Winning by Lending into Acquisition Financing Down Cycles

Posted on: March 27th, 2024

acquisition-financing

Acquisition financing is the product of business understanding which is exhaustively vetted through business diligence throughout the deal lifecycle. The acquisition financing lender’s interest germinates through the arousal of their business and commercial instincts. The lender must usually like many things about the company to move forward including its industry, financial profile, acquisition rationale, projected cashflow, operational efficiency and management team.

Additionally, the acquisition financing lender’s take on the economy plays a large role in their decision-making. Lenders tend to move in herd-like fashion and take their cues from the financial markets be it the debt market, the stock market or interest rates. When the markets are turning positive or good, acquisition financing lenders tend to see the glass as half full. When the markets are volatile, they struggle to see the upside and tend to adopt a more negative view. The presence of animal spirits or businessperson optimism is a huge unquantified factor in acquisition financing provider’s decision tree. When times are good, positivity radiates and acquisition financing flows abundantly. When the worm turns, pessimism takes hold which can lead to a negative feedback loop, wherein negative thinking gets reinforced by negative headlines leading to further declines in confidence.

Over the last 35 years, the acquisition financing markets have had their best performance when lenders behave in a contrarian fashion, bucking the trend and lending into the market when others aren’t. When a rising tide leads to high levels of lending, acquisition financing structures stretch too far on quality and price. Too many bad deals get done leading to future return underperformance for the debt provider. On the other hand, when the market is in a downturn, many lenders pull back in herd-like fashion and vacate the market. They pull in their horns and turn down high quality companies which offer low risk and high return. For many markets including the acquisition financing market, pricing and quality is best when there is less competition. Those lenders that can stand strong amidst negative headwinds and make loans into a downcycle, will book better assets at higher risk adjusted return.

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.