Understanding Acquisition Financing Structures

Acquisition financing structures are often thought of in a one size fits all manner. The dominant structures include a meaningful equity investment percentage in the range of 25% to 35% coupled with debt financing for the remaining percentage of 65% to 75%. While this is a perfectly fine structure, many independent buyers don’t have 35% of the purchase price as equity to invest, which makes this a non-starter. At the same time, lenders have evolved to become more risk tolerant and are able to provide debt securities that play virtually the same role as equity.

Benefits of Ideal Acquisition Financing Structures

As the range of debt offerings has expanded over the years, there are more structural approaches available to the buyer to design an optimal acquisition financing structure. These ideal acquisition financing structures solve for several constraints and provide a buyer with three important benefits – equity stretch, capital overfunding and financial balance. These benefits bring significant value to the buyer in both their purchase and scale-up of the acquired company.

Benefit #1 – Equity Stretch – This means you can put in a lower equity percentage and still end up owning 100% of the shares. Rather than take on an equity partner, you set up the deal with extra layers of debt capital, that qualify as equity.

Benefit #2 – Capital Overfunding – This means you can bring in more than just the capital needed to close. Overfunding your deal gives you growth capital and working capital, which is needed to spur faster growth and for unexpected expenditures.

Benefit #3 – Financial Balance – This means you are not excessively consumed with paying back the loan too quickly. You have extra liquidity and the ability to make long term investments to spur business growth.

Tips to Optimize your Acquisition Financing Structures

The key to these structures is understanding the how to create and layer different forms of debt into a cohesive package. This requires market intelligence, as you need to know the parameters of each debt layer and how they work together, to design a marketable acquisition financing structure. In general, the deeper and longer each loan layer will go, the more value it has for the acquisition financing structure, assuming the company can service the debt. If a senior lender is willing to lend up to 4 times EBITDA vs. Their traditional 3 times EBITDA, they are going to the mezzanine level of lending. When a mezzanine lender is willing to lend to 4.5 times EBITDA vs. Their traditional 4 times EBITDA, they are lending at the equity level. This type of multiple extension gives a buyer tremendous value, as you are getting more loan amount at a lower level of cost. The optimal acquisition financing structures capture these efficiencies. Here are three tips to optimize your acquisition financing structures.

Seller Notes Usage – Seller notes count as equity if their principal payments are significantly deferred, and they are subordinated to bank. When you are able to get a seller to hold 20% of the deal in a long term note, you are designing quasi-equity into your deal, allowing you to take credit for the seller note, as if it is part of your equity investment.
Unitranche Loan Usage – These loans are basically two loans rolled into one from two different lenders. They have an agreement between them as to how the loan payments and interest are allocated. Because both lenders are integrated in the same structure, they have the position as the only lender to the company, essentially a one-stop shop. This gives them more comfort than two separate lenders usually have and allow them to lend deeper, giving you more value.
Usage of Mezzanine Debt instead of Equity – Mezzanine lenders lend against the cash flow enterprise value of a company. If they feel strongly about a borrower, they can often go beyond their standard multiple, effectively lending into the equity layer. Mezzanine capital is extremely long term and principal payments are usually not due until the end of five years. Mezzanine lenders charge lower rates of return than equity investors. It is a powerful trade when you substitute mezzanine debt for equity capital as you ultimately end up with more ownership. Banks consider mezzanine debt as equity as it is subordinated to their loan, so you can count it as part of your equity investment.

In the acquisition financing arena, capital availability is destiny as companies require reliable access to capital to grow over the long term. Unforeseen capital needs usually arise when acquirers least expect it. This can cause some concern for the acquisition financing provider, especially when covenants tighten up and that working capital availability is utilized faster than expected.

Mezzanine debt borrowing is usually a straightforward activity that many companies use for funding of transitional growth. Mezzanine debt lenders are highly transparent about their due diligence approach and their post-closing loan management making it easy for companies to engage with.

Elections have consequences and positive ones at that for the acquisition financing middle market. While much media attention is paid to the direction of the yield curve and the Fed’s likely rate cuts, scant attention is paid to the more important drivers of the acquisition financing market – business psychology and regulatory climate.