Financing Acquisitions Meaning
Financing an acquisition is the process in which a company that plans to buy another company tries to get funding via debt, equity, preferred equity or one of the many alternative methods available. It 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.
How to Finance a Business Acquisition?
There are many ways in which you can finance business acquisition. Popular methodologies are listed below.
- #1 – Cash transaction
- #2 – Stock Swaps
- #3 – Debt financing
- #4 – Mezzanine Debt/ Quasi Debt
- #5 – Equity investmentEquity InvestmentEquity investment is the amount pooled in by the investors in the shares of the companies listed on the stock exchange for trading. The shareholders make gain from such holdings in the form of returns or increase in stock value.
- #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 business 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 the case of an all-cash deal, the equity portion of the parent company’s balance sheet is unchanged. This kind of transaction mostly occurs 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 transactions was that once the acquirer pays cash to the seller, it automatically acquirers all risks of the company. However, in a share exchange, the risks are shared in the proportion of ownership in the new and combined entity. Though the proportion of cash transactions 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. It is an all-cash deal 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 history.
#2 – Stock Swaps
For companies whose stock is publicly traded, one very common method is to exchange the acquirer’s stock for that of Target Company. For private companies, it is a sensible option when the owner of 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 the share swapShare SwapA share swap occurs when one equity-based asset is exchanged for another equity-based asset. This is common in acquisitions and mergers. When a share swap is initiated, the share values of both companies are accurately priced to determine the fair swap ratio. is a valuable tool.
Appropriate valuation of the stock is of utmost importance in case of a stock swap for private companies. Experienced merchant bankersMerchant BankersMerchant Bank is a company that provides services like fundraising activities like IPOs, FPOs, loans, underwriting. They only deal with companies and businesses. follow certain methodologies to value the stocks such as:
#3 – Debt Financing
One of the most preferred ways of financing 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 the acquisition, scrutinizes the projected cash flow of the target company, their liabilities, and their profit marginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. . 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 Asset-backed financing, where banks lend finance based on the collaterals of the target company on offer. These collaterals refer to fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples., inventory, intellectual property, and receivables.
Debt is one of the most sought after forms of financing acquisitions due to the lower cost of capital than equity. Plus, it also offers tax advantagesTax AdvantagesTax Advantage are the types of investments or saving plans that benefit tax exemption, deferred tax, and other tax benefits. Examples include Government bonds, Annuities, Retirement Plans. . These debts 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 a 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 is typically 8% to 12 % fixed/floating.
#4 – Mezzanine Debt/ Quasi Debt
Mezzanine financingMezzanine FinancingMezzanine financing is a type of financing that combines the characteristics of debt and equity financing by granting lenders the right to convert their loan into equity in the event of a default (only after other senior debts are paid off). 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 a 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%. It 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 the same goes for 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 a larger amount of equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.. Also, this form of financing allows more flexibility because there is no commitment to periodic scheduled payments.
One of the crucial features of financing acquisitions with equity is the relinquishment of ownership. The equity investorsEquity InvestorsAn equity investor is that person or entity who contributes a certain sum to public or private companies for a specific period to obtain financial gains in the form of capital appreciation, dividend payouts, stock value appraisal, etc. 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 these methods is seller note, where the seller loans money to the buyer to finance acquisitions, wherein the latter pays a 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 certainly 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 that 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. It 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 flowsOperating Cash FlowsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.. 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 strong and consistent cash flow with minimal capital requirements. The 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!
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Now that we have certain learning about LBOs let us figure out a little about its background. It 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 by 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 the growing participation of private equity firms that secured funds from institutional investors. High-yield junk bond financing gave way to syndicated leveraged loansLeveraged LoansLeveraged loans are loans that have a high risk of default in repayment since they are offered to firms or individuals that already have considerable levels of debt and may have a poor history or credit as a result of which such loans have a high rate of interest. 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. It is mainly to prevent the siphoning off of the cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. 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 becomes more exposed to downturns in the economic cycle.
KKR bought TXU Corp. for $45 billion in 2007. It was touted as one of the largest LBOs in history, but by 2013 the company filed for bankruptcy protection. The latter was burdened with more than $40 billion for debt, and unfavorable industry conditions 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-thirds of it financed by debt. Will the newly formed entity produce enough cash flows to service the massive 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 are more suitable for companies that are mature with stable cash flows and aren’t in a requirement for any substantial capital expenditure. Companies that are eyeing rapid growth require a massive 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.