Acquisition Financing Explained – A Navigational Guide

Acquisition financing is capital used by any type of middle market buyer to acquire another business. Acquisition financing supports all forms of deal types and strategic growth scenarios. The most common acquisition financing deals are founder-owned companies and independent sponsors buying a company. These buyers need access to a large lender universe and a clear financing roadmap to navigate the lender process. Acquisition financing is not provided by banks but by private lenders including mezzanine debt lenders, private credit funds and business development corporations. These funds are positioned in the market according to deal sizes, deal types and industry focus which makes it tough to connect with. Acquisition financing is not a commodity loan, but a specialized loan structured to the specific requirements of the buyer. It is always tailored to the unique needs of the buyer and the company’s growth plan. Once structured properly, it will provide continuous funding support to a company’s acquisition program. Companies use acquisition financing in pursuit a number of corporate growth strategies. These include regional expansion, vertical integration, product innovation and sales channel entry. Acquisition financing is a big difference maker for fast growth companies enabling market leadership and rapid ascent in valuation gains.

The Importance of Acquisition Financing

Acquisition financing unleashes strategic growth for a company. This type of fast growth cannot be achieved solely through organic growth without the boost of an acquisition. Companies grow faster and more soundly through the power of acquisition financing. The following are the different strategies inherent to a sensible acquisition.

1. Business Scale-Up: With acquisition financing, companies can increase their operational capacity and market footprint in a significant way. This provides operational muscle and regional diversification to the business model.
2. Product Innovation: Acquisitions enable product line expansion and new product innovation. Purchasing a complementary company allows for creation of new product offerings and the ability to drive more spend from the existing customer base.
3. Distribution Channel: Acquisitions of companies enable a company to expand their customer base and strengthen their market position. Acquisition of customer channels allows for more product sell through and higher gross margins.
4. Capacity Expansion: Acquisitions expand a company’s resource base including the size of its facility, workforce, supply chain and information systems. It allows for transformative and efficient scale up of systems to handle business growth and volume increases.

Different Forms of Acquisition Financing

Cash Flow Based Loans

These loans are built through a multiple of adjusted EBITDA. The loan amount is usually much higher than the collateral in the business. These loans come from many different capital providers. They have long terms and flexible advancing structures. Cash flow based loans are the life blood of acquisition financing in the middle market.

• Commercial and Industrial Term Loans: Loans predetermined repayment schedules, based on fixed charge coverage and leverage ratios. Commercial and Industrial loans are usually provided by banks based on their confidence in the cash flow of the business.
• Mezzanine Debt Loans: Long term loans that require only interest payments over the term with all principal due in a balloon payment. These loans fund acquisitions or other growth strategy that will result in a major boost in business size and profitability.
• Unitranche Loans: Long term loans that blend a senior loan and a mezzanine loan together. They have minimal principal requirements, and their interest rate is lower than a mezzanine debt loan but higher than a bank loan.

Advantages:

• No shareholder dilution.
• Customized structure to fund today and into the future.
• Loan pricing is low relative to raising equity.
• Most cash flow loans do not require a personal guarantee.

Disadvantages:

• Adding leverage to the balance sheet creates fixed debt service obligations.
• Lender has restrictions on discretionary owner distributions.
• Lender requires covenants to ensure business is performing.

Structured Equity Financing

Structured equity financing involves raising capital through issuance of preferred stock which is similar to a loan but has higher returns and fixed return payment obligations. It is used in tandem with cash flow-based loans in a transaction structure.

Advantages:

• There is no current interest paid.
• A fixed dividend accrues on a cash-less basis.
• There is a fixed return payable upon redemption of the preferred stock. This caps their return.
• There is no share dilution.

Disadvantages:

• The return paid at redemption is contractually owed and is not dependent on the growth or value of the business at the time of redemption.
• The preferred stock redemption likely causes a refinancing event.

Mezzanine Debt Financing

Mezzanine debt is part debt and part equity in its make-up. It is a great equity substitute for founder-owned companies that need acquisition capital but do not want to take private equity investment. Most acquisition financing can be supplied 100% with mezzanine debt as long as the founder has solid equity value in the business. It is a superior route than private equity which is intrusive and hard to deal with. Mezzanine debt lenders are pragmatic, passive and patient.

Advantages:

• Substitute equity for debt.
• No personal guarantee
• Greater loan amount than a bank loan.
• Patient long term capital.

Disadvantages:

• Higher interest rate.
• Reporting requirements.
• Covenanted performance,

Best Use Cases:

• Funding of acquisition roll-ups.
• Funding strategic and one-off complementary acquisitions
• Funding growth strategies
• Funding dividends to owners.
• Refinancing non-cooperative lenders.
• Rebuilding balance sheet after chronic period of losses.

