instead of 29.4, 9.4 per cent more, to match the equity of the 80 per cent converter, because it still carries 80.0 of debt instead of 52.4.
This article is one calculation from The Private Equity Operating Partner. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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