Posted on: November 23rd, 2017
Acquisition Financing has distinctive characteristics that make it different than other forms of financing. Acquisition financing describes a capital need from the perspective of a buyer looking to acquire a business. When buying a business, the purchaser seeks capital to supplement their equity investment either in the form of debt or additional equity capital. Whether the purchaser is a company, a private equity fund or an independent sponsor, the goal of acquisition financing is the same – to fund the purchase of the business. Acquisition financing can be provided by a loan or equity investment, or a customized blend of the two. The type of acquisition financing used is often driven by a number of factors specific to the deal such as price of the company, the available loan options and the amount of equity investment. Most acquisition financing structures consist of one or two layers of debt capital.
Tip #1 – Acquisition financing structures consist of layers of debt and equity capital.
Tip #2 – Ensure you have the right amount of capital and timescale built into your acquisition financing structure.
Acquisition financing solutions are best when custom designed for each transaction. An asset-based or a cash flow- based methodology is used to determine the optimum loan structure. The key to designing the optimum acquisition financing structure is to ensure you raise the right amount of capital, with the right repayment timeframe, at the best possible price. Acquisition financing should also consider the growth capital needed to execute the growth plan, once the acquisition is complete. If there is too much financial pressure on the company, and too little long term patient capital, then the success of the acquisition could be at risk.
How to Determine the Best Acquisition Financing Structures
Arriving at the best acquisition financing structure involves assessing your deal from a number of angles. An acquirer should assess the purchase price, the asset base, the cash flow value and the required growth capital. Loan structure analysis starts with a simple sources of capital and uses of capital schedule wherein the purchaser budgets how much cash they have and how much cash they need to raise to complete the deal. The difference between the purchase price and the purchaser’s cash is the funding gap. This funding gap can be filled in many different ways.
Tip #3 – The funding gap is the difference between your cash on hand and the cash you need to close.
Tip #4 – The funding gap can be filled with either senior debt, mezzanine debt or additional equity.
It can be filled with senior debt, mezzanine debt, unitranche debt, or additional equity. Each debt type has distinct requirements that your deal may or may not qualify for. The amount of senior debt availability is based either on the asset base or cash flow value. The asset base is a number equal to a percentage of the liquidation value of the assets. Cash flow value is a number equal to a multiple of adjusted EBITDA, with the multiple usually in the 2.0 to 3.0 range. These calculations will provide clarity as to potential senior debt capacity, and lead you in the direction of either an asset based structure or a cash flow based structure.
Tip #5 – Senior debt requires short term repayment, mezzanine debt does not.
Tip #6 – Mezzanine debt has no mandatory principal payments, it is a 100% balloon payment at maturity.
Most acquiring middle market companies will have a higher senior debt capacity based on the cash flow multiple calculation. In most deals, the senior debt layer only funds a portion of the funding gap needed to close. Mezzanine debt, another popular form of acquisition financing, also uses a cash flow approach and will usually lend from 3.0 to 4.5 times a company’s adjusted EBITDA, inclusive of the senior debt layer. This gives an acquirer an extra room to fill the funding gap. While most acquisition structures use both senior and mezzanine debt, there are pros and cons to both forms of debt capital that are important to consider when structuring. Senior debt is usually provided by banks who are risk averse and impose security provisions and financial covenants on the business. The usual maturity is 4 to 5 years with mandatory quarterly principal repayments over the term of the loan. Principal repayments start right after the loan funds and continue until the loan is repaid in full. This results in the company having to service heavy loan payments to the bank, at a time when cash flow may be better invested in growth. Alternatively, Mezzanine debt is provided by debt funds with a long term focus, and require little to no principal repayments over the term of the loan. Mezzanine lenders unlike banks, are more relaxed and give the company more time to repay the loan. Their usual term is 5 to 6 years with a balloon payment of 100% of loan principal at the maturity date. Mezzanine loans carry higher interest rates, due to the fact that the loans are largely unsecured and repaid by future cash flow. With the senior bank lender in first position, the ultimate repayment is less certain for the mezzanine lender. The higher rates reflect the higher value mezzanine brings to the table within the acquisition financing structure. It is effectively an inexpensive form of equity capital, and provides valuable time, flexibility and structural soundness to the borrower.
