Wednesday, May 22, 2024
Wednesday, May 22, 2024

Optimal Capital Structure on a Search Fund with Capital Intensive businesses

With over 13 years of experience in capital-intensive businesses within the oil and gas sector, I've witnessed firsthand and...

By Matheus Vilela, Executive Diploma in Financial Strategy 2023 – Said Business School / University of Oxford

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With over 13 years of experience in capital-intensive businesses within the oil and gas sector, I’ve witnessed firsthand and learned how to deliver the transformative power of solid financial approaches in unlocking competitive advantages. My recent journey interviewing Search Fund investors uncovered a prevailing trend among investors favouring light asset businesses and a concentration on services over capital-intensive enterprises. I was very intrigued by the motivation and as a result, I ended up using the Executive Diploma in Financial Strategy at Oxford University / Said Business School as a research platform to investigate the underlying assumptions and potential opportunities in this space, of which I am very excited to share my qualitative and quantitative opinion and findings

The Capital-Intensive Dilemma, a Qualitative Opinion

Ordinarily, Search Fund investors often hesitate to consider medium or high-capital-intensive businesses due to perceived financial and operational challenges. Through interviews with over 50 investors, I gleaned insights into their perspectives and I have reflected on their most common statements, which appose to the medium or high-capital-intensive business.

  • Yearly CAPEX requirement

Investors’ Perception: The EBITDA generated will be eroded by the CAPEX required to keep the asset in a healthy operation state.

My thoughts: The valuation of the business should factor the FCFF (Free Cash Flow to Firm) and FCFE (Free Cash Flow to Equity), not the EBITDA, as a result, previous CAPEX and asset due diligence would allow us to offset the effect of the previous CAPEX in the acquisition and throughout the forecast based on the asset due diligence.

FCFF = EBIT (1-tax) + depreciation – Delta working capital – CAPEX

FCFF is cash available to all providers after expenses, investments, and taxes, reflecting overall financial health and cash generation.

FCFE = FCFF – interest (1-tax) + Net Borrowing

FCFE is cash available to equity holders after expenses, investments, and debt repayment or acquisition, reflecting shareholder returns and financial health.

In other words, financially speaking, for the same given EBITDA and the same equivalent business, the valuation of a capital-intensive compared to a light asset business will necessarily be lower.

  • Additional equity required for the acquisition

Investors Perception: It would require investors’ additional equity to buy the business, due to the presence of assets.

My thoughts: The presence of an asset should not influence directly the business valuation as the product of the asset is indeed the FCFF and FCFE produced, which should be fundamentally and financially the object of the acquisition.

On the other side, I do highlight the difference between value (a financial function of the overall business performance and possible synergy) and the  price (a function of the market)

  • Complexity

Investors’ Perception: A business that has assets is typically more challenging to run, increasing the risk and uncertainty.

My thoughts: The asset fundamentally replaces labour in the operations, which has been one of the largest challenges of European business for decades.  It is important to remember that, when we compare with a light asset or service business we are predominantly dealing with labour-intense operations, which in my opinion is a far greater challenge to manage in European business due to the scarce and costly manpower.

This qualitative aspect itself represents a substantial agenda towards capital-intensive business in Europe.

Moreover, in case the business is indeed more complex to run, it should represent an entrance barrier and margins should reflect it.

Risk Analysis and Optimum Capital Structure

Navigating the complexities of capital structure decisions is crucial for maximising financial performance while managing risk effectively. Achieving the optimal balance between debt leverage and risk management requires a thorough assessment of various factors. By carefully analysing the risk-return trade-off, businesses can position themselves strategically for long-term success, enjoying benefits such as reduced financing costs, higher valuation, and improved investment return.

The optimisation, or decrease, of the WACC (Weight Average Costs of Capital), is absolutely strategic for any organization due to the several benefits it provides to the business:

  • Reduced financing costs
  • Provide a higher Valuation
  • Improved Investment Return
  • Financial Competitive Advantage
  • Eased Access to Capital
  • Investor Attraction
  • Financial Flexibility
  • Enhanced Shareholder Value
  • Increased Pipeline of Projects

Strategically deploying assets as collateral for debt procurement offers businesses an extra edge in accessing additional capital at competitive rates. By leveraging assets effectively, businesses can optimize their capital structure and enhance financial efficiency, fuelling growth and expansion initiatives.

