Debt Capacity Analysis: The Foundation of Smart Acquisition Financing

First time users of acquisition financing often wade into the deep end with little focus on debt capacity. Debt capacity analysis is the foundation of all M&A and acquisition financing structures. There are several important principles of debt capacity that underpin how a smart acquisition financing provider will view your deal. Within each principle, there are objective and subjective factors which are used to design creative and market-leading structures. Financial performance measurement is a key determinant of debt capacity and is handled on a two-fold approach.

Most companies are measured on the historical trailing twelve-month approach. Contractual revenue companies with low historical attrition can present a run rate measurement convention. EBITDA, (earnings before interest, taxes, depreciation and amortization) whether TTM or run rate, is multiplied by a multiple considered appropriate for the unique risk profile of the acquisition financing. EBITDA should always be adjusted meaning it is not strictly actual EBITDA but presented as if certain financial charges during the year were extraordinary, one-time or non-recurring. There is no limit to the level of creativity used in calibrating adjustments though the higher the level of adjustments, the lower the overall quality of earnings. The more a lender has to rely on adjustments instead of hard, actual EBITDA, the less comfort they will have in the deal.

EBITDA should be presented on a combined basis including the results of the acquirer. Within a roll-up scenario with acquisitions of like-kind business, the acquirer gets the benefit of their existing cost structure overlaid on the roll-up target acquisition. The debt capacity is not an independent calculation but interrelates to the level of equity the owner has or will invest in the deal. Most acquisition financing lenders take their cue from private equity financings wherein they use a loan to value ratio. If the owner has significant equity in the existing company, and the loan amount conforms to a market-level multiple ratios, the lender will likely provide 100% acquisition financing. If the buyer has no rollover equity or cash to invest in, the acquisition financing lender will pass on the deal.

Finally, industry factors and deal type play an important role in setting the macro tone for lender debt capacity analysis. If the industry is low margin and highly competitive, the multiples will be much tighter. If all of the financing is used in an acquisition or investment, it will receive a more generous multiple. The key to creating a smart acquisition financing structure is to do your homework and master these basics before launch of the acquisition financing process.