Tip # 7 – Mezzanine debt is patient capital and a great equity substitute for your acquisition financing structure.
The best acquisition financing structures prioritize capital availability, loan flexibility, and foundational soundness. The purchaser needs to ensure there is enough capital available to not only buy the business but to grow the business. Often acquirers underestimate the amount of cash and time needed to execute the growth plan so it pays to be super conservative and make sure the deal is overcapitalized for growth. The loan structure repayments should not be burdensome to the company’s cash flow and allow for proper investment in working capital and growth initiatives. Too heavy a senior debt component can rapidly erode a company’s liquidity and cause it to choke on its working capital requirement. The structure should foundationally sound and give the acquirer enough time and space to be able to make the acquisition a success. This means that the structure should be able to withstand negative surprises or unexpected events such as a loss of a large customer or a product recall. If the structure is not strong enough, then when adversity strikes, the whole edifice may tumble.
What are the Advantages & Disadvantages of Senior Debt In your Acquisition Financing Structure?
Senior Debt is an important part of the overall structure. Most acquisitions would not be profitable ventures if they were 100% equity financed. Senior debt offers a low cost way to fund a portion of the funding gap. Senior loan rates range from Libor plus 300 basis points to Libor plus 550 basis points. Senior lenders are both focused on the quality of the balance sheet and the quality of the earnings of the business. Typical terms are 4 to 5 years, with mandatory repayments on a quarterly basis. Most senior lenders, especially banks, are not able to flex the repayment schedule but require straight line repayment of 20% per annum over a 5 year term. While systematic deleveraging is a sensible thing to do, this can be onerous for a company that needs to use it cash flow to fund growth. When most of your profit is consumed by debt service payments to the bank, your working capital can become squeezed and your liquidity can tighten. This causes a business to restrict long term investment in innovation, marketing and product development to satisfy the short term repayment needs of their bank. In addition, senior lenders, especially banks are not flexible with respect to covenants and reporting requirements. If the Company encounters difficulty and has a covenant breach, Banks are prone to overreact and subject you to audits and reviews which can take a lot of time and cause management distraction. While senior debt is an essential ingredient in all acquisition financing structures, too much of it can cause a company to lose financial flexibility and long term mobility.
Tip #8 – Too much senior debt can endanger your liquidity and weaken your financial strength.
What are the Advantages & Disadvantages of Mezzanine Debt In your Acquisition Financing Structure?
Mezzanine debt is an essential building block for an acquisition financing structure. It is long term, patient capital and a great substitute for equity. Mezzanine debt has long brought value to many acquisition financing structures due to its ability to stretch further and provide the last bit of hard-to- raise funding. Mezzanine lenders think differently than senior lenders and have a more holistic view of the creditworthiness of a borrower. Most banks see creditworthiness through a simplistic lens of asset liquidation or personal guarantees. The real key to creditworthiness is the durability of the company’s cash flow value and its underlying drivers – customers, products, market, management and operations. Mezzanine lenders subscribe to this dynamic view of creditworthiness, which allows them to have more flexibility and subjectivity in their lending decisions. Through underwriting the durability of cash flow value, mezzanine lenders learn a lot about a company and become smarter about the challenges the company faces in the future. This gives them more knowledge about the company and the ability to be patient when the company hits a speed bump.
Tip # 9 – Mezzanine debt will lend up to 4.5 times EBITDA.