The graph below demonstrates three fundamental zones. The low-performance financial zone, where the lack of debt imposes on the business a much higher WACC, the optimum capital structure zone, where the acceleration of the Beta increases up to a level where the risk is worth the reward (limited by the tangent of 45% at the Delta curve).  The precise optimum capital point is defined by a series of specific technical-finance business criteria and shareholder profiles. Finally, we have, what I call the suboptimum risk-reward zone, where the risk of the high debt level is questionable. However, it is important to highlight that although the risk of high debt is significantly larger, the impact due to the lower equity required is minimized. We are going to review it in the final Comparison Analysis and Outcomes.

The Methodology and a quantitative approach

Monte Carlo is one of the most powerful tools for scenario simulation in the market. It is based on a mathematical technique forged on statistics to obtain a large number of samples of two or more variables that exhibit a weak or strong correlation. Utilizing the Monte Carlo Method, I sought to assess how investors should evaluate capital-intensive and non-capital-intensive (traditional), on the same EBITDA basis. By simulating over 8000 scenarios with businesses with EBITDA ranging from £1-8m (in intervals of £1m each), I aimed to provide robust insights into potential outcomes and risks associated with the two different business models.

List of Assumptions

To reflect the investor viewpoint, the simulation contrasts a non-asset firm with a capital-intensive corporation, focusing on the outcomes of Return on Equity (ROE), Return on Invested Capital (ROIC), Debt Service Coverage Rate (DSCR), and Equity need. The assumptions for the Monte Carlo model are defined below:

  1. The model establishes the EBITDA at a fixed random value in each EBITDA range
  2. The comparison is based on a static model, not a long-term forecast;
  3. The model starts from £1m up to £8m, with £1m gap between them;
  4. Adopted Minimum, Most Likely and Maximum conditions for the asset, EBITDA, Capex, Depreciation, Beta, Debt from cash flow and Debt from the asset, in a triangular statistical pattern;
  5. Asset – 3 x EBITDA in the capital intensive case;
  6. Capex – 10% of EBITDA;
  7. Depreciation – 6.7% EBITDA;
  8. Interest – 7.5% debt, no principal payment (bond);
  9. Equity Beta – 0.95, 1.2 and 1.8, reflecting a more conservative business profile;
  10. Debt from cash flow – 60%;
  11. Debt from an asset – 30%, 40% or 50% of the total asset value;
  12. Maximum Debt is no greater than the valuation;
  13. Minimum Equity is no smaller than £1.00;
  14. When the ROE is above 200% we will cap it at a maximum of 200%;
  15. When Debt represents 100% of the valuation, we will cap the Beta to the maximum Beta from the model where Debt is lower than 100%;

Comparison Analysis and Outcomes

Analysing the outcomes of the Monte Carlo simulations, I found that capital-intensive ventures exhibited the following characteristics

Positive effects noted:

Valuation: ~ -13%;

ROE: ~ +140%;

ROIC: ~ +16%;

Equity: ~ -59%;

DSCR: nominal ~ 2.7;

Debt: ~ +16%.

Negative effect noted:

FCFF: ~ -13%;

FCFE: ~ -33%;

Net Profit: ~ -20%;

DSCR: ~ -14%;

Beta: ~ +190%,

In summary, for the same given EBITDA, a capital-intensive business should have a lower valuation and would offer a greater opportunity to acquire additional debt, as a consequence, less equity is required for the acquisition and ROE and ROIC would be maximized. The caveat is that the business would incur an incremental risk as the additional debt increases the  Beta level, however, if the DSCR indicator suggests enough coverage, the capital-intensive business should most definitely be considered as an option.

Moreover, the results indicate that a small percentage (1-3%) of capital-intensive businesses could offer a unique acquisition opportunity for investors. A  profitable business could be acquired with 100% debt! As a result, mathematically speaking, the ROE is infinite, once no Equity is not required to acquire the business. This is demonstrated in the graph where the ROE is artificially capped at 200%.


Based on my experience and findings, I believe that the Search Fund community should re-examine capital-intensive ventures. Historically disregarded by the community, these ventures offer significant potential for investors seeking to achieve superior returns while effectively managing risk. By strategically leveraging assets and optimizing capital structure, investors can unlock opportunities and contribute to the growth and efficiency of acquired ventures.

In conclusion, capital-intensive enterprises should emerge as an investment priority for selected investors, offering compelling opportunities for strategic decision-making and financial management. By carefully evaluating risk and maximizing financial performance, investors can position themselves for long-term success in the dynamic landscape of the Search Fund community.

If you have any comments, questions, criticism or just connect, I would be honoured to engage with you, so please don’t hesitate to contact me at or

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