The Imperfection of Loan to Value Ratios in Acquisition Financing

Posted on: July 25th, 2023

acquisition-financing

Loan to value ratios are a key statistic used by acquisition financing providers when establishing debt capacity in each deal. This ratio measures the amount of the acquisition financing loan relative to the total transaction value. In a buyout, the LTV denominator is the purchase price. In market good times, the LTV percentage gradually increases which enables equity providers to minimize cash invested. LTV ratios are highly dependent on the valuation variable. LTV ratio math has evolved from the larger ticket leveraged lending and BDC market.

It is an important metric to use when structuring your deal but does not tell the full story, especially with deals at favorable purchase prices. When a purchase price is lower than market value, the loan to value approach often does not recognize the intrinsic value of this purchase price discount. For example, if a company is being acquired at $10 million and it is worth $12 million, most acquisition financing lenders will still use the same LTV ratio on the lower purchase price. A lender who would make an $8 million acquisition financing loan (66% LTV) off a $12 million valuation, will only make a $6.6 million acquisition financing loan (66% LTV) off a $10 million valuation for the exact same company. Despite the company and EBITDA being the same in both cases, the lower valuation works against a buyer due to the rigidity of LTV application.

Fortunately, in bullish markets, acquisition financing lenders will entertain the notion of a purchase price discount and lean more on a leverage ratio as their primary structuring metric to make a deal work. In bearish markets, they hide behind the LTV as a reason not to move forward even though the leverage ratio and debt service coverages are strong. This tendency makes it harder for independent sponsors to find workable acquisition financing solutions. It underscores the need for a sponsor to bring a healthy sum of equity capital and to take advantage of seller notes and earn-outs when structuring the deal at the front end.

As new acquisition financing credit funds pivot to non-private equity sponsored deals, many lack experience with the asset class. Non-sponsored deals such as direct loans to companies or loans to independent sponsors making acquisitions are quite different from private equity backed deals and require a different thought process and engagement style from the lender.

During their underwriting processes, acquisition financing providers analyze probable performance projections for their proposed borrowers. The underwriter often toggles between a few scenarios to sensitize the growth variables leading to slower revenue and margin growth over time. The lender’s underwriting view is usually an extension of its credit intelligence and historical experience.

Mezzanine debt loans occupy the risky echelon beneath the bank but ahead of the equity in a capital structure. They are naturally subordinated to the bank loan via an intercreditor agreement wherein the senior lender retains the power to block their interest or force them to standstill.