Source used – Book: Bedrijf te koop – Handboek voor koop, verkoop en buyout van bedrijven. Arthur Goedkoop & Ad Veken. Publisher: Business Contact. March 2011.
Financing an M&A transaction: Introduction
This blog is an introduction on how to finance acquisitions. Acquisitions are financed with different financial instruments and different financing structures.
Concerning the financing of companies there are actually only two types of financing:
1. Uncommitted financing;
2. Committed financing.
Uncommitted financing can be seen as a revolving credit facility (“revolver”) or financing of working capital. In theory, this type of financing can be cancelled by the bank every day. And committed financing is there for a fixed pre-determined period of time.
(Goedkoop & Veken, 2011)
Types of financing
In large acquisitions, multiple types of financing are used, ranging from senior debt to junior debt.
Senior debt
Financing forms with the best secured positions are called “senior debt”. The instruments are usually issued by banks.
“Second lien” is a relatively new product and is less used in The Netherlands (where I am from and based). Concerning the level of security, issuers of second lien instruments are lower in ranking than senior debt issuers. Second lien instruments are issued by banks and institutional investors.
Junior debt
Junior debt, or subordinated debt, are loans with the least level of security. A form of junior debt that is used a lot is “mezzanine financing”. Concerning the level of security, it lies in between senior debt and equity, because mezzanine means “in the middle”.
Another form of financing is PIK loans (“payment in kind”). Withing these types of loans interest is not paid in cash but added to the face value of the loan, and paid in the end.
(Goedkoop & Veken, 2011)
Buying assets or shares
When you buy the assets/liabilities of a company, the goodwill that is paid can be amortized by the buyer. And the results of the target and the buyer are automatically consolidated. The costs (consultants) of the acquisition are in general deductible for tax, direct or on the longer term. Because of the amortization of goodwill by the buyer, the “book profit” (goodwill for the buyer) is taxed for the seller. So it could be the case that the price of an acquisition is higher with an asset/liabilities deal. This is because of the tax payment of the seller on the profits made on the book value of the assets. With a share deal, goodwill can not be amortized for tax purposes by the buyer. And the costs (consultants) of the takeover are not deductible for tax purposes either.
(Goedkoop & Veken, 2011)
Private equity vs. a strategic buyer
In the case of a strategic buyer, the bank will not only look at the possibilities to finance the target. They will then obviously also look at the financing capacity and structure of the buyer. Corporate finance consultant (or investment bankers) assess this by building a so called “M&A model” in excel. And when a corporate finance consultant (or investment banker) assesses the possibilities for a financial investor to finance a deal, they build a so called “LBO model” in excel. These financial investors, also called financial sponsors (private equity), are used to do deals with high levels of debt. This can be compared with strategic parties who are in general more reluctant for this.
When a company takes on high levels of debt, it has a big influence on how to run the company afterward. The large levels of interest and principal that need to be paid require a very careful monitoring of the returns and liquidity of a company. This is why strategic parties are often more reluctant than private equity parties to take on very high levels of debt (even when this increases the return on equity a lot, the good old “leverage”). And private equity parties are far less reluctant with this because they are (relatively) masters in this game.
Buyout structure & debt pushdown
In a typical buyout, when a private equity party buys a company, often a new company is set up. These are called “Newco” which stands for “new company”. This newco takes over the shares in the company (target) and often the management also gets shares in the newco.
With respect to the structuring of the financing of the acquisition, we need to look at the newco and the operating company (this is the company bought). These “operating companies” are often called “opcos”. As you can imagine, a bank prefers to finance a takeover at the opco level, because these opcos actually possess the assets for production, accounts receivables, inventories and other assets. In other words, the money is, and is made, in the opcos! So in case of bankruptcy, the bank can sell the assets of the opcos in order to make (some of) their money back.
Because banks want to finance the money in the opcos, in most buyouts a “debt push down” is used. This means that a part of the financing needed in the newco (to pay for the acquisition) is pushed down to the opcos. And then from here, the money is paid back up to the newco through a dividend pay-out (in order to be able to pay for the acquisition).
When we look at the total financing needs in the newco, to pay for the acquisition, this consists out of three components:
- The price for the shares (market value of equity of the target);
- The level of the debt that needs to be re-financed (this is together with the equity value the: enterprise value);
- Transaction costs (e.g., investment bankers, corporate finance consultants, credit bank, lawyers, tax lawyers, accountants, etc.).
