Posted on: October 19th, 2020

Acquisition Financing Rates of Return Acquisition financing loan structures are priced in interest rates on a nominal basis. Middle market bank interest rates in today’s market are approximately Libor plus 300 to 400 basis points.Non-bank middle market rates run from Libor plus 400 to 700 basis points depending on the risk. Mezzanine debt interest rates range from 10% to 12% which seems high relative to the bank and non-bank rates. This comparison is illustrative in highlighting the mutual exclusivity of these forms of capital.

Mezzanine rates are higher because they have more risk in a debt structure and provide a riskier layer of capital than a bank or even a non-bank provides. On a nominal comparison basis, there is a 100 to 300 basis point spread between bank and non-bank rates. There is a 700 to 800 point spread between bank and mezzanine rates. This same nominal relationship exists in the bond market with the 10-year treasury at .65% as of today and the average junk bond rate of 5.45%. Ostensibly, the junk bond rate is nearly 5% higher and certainly nominally more costly. Yet, junk bonds are far riskier than Treasuries which carry a government guarantee and a AAA credit rating.

Most companies especially middle market companies are no where near triple A credit rated. Companies seeking significant growth through acquisition and fast organic growth need high levels of capital relative to their company credit rating, and non-bank and mezzanine debt are a great way to finance it. You pay more for these forms of debt capital because they provide far more capital than a super safe, triple A credit rated loan would provide. The way to think about higher priced forms of debt capital is not to overfocus on their cost, but on their value. If a 10% interest rate loan allows you to fund 100% of your acquisition need, without any equity dilution, then it has a very low real debt cost.

While its nominal interest rate may seem high, its real cost is quite low. Viewing debt costs through this real rate of return prism allows you to clearly see the cost to value relationship. It may cost more, but provides significantly more value, thereby allowing you to generate a superior internal rate of return on the acquisition.

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.