The Wild Card with Acquisition Financing

Posted on: July 21st, 2023

In acquisition financing, most buyers automatically assume the target asset has enduring value and hence can support as much acquisition financing as needed. For buyers, their focus is on getting the deal closed as opposed to critically assessing the factors that underpin the asset value. This happens frequently in markets with frenzied roll-up activity where buyers hew to a valuation formula.

Acquisition attractiveness is measured as a discount to prevailing market multiples as opposed to properly focusing on the wild card factor of all acquisition financing transactions – future business performance. The deep seeded assumption of acquirers and lenders alike is that once the asset changes hands, performance will continue to chug along as historical growth rates. Frequently, once the sale occurs, performance trends diverge from historical levels for any number of reasons. The historical growth may have been unsustainable, marked demand may suddenly contract, or a key person or customer may depart.

Additionally, the pre-closing profitability may unintentionally overstate the true level of earnings. Acquisition financing is calibrated at a multiple of historical EBITDA so materially adverse business performance not only erodes EBITDA but leads to an overleveraged condition. As business performance crumbles, the trailing twelve-month EBITDA contracts leading to an ever-escalating leverage ratio, which ultimately leads to a covenant breach. When this happens, it takes a lot of work to turn things around, regain the historical performance trend and exit the covenant doghouse.

Rather than pursue acquisition financing superficially, buyers would be wise to question the roots of the company’s value more deeply. If a company has strong roots and underlying strength, then regardless of any short-term issues, the business performance will prevail. If the company lacks identifiable strengths, it is more susceptible to underperformance and will require significant resources, investment and time to turn around. The art of identifying future business performance is a hard one to master, but it pays enormous dividends to those that do.

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.