Bespoke Financing Structures

Most deals are structured with a combination of different layers of capital which include bank debt, mezzanine debt, unitranche debt, structured equity and preferred equity. The final blend of layers depends on the size of the financing, its credit profile and the risk tolerance of the buyer.

Choosing the Best Type of Capital Structure

Selecting the optimal financing structure is important to deal success. Companies must consider:

• Amount of Acquisition Financing – how much is needed for the acquisition, growth and working capital.
• Level of Integration Risk and Projected Performance – how stable is projected performance.
• Ownership Risk Tolerance – debt brings high reward yet financial risk.
•  Future Capital Need – what is ongoing capital need given the strategic plan.

Comparison Table

Steps to Secure Acquisition Financing

1. Define Acquisition Goals – Why are we buying this company? How does it help us reach our long-term goals?
2. Assemble a Team of Acquisition Professionals – Bring in an acquisition financing advisor as the team leader and create a working team.
3. Learn the Fundamentals – spend time understanding the different loans available, the loan process and the lender terms and requirements. How will this change the way you currently run the business.
4. Create the Perfect Loan Structure – ensure the loan you are asking for reflects the acquisition as well as additional growth capital needs.
5. Prepare High Quality Materials for Initial Presentation to Lenders – invest in developing a strong confidential memorandum and financial projection model. Identify any weaknesses your business model may have.
6. Approach the Lender Market with Strength – create a process to contact at least 40 lenders who are suitable for your particular type of deal.
7. Screen and evaluate the lenders – make sure to interview and ask tough questions of the lenders to scenario-plan a future lender relationship. Select the lender you feel most comfortable with.
   • Discuss interest rates, fees, and collateral terms.
   • Set up repayment schedules and contingencies.
8. Manage the Financial Due Diligence Process – ensure your financial statements are easy to review by the lender’s accountant. Present the operational side of the business to the lender.
9. Secure Investment Committee Approval – the lender will receive clearance from their Investment Committee once they have completed and presented their due diligence findings.
10. Legal Closing:

Frequently Encountered Issues when Closing an Acquisition Financing

• Financial diligence takes too long. Solution: Bring in an accounting before you approach the lender to organize and remediate.
• Financing Process takes too long. Solution: Bring in an acquisition lender who can move fast and ensure you have enough time to close the acquisition in your letter of intent.
• The deal needs more capital than planned for. Solution: Overestimate your budgeted capital need on the front end.
• Financial Performance goes soft during diligence Solution: Communicate immediately to the lender and explain positive business trends in the underlying business.
• It takes longer to integrate post-closing: Solution: Plan integration before the deal closes and line up dedicated resources.
• Negative Diligence Findings. Solution: Conduct a thorough self-assessment early on in the process to find any possible weaknesses. Nip any negative finding in the bud and explain your plan to get past it.

In-Depth Case Studies

Case Study 1: A Tech Platform Company Acquires a competitor.

Techco, a revenue cycle management company, acquired a competitor through a combination of mezzanine debt financing and a seller earn-out. Due to the favorable purchase price of 4 times EBITDA total paid with 3 times EBITDA paid at closing, the buyer was able to mezzanine finance the deal leading to adding $8 million in revenue growth and $1.5 million in EBITDA growth to the platform.

Case Study 2: Family business raises financing to fund acquisition growth.

A Family-owned business expanded market share in their industry through selected add on acquisitions in adjacent regional areas to their main service area. Bank financing and seller notes were used to fund the acquisitions which were successfully integrated. The Company increased gross margin and EBITDA post-acquisition due to their reduction of overlapping cost structure.

Case Study 3: Management Buyout

The management team uses their small 15% stake in the company and raises mezzanine financing to acquire the remaining 85% through mezzanine debt financing. They buy the owner out and then are able to implement their own growth plan and increase revenue 20% over the historical growth rate.

Partnering with Financial Advisors

Advisors are needed on your team to bring market and deal doing expertise. They bring the following valuable skills:

• Consulting Advice – help you see your company objectively.
• Financing Expertise – provide views on best way to finance the deal.
• Loan Structure Expertise – create a loan structure that suits short and long-term capital needs.
• Future Capital Insight – create a pathway to future funding with the lender.
• Lender Relationships – bring wide number of lenders to your deal.
• Deal Advice: assist in valuation negotiations and seller hot button issues.
• Process Tips – remove timing bottlenecks to achieve a quick close.
• Transaction Support: become a part of your team and assist with the diligence blocking and tackling,
• Capital Allocation Advice – provide views to help decide best use for acquisition capital.

FAQs

Conclusion

Acquisition financing is the lifeblood of fast growth companies in today’s exciting economy.  It enables you to grow in a bold manner and scale up at a faster pace. There is a large and diverse acquisition financing lending market to tap into. The key is having expertise on your side to craft the best loan structure and find the right lender. While the landscape may seem complex, with the right planning, connections and expertise, businesses of all sizes can leverage acquisition financing to achieve exceptional outcomes.