The Imperfection of Loan to Value Ratios in Acquisition Financing

Posted on: July 25th, 2023

acquisition-financing

Loan to value ratios are a key statistic used by acquisition financing providers when establishing debt capacity in each deal. This ratio measures the amount of the acquisition financing loan relative to the total transaction value. In a buyout, the LTV denominator is the purchase price. In market good times, the LTV percentage gradually increases which enables equity providers to minimize cash invested. LTV ratios are highly dependent on the valuation variable. LTV ratio math has evolved from the larger ticket leveraged lending and BDC market.

It is an important metric to use when structuring your deal but does not tell the full story, especially with deals at favorable purchase prices. When a purchase price is lower than market value, the loan to value approach often does not recognize the intrinsic value of this purchase price discount. For example, if a company is being acquired at $10 million and it is worth $12 million, most acquisition financing lenders will still use the same LTV ratio on the lower purchase price. A lender who would make an $8 million acquisition financing loan (66% LTV) off a $12 million valuation, will only make a $6.6 million acquisition financing loan (66% LTV) off a $10 million valuation for the exact same company. Despite the company and EBITDA being the same in both cases, the lower valuation works against a buyer due to the rigidity of LTV application.

Fortunately, in bullish markets, acquisition financing lenders will entertain the notion of a purchase price discount and lean more on a leverage ratio as their primary structuring metric to make a deal work. In bearish markets, they hide behind the LTV as a reason not to move forward even though the leverage ratio and debt service coverages are strong. This tendency makes it harder for independent sponsors to find workable acquisition financing solutions. It underscores the need for a sponsor to bring a healthy sum of equity capital and to take advantage of seller notes and earn-outs when structuring the deal at the front end.

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.