Debt Financing of Acquisitions by Les Nemethy and Sergey Glekov

There are many reasons for using debt to finance an acquisition. Some buyers simply do not have enough cash. Others want to improve their return on equity by using low cost debt (see our earlier article “Optimizing Company Valuation via Cost of Capital”). Still other investors prefer to take advantage of tax write-offs permitted by deductibility of interest costs in most jurisdictions. Quantitative easing has also made debt cheap over the past decade, by historic standards. Debt financing may help avoid the need to raise equity financing, hence dilution of equity and control.

In most cases mid-sized companies have limited access to public capital markets (equity or bonds), hence there may not be that many alternatives to financing an acquisition by bank debt. The following table summarizes some of the basic types of bank debt to finance an acquisition. Exhibit 1: Types of Bank Debt Finance for Acquisitions1
Type Defined Characteristics Borrower Guarantor
Asset Based Financing Based on value, and liquidity of assets of the acquiror, target, or combination thereof. Asset-based loans differ from commercial term or revolving loans because of covenants and control focus on specified assets May be the acquiror or a Special Purpose Vehicle established by the buyer.  Assets of target may be securitized. Not a universal requirement
Cash Flow and Covenant Light Financing Based on credit quality of  borrower (and possibly guarantors), focused on cash flow available to service and repay the loan Access to such loans requires a robust and assured source of revenue and high credit quality  May be the acquiror or Special Purpose Vehicle established by the buyer. Assets of target may be securitized. Not necessarily required
Sponsor-Based Borrowing Based upon the strength of the proponent of the M&A transaction (e.g. sponsor), based upon its credit worthiness and covenants  Usually structured as a standard format term or revolving loan, or both, with a heavy requirement for sponsor support Can be the acquiror, as combined with the target or a co-borrowing relationship with the sponsor  The sponsor will always be required to provide a form of guarantee
Traditional Project Finance Project Finance may be defined as funding for the development of a specific project (where the enterprise might be deemed to be the project). Deals with the acquisition of a specific business enterprise usually in a single location with a single business purpose and with recourse limited to that “project” The borrower is the owner of the project to be acquired or constructed  May not involve a guarantee requirement because of project specific recourse
Structured Finance Finance where structuring is designed to alter liquidity and risk, or to transfer liquidity and risk aspects of the transaction to another entity, in a manner intended to provide increased liquidity to lenders and increased sources of funding to borrowers Includes such structuring techniques as the use of synthetic leases, lease-to- own, financing through structured funding vehicles Will generally be a Special Purpose Vehicle intended to isolate the transaction from possible operating loss and risks of the operating entity Will generally be the operating entity which is actually undertaking the business activity of interest, or its administrator

When an acquiror considers financing options, the potential to raise debt based on assets and cash flow of the target are usually taken into consideration, but the synergies between acquiror and target are sometimes neglected. Years ago, we were representing Hungarian Telephone and Cable Corporation (HTCC) in its acquisition of PanTel, a Central European data communications company, where we constructed a financial model that persuasively demonstrated synergies resulting from the acquisition in excess of EUR 20 million a year. This provided HTCC with the additional cash flow to service the additional acquisition financing, and calculating company valuation at 6x EBITDA, an additional EUR 120 million in valuation. (Care must be taken with synergy analysis, as synergies often prove to be a mirage).

In conclusion: debt financing is a flexible and relatively low-cost option for financing acquisitions, particularly in today’s competitive and liquid market environment. However, leverage is a significant risk which may contribute to or cause business failure, especially during recessions or financial crises. An acquiring firm’s financing decision should be strongly influenced by its debt capacity, existing leverage and target leverage ratio—in short, on shareholders’ appetite for risk versus reward. A balance must be struck.
1 Created by authors with data from M&A Trending Trends in Debt Financing by Alison Manzer

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