Financing Acquisitions | Cash | Debt | Equity | LBO | Swaps – Major decisions in our life hinge on financial resources, isn’t it? Acquiring another company is one such decision in the life cycle of an organization. A major decision such as this would not come into fruition without sound financial resources to back it.
Financing Acquisitions is a complex task and requires sound planning. What makes it complex is the fact that unlike other purchases, the financing structure of M&A can have plenty of permutations and combinations.
In this article, discuss various options the target companies have to finance the acquisition.
- Optimal Financing Terms for Acquisition
- Financing the Acquisition
- Flexibility & Suitability is the name of the game
Optimal Financing Terms for Acquisition
Acquiring capital and the optimal financing terms for acquisitions is surely a tricky task. The challenge is to secure the right financing mix with the least cost of capital. The sub-prime lending crisis in the past and prolonged sluggishness in the global economy in the past couple of years has led to significant alterations in our financial system and the way people perceive risk.
There are various modes of financing acquisitions. The target company can be paid cash or shares can be exchanged in consideration. While there are also many forms which entail the use of debt, equity and other blended financing techniques to finance an acquisition. The goal of acquisition finance is on structuring the most optimal financing solution for a company. This can be achieved only when the cost and adaptability of the financing structure is based on the company’s cash-flow generating capacity and inherent strength of its asset base.
Pre-requisites of an optimal acquisitions financing structure:
Before we proceed to understand the optimal financing structure for the acquisition, let us take a look at certain pre-requisites for its formulation.
- The current and potential valuation of the acquisition target.
- Assessment of the projected performance of the target against the acquirer’s determined benchmark.
- Proper risk profiling of shareholders on both sides.
- Access to financing channels and establishing strong ties with them.
- Focus to remain on value creation and growth maximization
Financing the Acquisition
There are many ways in which you can finance the acquisition. Popular methodologies are listed below.
- #1 – Cash transaction
- #2 – Stock Swaps
- #3 – Debt financing
- #4 – Mezzanine Debt/ Quasi Debt
- #5 – Equity investment
- #6 – Vendor Take-Back Loan (VTB) or Seller’s financing
- #7 – Leveraged Buyout: A unique mix of debt and equity
Please note in large acquisitions, financing the acquisition can be a combination of two or more methods.
#1 – Cash transaction
In an all-cash deal, the transaction is simple. Shares are exchanged for cash. In case of an all-cash deal, the equity portion of the parent company’s balance sheet is unchanged. This kind of transaction mostly takes place when the acquiring company is much larger than the target company and it has substantial cash reserves.
In the late 80s, most of the large M&A deals were paid entirely in cash. Stock accounted for less than 2%. But after a decade, the trend totally reversed. More than 50% of the value of all large deals were paid for entirely in stock, while cash transactions were cut down to only 15% to 17%.
This shift was quite a tectonic one as it altered the roles of the parties concerned. In a cash deal, the roles of the two parties were clearly defined, and the barter of money for shares depicted a simple transfer of ownership. The main tenet of all cash transaction was that once the acquire pays cash to seller it automatically acquirers all risks of the company. However, in share exchange, the risks are shared in the proportion of ownership in the new and combined entity. Though the proportion of cash transaction has reduced drastically, it hasn’t become redundant altogether. For instance, a very recent announcement by Google to cloud software company, Apigee in a deal valued at about $625 million. This is an all cash deals with $17.40 being paid for each share.
In another instance, Bayer has planned to acquire US seeds firm Monsanto in a $128 a share deal which is being touted as the largest cash deal in the history.
#2 – Stock Swaps
For companies whose stock is publicly traded, one very common method is to exchange acquirer’s stock for that of Target Company. For private companies, it is a sensible option when the owner of the Target would like to retain some stake in the combined entity. If the owner of Target Company is involved in the active management of operations and the success of the company depends on his or her proficiency, then stock swap is a valuable tool.
Appropriate valuation of stock is of utmost importance in case of stock swap for private companies. Experienced merchant bankers follow certain methodologies to value the stocks such as:
- 1) Comparable Company Analysis
- 2) Comparable Transaction Valuation Analysis
- 3) Discounted Cash Flow Valuation Analysis
#3 – Debt financing
One of the most preferred way of financing the acquisitions is debt financing. Paying out of cash isn’t the forte of many companies or it is something that their balance sheets don’t permit. It is also said that debt is the cheapest method of financing an M&A bid and has many forms of it.
Usually, the bank while disbursing funds for acquisition scrutinizes the projected cash flow of the target company, their liabilities, and their profit margins. Thus as a pre-requisite, the financial health of both the companies, the Target as well as the acquirer is thoroughly analyzed.
Another method of financing is the Asset-backed financing where banks lend finance based on the collaterals of the target company on offer. These collaterals refer to fixed assets, inventory, intellectual property and receivables.
Debt is one of the most sought after forms of financing acquisitions due to lower cost of capital than equity. Plus it also offers tax advantages. These debt are mostly Senior debt or Revolver debt, comes with a low interest rate and the quantum is more regulated. The rate of return is typically 4%-8% fixed/ floating coupon. There is also subordinated debt, where lenders are aggressive in the amount of loan disbursed but they do charge a higher rate of interest. Sometimes there is also an equity component involved. The coupon rate for these are typically 8% to 12 % fixed/floating.
#4 – Mezzanine Debt/ Quasi Debt
Mezzanine financing is an amalgamated form of capital with characteristics of both debt and equity. It is similar to subordinate debt in nature but comes with an option of conversion to equity. Target companies with strong balance sheet and consistent profitability are best suited for mezzanine financing. These companies do not have a strong asset base but boast of consistent cash flows though. Mezzanine debt or quasi debt carries a fixed coupon in the range of 12% to 15%. This is slightly higher than the subordinate debt.
