The Primacy of Skin in the Game for Independent Sponsor Acquisitions

Acquisition financing lenders can be particular about the types of business they’ll lend to. Lenders can be persnickety and have preferences as to industry, size, growth rate and collateral type. By definition, lenders are not investors, but make loans and their profit comes on the interest spread for the most part. They have hardly any upside in a deal, unless they have some equity warrants.

All lenders, especially senior lenders, need to ensure return of their principal in order for their overall returns to work. They cannot make money charging 5% interest if they lose 20% of their principal. They mitigate the risk of principal non-payment through a number of ways. Some lenders require personal guarantees, some require a second way out, and others use conservative debt structures. Good lenders can determine the point at which their risk layer ends and the equity risk layer begins. To do this, it is imperative for all acquirers to understand a cardinal rule to acquisition lending, the importance of having skin in the game.

Lender’s need to have comfort that their loan fits within the market value of the entity. In simplest terms, if you are buying a company for $10 million, the lender will not provide $10 million or 100% of the funding. They want to be sure their loan is on top of an equity layer in the business. The equity layer needs to be part cash and part rollover equity or seller note. They key is that someone has to have skin in the game in the form of fresh cash coming in.

Independent sponsors looking for 100% financing are essentially seeking no-money down deals, where they get all of the upside and the lender gets all of the downside. Deals with this type of risk asymmetry rarely get closed. Lenders can’t do much with buyers that have no equity to put in. The proposition of no-money down deals is problematic in several ways. First, when you ask for this type of arrangement, the lender knows you have no money.  You are self identifying to the lender as a lightweight and not qualified to buy a company. You look unserious and not someone who understands risk reward. There are some lenders, such as mezzanine lenders with an equity orientation, who you can have conversations with, but ultimately, you have limited value to them if you are only bringing the deal to the table. Most mezzanine funds will pay you a fee or let you have a small equity percentage for finding the deal. If you are going to play the independent sponsor game, you should really be sure you have cash to invest. There is no hard and fast rule how much, but inevitably there needs to be some skin in the game.