Standard pricing is 12% interest plus an additional return kicker. Standard term is 5 years with 100% of the principal repaid through a balloon payment at the maturity date. With a mezzanine loan, a company has full use of the loan proceeds for the 5 year term, and is not obligated to repay principal. Mezzanine lenders are beneficial for scaling a company through multiple acquisitions, in what may be described as a roll-up. The clear advantages of a mezzanine approach are the educated, patient approach of the lender combined with the cash flow benefit of no required principal repayments until maturity. This helps a company generate cash flow at an accelerated rate and leads to higher velocity growth. When cash flow is reinvested into growth, as opposed to paying back a loan, a company is free to pursue proactive, innovative growth.
Tip # 10 – Mezzanine debt gives foundational strength to any acquisition financing loan structure.
Mezzanine gives more foundational strength to the acquisition financing loan structure. The foundational strength comes in the form of more time to perform, more capital to create and more capital cushion to buffer. The drawback to a mezzanine approach can be the cost relative to the cost of senior loan. Most mezzanine loans blend out cost wise at 15% between the interest rate and the equity kicker. Yet comparing mezzanine to senior debt is akin to comparing apples to oranges. When compared to the cost of raising equity, mezzanine is a steal of a deal.
What is Unitranche and why is it a popular Acquisition Financing Structure?
Unitranche is a blending of both senior debt and mezzanine debt in one integrated solution. This form of debt is also known as a one stop financing as the debt is supplied by one lending institution. This debt structure usually has lower annual principal payment requirements than senior loans, with principal payments equal to 5% to 10% of the loan amount per annum. The overall cost of the this debt structure is generally less than the blended cost of a two-stop senior and mezzanine structure due to the mitigation of risk to the lender by being the sole lender to the Company. Most middle market unitranche loans are priced between Libor plus 600 basis points and Libor plus 900 basis points. As the sole supplier of capital, the lender has more control, which reduces the riskiness of the loan and allows them to offer slightly lower pricing than a blended senior-mezzanine structure.
Tip #11 – Unitranche is a blend of senior and mezzanine debt in one integrated loan structure.
Unitranche is popular due to the ease of dealing with one lender. Deals with more than one lender have more complexity due to the need for lenders to reach agreement on intercreditor issues. When you have one lender, you are able to get through the due diligence and closing process more rapidly. Closing is streamlined and future drawdowns for add on acquisitions is also simplified. Despite the advantages in pricing and closing, Unitranche loans are selective as to level of Company EBITDA. Generally, Unitranche providers will consider companies as long as they have greater than $4 million in EBITDA. One downside to dealing with a Unitranche lender is that they have more leverage over a borrower. If a company is underperforming and busting covenants, it is safer to have a senior lender and a mezzanine lender than a single unitranche lender. In a difficult time, the senior lender has the ability to shut off the mezzanine interest payments and force the mezzanine lender to standstill. In the same situation, there is no such protective measure with a unitranche provider.
What is the Optimum Acquisition Financing Structure?
Determination of the best structure for your deal is more of an art than a science. It depends on a number of objective factors and unknowable subjective, factors. If the acquisition price is low then a structure with more senior and less mezzanine debt will work. If the acquisition price is high relative to the asset base, then a structure with more mezzanine and less senior will work better. Similarly, the risk of integrating the acquired company into your business is important to note. If the risk of integration is high, then use more mezzanine debt in the structure. If low, then you can use more senior debt. Careful consideration should be given to how much capital and time is needed to make the acquisition a long term success. This should be analyzed in detail pre closing but ultimately, this is but a subjective estimate that is not entirely knowable upfront. All acquisitions have key operational steps that need to be implemented post-closing. If you need more capital and time to transform the acquisition into a market leading company, then your structure should skew towards a blend of more mezzanine debt and equity and less senior debt. This will give you more time to perform and cash to invest in getting the business going in the successful direction. Finally, all smart acquirers build optionality into their plans so that if things cost more or take longer, they will live to fight another day. It is advisable to create a capital buffer as part of your acquisition financing structure to give you insurance in case things go awry. Ultimately, it is having access to the right amount of capital that will determine the success or failure of your deal. So be sure to structure your acquisition financing wisely.