The appeal of Mezzanine financing lies in its flexibility. It is a long-term capital that has the potential to spur corporate growth and value creation.
#5 – Equity investment
We know that the most expensive form of capital is equity and same goes in the case of acquisition financing too. Equity comes at a premium because it carries maximum risk. The high cost is actually the risk premium. The riskiness arises out of having no claim to the company’s assets.
Acquirers who target companies operating in volatile industries and have unstable free cash flows usually opt for larger amount of Equity financing. Also, this form of financing allows more flexibility because there is no commitment for periodic scheduled payments.
One of the important features of financing acquisitions with equity is relinquishment of ownership. The equity investors can be corporations, venture capitalists, private equity etc. These investors assume some amount of ownership or representation in the Board of Directors.
#6 – Vendor Take-Back Loan (VTB) or Seller’s financing
Not all sources of financing are external. Sometimes acquirer seeks financing from the target firms as well. The buyer typically resorts to this when he faces difficulty in obtaining outside capital. Some of the ways of seller financing are note, earn-outs, delayed payments, consulting agreement etc. One of this method is seller note where the seller loans money to the buyer to finance acquisitions, wherein the latter pays certain portion of the transaction at a later date.
Read more about Vendor take back loan here.
#7 – Leveraged Buyout: A unique mix of debt and equity
We have understood the features of debt and equity investments, but there are certain other forms of structuring the deal. One of the most popular forms of M&A is Leveraged Buyout. Technically defined, LBO is a purchase of a public/ private company or the assets of a company which is financed by a mix of debt and equity.
Leveraged buyouts are quite similar to usual M&A deals, however, in the latter there is an assumption that the buyer offloads the target in the future. More or less this is another form of a hostile takeover. This is a way of bringing inefficient organizations back on track and re-calibrate the position of management and stakeholders.
The debt equity ratio is more than 1.0x in these situations. The debt component is 50-80% in these cases. Both the assets of the Acquirer and Target Company are treated as secured collaterals in this type of business deal.
The companies involved in these transactions are typically mature and generating consistent operating cash flows. According to Jennifer Lindsey in her book The Entrepreneur’s Guide to Capital, the best fit for a successful LBO will be the one in growth stage of industry life cycle, have formidable asset base as collateral for huge loans, and feature crème-de-la-crème in management.
Now having a strong asset base doesn’t mean that cash flows can take a back seat. It is imperative that the target company has a strong and consistent cash flow with minimal capital requirements. Low capital requirement stems from the condition that the resultant debt must be repaid quickly.
Some of the other factors accentuating the prospects for a successful LBO are a dominant market position and a robust customer base. So it’s not just about financials you see!
Read more on LBO –
Now that we have a certain learning about LBOs, let us figure out a little about its background. This will help us to understand how it came into being and how relevant is it today.
LBOs soared during the late 1980s amid the junk-bond-finance frenzy. Most of these buyouts were financed the high-yield bond market and the debt was mostly speculative in nature. By the end of 1980, the junk bond market collapsed, excessive speculation cooled off and the LBOs lost steam. What followed by tighter regulatory mechanism, stringent capital requirement rules, due to which commercial banks lost interest in financing the deals.
The volume of LBO deals resurged in the mid-2000s due to growing participation of private equity firms that secured funds from institutional investors. High-yield junk bond financing gave way to syndicated leveraged loans as the main source of financing.
The core idea behind LBOs is to compel organizations to produce a steady stream of free cash flows to finance the debt taken for their acquisition. This is mainly to prevent the siphoning off of the cash flows to other unprofitable ventures.
The table below illustrates that over the last three decades the buyout targets generated greater free cash flow and incurred lower capital expenditure as compared to their non-LBO counterparts.
Pros and cons are two sides of the same coin and both co-exist. So LBOs also come with their share of drawbacks. The heavy debt burden heightens the default risks for buyout targets and become more exposed to downturns in economic cycle.
KKR bought TXU Corp. for $45 billion in 2007. This was touted as one of the largest LBOs in the history, but by 2013 the company filed for bankruptcy protection. The latter was burdened with more than $40 billion for debt and unfavorable industry condition for the US utility sector made things worse. One event led to the other and eventually and quite unfortunately, of course, TXU Corp. filed for bankruptcy.
But does that mean LBOs have been black-listed by US corporates? “No”. The Dell-EMC deal that closed in September 2016 is a clear enough indication that Leveraged buyouts are back. The deal is worth about $60 billion with two-third of it financed by debt. Will the newly formed entity produce enough cash flows to service the huge debt pile and wade its way through the complexities of the deal is something to be seen.
Flexibility & Suitability is the name of the game
Financing for acquisitions can be procured in various forms, but what matters most is how optimal it is and how well-aligned it is with the nature and larger goals of the deal. Designing the financing structure according to the suitability of the situation matters most. Also, the capital structure should be flexible enough to be changed according to the situation.
Debt is undoubtedly cheaper than equity, but the interest requirements can curtail a company’s flexibility. Large amounts of debt is more suitable for companies which are mature with stable cash flows and aren’t in requirement for any substantial capital expenditure. Companies that are eyeing rapid growth, require huge quantum of capital for growth, and compete in volatile markets are more appropriate candidates for equity capital. While debt and equity share the largest pie, there are other forms also which find their existence due to the uniqueness of each deal.