Posted on: June 10th, 2019

Avoid Funding Hole

Most acquisitions conform to traditional deal structures with a large equity component in the capital stack. Most buyers are required to invest upwards of 30% equity by the lender, to give their deal a more financeable structure.

Bank acquisition lenders will only stretch so far their loan amount. Often, even with a large equity commitment, there is still a gap between the available sources and uses of funds. This gap, or funding hole, is an impediment to closing and usually shows up late in the process when all parties have a closing date in sight. There are a number of ways to fill the hole midstream, yet the smart move is to eliminate it altogether from the deal process. Most buyers resign to putting in more equity or resort to using expensive transitional capital that they refinance after the closing.

These approaches do work, but they are expensive and not altogether the best long term solution. Deals need a debt structure that is built for the long term that provides both flexibility and capital optionality. Through rethinking your approach to debt capital, you can build a better structure, with more value that will fill whatever funding hole your deal runs into. Here are our 4 tips to avoiding a funding hole in funding you acquisition or growth:

Do a deep analysis of your debt capacity – there are several ways to measure your debt capacity and you need to understand the approaches and their benefits. An advisor can provide you market information to help guide your process.
Scrub your numbers and understand pro forma adjustments – Debt capacity analysis requires good clean numbers combined with an ability to translate business events into pro forma adjustments.
Learn your loan options – lenders come in all shapes and sizes. Some will lend off of cash flow and others off of assets. Some are good for a roll-up while others are better for a single acquisition.
Overfund your deal – buyers often underestimate the amount of capital needed to buy and grow the business. Make sure you extra capital on your balance sheet for a rainy day.

As the Fed decides to ease interest rates, middle market acquisition financing structures will benefit in a number of ways. The underlying values of middle market companies will increase leading to a higher enterprise value and lower loan to value ratios for existing portfolio companies of acquisition financing lenders.

The role of acquisition financing is infrequently elevated above a functional transactional one. When a business needs financing to acquire, they go to the market and source acquisition financing to supplement their equity investment to close the deal. Despite existing in many different forms, acquisition financing is rarely explained in terms of the value it brings to the acquirer.

Acquisition financing underwriting usually focuses on business and financial issues that underpin the stability of cash flow. Providers of acquisition financing usually validate the durability of a company’s competitive advantage and the depth of its resource base. Environmental issues are usually not a major part of the analysis in today’s service and technology-based economy.

4 Tips to Avoid a Funding Hole