The Wild Card with Acquisition Financing

Posted on: July 21st, 2023

In acquisition financing, most buyers automatically assume the target asset has enduring value and hence can support as much acquisition financing as needed. For buyers, their focus is on getting the deal closed as opposed to critically assessing the factors that underpin the asset value. This happens frequently in markets with frenzied roll-up activity where buyers hew to a valuation formula.

Acquisition attractiveness is measured as a discount to prevailing market multiples as opposed to properly focusing on the wild card factor of all acquisition financing transactions – future business performance. The deep seeded assumption of acquirers and lenders alike is that once the asset changes hands, performance will continue to chug along as historical growth rates. Frequently, once the sale occurs, performance trends diverge from historical levels for any number of reasons. The historical growth may have been unsustainable, marked demand may suddenly contract, or a key person or customer may depart.

Additionally, the pre-closing profitability may unintentionally overstate the true level of earnings. Acquisition financing is calibrated at a multiple of historical EBITDA so materially adverse business performance not only erodes EBITDA but leads to an overleveraged condition. As business performance crumbles, the trailing twelve-month EBITDA contracts leading to an ever-escalating leverage ratio, which ultimately leads to a covenant breach. When this happens, it takes a lot of work to turn things around, regain the historical performance trend and exit the covenant doghouse.

Rather than pursue acquisition financing superficially, buyers would be wise to question the roots of the company’s value more deeply. If a company has strong roots and underlying strength, then regardless of any short-term issues, the business performance will prevail. If the company lacks identifiable strengths, it is more susceptible to underperformance and will require significant resources, investment and time to turn around. The art of identifying future business performance is a hard one to master, but it pays enormous dividends to those that do.

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.