The Importance of Equity in Your Acquisition Financing Deal Structure

Posted on: October 10th, 2022

acquisition-financing

Most independent sponsors in pursuit of acquisition financing are highly successful and confident business people with a knack for capitalizing on market opportunity. As entrepreneurs, they can do a lot with a little and believe in the power of their gut instincts when it comes to big decisions.

In the acquisition financing arena, there is no bigger decision than how to structure your deal. A good deal structure will communicate strong sponsorship and transactional credibility, something that acquisition financing lenders are constantly screening for. A weak deal structure, such as one with no equity, will get little to no serious consideration from a lender, leading to significant wasted time and energy. Though one would think this self-evident, trying to do a deal without any cash equity investment is a nonstarter. In many deals, no-equity sponsors usually triangulate in lender discussions to understand how much cash equity the lender needs them to invest.

This approach is backwards as sponsors are always in a stronger position by understanding the need for and importance of equity before commencing lender discussions. No-equity sponsors usually promote the amount of residual seller equity or seller note in the deal as valid reason for not putting in cash equity. Or they may extol the virtue of the below market purchase price for the deal, or their significant value they have created via signing and negotiating the deal. There is no limit to the amount of creativity no-equity sponsors use to justify their unwillingness to invest cold hard cash in their deal. Cash equity is important for all deal structures, especially roll-up deals for the following reasons:

Lenders will not fund 100% of your deal – Lenders need the buyer to have capital at risk in the deal. They will not fund into a deal where they have all the downside. A buyer needs skin in the game to be seen as a credible person to the lender.
Mitigates Risk for the Lender – An equity layer creates a risk buffer for the acquisition financing lender, especially if the company needs more capital post-closing.
Creates Faster Acquisition Scale up – In roll-ups, there are many acquisitions often closed simultaneously creating integration risk. Through funding a substantial portion of your deals with equity, the lender is more willing to continue to lend.
Creates Accelerated Growth – cash equity unlocks your ability to make selective investments in people, systems, and development to achieve faster growth.
Insurance Policy – Roll-ups are risky and often one deal often goes south. When you have too much debt and this happens, the company becomes operationally inflexible and financially stressed. Cash equity lowers the debt and increases the cash position, allowing you to absorb any negative financial shocks.

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.