Working capital costs an LBO the change, not the level, so the faster the plan grows, the more cash it never sees.
Working capital costs an LBO through growth: each year the company grows, it has to fund more receivables and inventory, and that cash does not repay debt. On an illustrative $480.0 million buyout growing revenue 6 per cent a year, net working capital at 20 per cent of revenue absorbs $33.8 million over five years and returns 16.34 per cent, against 17.27 per cent at 10 per cent of revenue. Each point of revenue tied up in working capital costs about 9 basis points of IRR; a programme that takes it from 20 to 15 per cent adds 1.92 points.
Worked in full in The Buyout Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most LBO discussions of value creation stop at EBITDA growth, multiple and leverage. Working capital sits between EBITDA and free cash flow, and in a growing business it is a recurring use of cash, not a one-off. The question is how much it matters, and when.
| Input | Value |
|---|---|
| Revenue at entry | 500.0 |
| EBITDA margin | 12.0% |
| EBITDA at entry | 60.0 |
| Entry and exit multiple | 8.0x |
| Enterprise value | 480.0 |
| Debt, 4.5x EBITDA, at 8.0% interest | 270.0 |
| Transaction fees | 10.0 |
| Sponsor equity | 220.0 |
| Revenue growth a year | 6.0% |
| Capex, equal to depreciation, % of revenue | 3.0% |
| Tax rate on EBITDA less depreciation and interest | 25.0% |
| Holding period | 5 years |
All free cash flow repays debt, as in a cash sweep. The exit is at the entry multiple, so the only things that differ between cases are cash and debt.
ΔNWC = NWC % × (revenue this year − revenue last year)
At 20 per cent: year 1 revenue is 530.0, up 30.0, so ΔNWC = 20% × 30.0 = 6.0. It rises with revenue to 7.6 in year 5, and totals 33.8 over the hold.
FCF = EBITDA − capex − tax − interest − ΔNWC
Year 1 at 20 per cent: 63.6 of EBITDA leaves 13.6 after capex, tax, interest and 6.0 of working capital. Debt falls from 270.0 to 256.4.
Equity at exit = 8.0 × year-5 EBITDA − net debt = 8.0 × 80.3 − 173.4 = 469.0
MOIC = 469.0 / 220.0 = 2.13x; IRR = 2.13^(1/5) − 1 = 16.34%. Excel: =(469.0/220.0)^(1/5)-1
| NWC, % of revenue | Cash into NWC, 5 years | Year-1 FCF | Net debt at exit | Exit equity | MOIC | IRR |
|---|---|---|---|---|---|---|
| 10% | 16.9 | 16.6 | 154.4 | 487.9 | 2.22x | 17.27% |
| 15% | 25.4 | 15.1 | 163.9 | 478.4 | 2.17x | 16.81% |
| 20% | 33.8 | 13.6 | 173.4 | 469.0 | 2.13x | 16.34% |
| 25% | 42.3 | 12.1 | 182.8 | 459.5 | 2.09x | 15.87% |
Every 5 points of working capital intensity move exit equity by 9.5 million and the IRR by 0.47 points: 1.89 million and about 9 basis points per point of revenue. The effect is more than the cash itself. The 16.9 million of extra working capital at 20 per cent against 10 per cent becomes 18.9 million of exit equity, because the cash that did not repay debt also carried 8.0 per cent interest, net of tax, for the rest of the hold.
The level of working capital is not what costs money; the change is. The opening working capital is bought with the company and paid for inside the 480.0. What the sponsor funds after closing is working capital on new revenue, so the drag scales with growth:
| Revenue growth a year | Cash into NWC at 20% | IRR at 20% | IRR at 10% | Gap, points |
|---|---|---|---|---|
| 0% | 0.0 | 7.03% | 7.03% | 0.00 |
| 3% | 15.9 | 11.82% | 12.33% | 0.52 |
| 6% | 33.8 | 16.34% | 17.27% | 0.92 |
| 9% | 53.9 | 20.67% | 21.93% | 1.26 |
A flat business pays nothing for working capital intensity in an LBO; a fast-growing one pays more each year. The growth plans that make the EBITDA case are the same plans that consume cash, which is why a returns bridge that shows EBITDA growth without the working capital it needed overstates the operating contribution.
Take the 20 per cent case and assume a programme on collections, payment terms and stock that brings intensity to 17.5 per cent in year 1 and 15 per cent from year 2. Working capital releases 7.2 in year 1 and 8.5 in year 2 instead of absorbing 6.0 and 6.4, and then grows at the lower rate. Over five years it absorbs a net 0.4 instead of 33.8.
Exit equity 509.1 against 469.0: +40.1 million. MOIC 2.31x, IRR 18.27%, +1.92 points.
That is four times the gain from simply being a 15 per cent business throughout, because the programme also releases cash from the working capital that was bought at entry. It is one of the few levers that pays early in the hold, when debt and interest are highest.
The release has to be real at exit. The buyer will set a working capital peg on a normal level for the business. If the improvement came from stretching suppliers beyond sustainable terms, the peg will be set on the old level and the gain comes back off the price, as worked in how to calculate a net working capital peg.
Modelling working capital as a percentage of revenue and leaving the percentage constant, then treating it as neutral. Constant intensity is not neutral in a growing business: here it absorbs 33.8 million that would otherwise have repaid debt, and costs 0.92 points of IRR against a business with half the intensity. The second mistake is the reverse: crediting a one-off release in every year, which only happens if intensity keeps falling.
In an LBO, working capital costs the change, not the level, so its drag is proportional to growth: about 9 basis points of IRR per point of intensity at 6 per cent growth here, and nothing at zero. Taking intensity down early is worth about four times the gain of simply running at the lower level, because it also releases cash that was bought at entry. The full model with the cash sweep, the balance sheet and the exit waterfall is in the free workbooks for this case.
Barely. The working capital at entry is bought with the company and paid for in the purchase price; what reduces debt repayment is the increase each year. With zero revenue growth, the illustrative buyout returns 7.03 per cent whether working capital is 10 or 20 per cent of revenue. At 9 per cent growth the gap widens to 1.26 points of IRR.
More than the cash released, because it also saves interest on the debt it repays. In the illustration, taking working capital from 20 to 15 per cent of revenue over two years adds 40.1 million of exit equity and 1.92 points of IRR on a 220.0 million equity cheque. It is only worth that if the lower level is sustainable, because the buyer's peg will be set on a normal level.
Because more revenue needs more receivables and inventory before it turns into cash. At 20 per cent of revenue, 30.0 of extra revenue in year 1 ties up 6.0, so 63.6 of EBITDA produces only 13.6 of cash to repay debt after capex, tax and interest. Leaving it out overstates debt paydown and the exit equity.
This article is one calculation from The Buyout Investor. 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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