Posted on: April 18th, 2022
Lending, especially acquisition financing, is an inexact science, combining objective and subjective principles. Many banks and larger funds try to standardize their decisioning so that it can be centrally controlled. This results in a quantitative approach to underwriting, resulting in lenders playing the role of data gathers and model inputters. Much subjective evaluation is crowded out in this approach, leading to acquisition financing lending decisions determined by a risk rating model.
For low-risk lending, this may work well but for higher risk, middle market deals, the tyranny of the risk rating model often leads to subpar outcomes for both lenders and borrower alike. Risk ratings, quite simply, do not tell the whole story. They do not adequately factor in the quality of the acquisition financing sponsor. Strong sponsors have business growth backgrounds that augurs well for success in their new deal. Through their prior successes, sponsors develop high level insight and superior judgment, and have a certain “it factor” about their ability to make things happen.
These special entrepreneurs have great energy and inevitability about their vision. This can be sensed by acquisition financing lenders on the front lines, but often does not weigh heavily on the lender’s final decision. Risk ratings also do not adequately factor in the sponsor’s ability to mobilize resources to manage the business transformation. Experienced sponsors have teams of talented people and business relationships they bring to their newly acquired companies. Acquisition financing lenders often do not spend enough time understanding how transformative these added resources can be.
Finally, acquisition financing risk ratings often fail to appreciate the subtleties of the buyer and seller relationship. The default lender position is that the seller is exiting to the highest bidder and that the seller does not care about the company after the closing. This is misguided thinking as sellers, especially owner operators, care deeply about who the buyer is as they have loyalty to their employees. Most owner operators want to make sure the new buyer will not overly change the business and continue to employee their trusted employees. While the price the buyer is paying is important, it does not tell the whole story as to why the seller has selected the buyer. This perspective, while valuable to a lending decision, is often overlooked by lenders in their zeal to quantify as opposed to contextualize information.