This financing need is then further spread over the newco and opco(s). You can study my former blogs on the “M&A model” and “LBO model” to get familiar with how this is technically modeled in excel.
(Goedkoop & Veken, 2011)
Covenants
When a bank issues “committed financing”, as discussed above, then they can not call back the debt whenever they want. But the banks still want to be able to take control when for example financial performance gets bad. And for that “covenants” are taken up in the credit agreements. The credit agreements (LMAs) mention in this perspective covenants as “positive undertakings” and “negative undertakings”.
Positive undertakings are circumstances that the taker of the debt should live up to, like certain legal rules.
Negative undertakings are circumstances that the taker of the debt should prevent to happen, for example selling important assets of the company.
Example 1
Three of the most used financial ratio covenants with acquisition finance are:
Leverage ratio:
This ratio looks at the relation of debt over EBITDA, and this number needs to be smaller than a certain number set in the credit documentation. E.g., 6 times EBITDA with a US LBO, 5 times EBITDA with a UK LBO and about 3 to 3.5 times EBITDA with financing in The Netherlands where I live.
Interest coverage ratio:
This ratio tells how many times a company can pay the interest out of EBIT(DA).
Debt service capacity ratio (DSCR):
This ratio tells how many times a company can pay the interest + principle out of EBIT(DA).
Example 2
A few restriction-covenants that are used a lot are:
No further debt:
No additional (bank) financing can be attracted without the consent of the current issuing bank(s).
Negative pledge:
No security-rights of assets can be given to other third parties.
Positive pledge:
Security-rights of assets need to be given to the bank (the bank who issued current debt) when they request this, and when they do not have the security-rights yet.
Cross default:
Banks can call back the debt immediately when the company does not pay interest and/or principal or violates the covenants.
Dividend restriction:
No dividend can be paid out to the shareholders when the company for example did not achieve certain ratios yet.
(Goedkoop & Veken, 2011)
Independent M&A Consultant & Trainer
J.J.P. (Joris) Kersten, MSc BSc RAB
- 130 recommendations on his training can be found on https://www.joriskersten.nl/nl/reviews
- Many articles & blogs of Joris on “Business Valuation” & the “Cost of Capital” can be found on www.joriskersten.nl
J.J.P. (Joris) Kersten MSc BSc RAB (1980) is the owner of “Kersten Corporate Finance” in The Netherlands, under which he works as an independent consultant in Mergers & Acquisitions (M&A’s) of medium-sized companies.
Joris performs business valuations, prepares pitch books, searches and selects candidate buyers and/or sellers, organises financing for takeovers and negotiates M&A transactions in an LOI and later in a share purchase agreement (in cooperation with (tax) lawyers). Moreover, Joris is associated with ‘AMT Training London’ for which he provides training in Corporate Finance & Financial Modelling at leading (“bulge bracket”) investment banks in New York, London and Hong Kong. Joris is also associated with the ‘Leoron Institute Dubai’, for which he provides finance training at leading investment banks and institutions in the Arab States of the Gulf. For example, at Al Jazira Capital in Saudi Arabia and TAQA in Saudi Arabia.
In addition, Joris provides lecturing in Corporate Finance & Accounting at leading Universities like: Nyenrode University Breukelen, TIAS Business School Utrecht, the Maastricht School of Management (MSM), the Luxembourg School of Business and SP Jain School of Global Management in Sydney. Moreover, he provides lecturing at partner Universities of MSM in Peru, Surinam, Mongolia and Kuwait, and at partner Universities of SP Jain in Dubai, Mumbai and Singapore.
Joris graduated in MSc Strategic Management and BSc Business Studies, both from Tilburg University. In addition, he has (cum laude) graduated as “Registered Advisor Business Acquisitions” (RAB), a 1-year study in the legal and tax aspects of M&A’s. Joris obtained a degree in “didactic skills” (Basic Qualification Education) in order to lecture at Universities.
Currently, Joris is following the “Executive Master of Business Valuation” to obtain his title as “Registered Valuator” (RV) given out by the “Netherlands Institute for Registered Valuators” (NIRV). This title will enable Joris to give out business valuation judgments in for example court cases.
J.J.P. (Joris) Kersten, MSc BSc RAB. Email: joris@kerstencf.nl. Phone: +31 6 8364 0527
