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Acquisition Financing: What Are the Best Ways to Finance an Acquisition?

We see our fill of requests and opportunities for needs in acquisition financing.

The capital needs range across the spectrum (i.e. debt, equity, mezzanine and everything conceivably in between).

The proposition that always baffles my brain the most includes the following scenario which varies little from the following:

Would-be acquirer: “I am looking for financing for an acquisition I to make in [fill in the industry].”

Me: “That’s great. Can you tell me a bit more about the deal/opportunity?”

Would-be acquirer: “Yes, the business is doing $XXM in revenue with earnings and/or cash flow $XM.”

Me: “Sounds like an interesting project. What are the proposed terms of the acquisition?”

Would-be acquirer: “Well, the owner has agreed to $XXM for the business.”

Me: “What about the structure of the deal? In other words, what does the capital stack look like? What equity is coming and who is bringing it?”

“Do you need to source equity, if not enough is coming to the table?”

“How much debt do you require?”

“What does the timing of the transaction look like?”

Would-be acquirer: “We are looking for 100% financing.”

Me: “Ok, so that means you’re actively looking at acquiring the business as an independent, fundless sponsor, is that correct?”

At the point, the conversation typically digresses from there. If our would-be acquirer in this scenario does not have a clue what an fundless sponsor is, they typically are not prepared to take themselves to market as such a sponsor either (i.e. full pitchbook, including the reasons they would make a great operator).

No, in most cases our would-be buyer read something on the internet where they can get 100% acquisition financing through some type of surety bond or other shady structure that smells of charlatans and snake-oil salesman.

No Equity Needed Acquisition Financing?

Before looking to acquire a business, there are several aspects to take into consideration.

First, private equity investing is exactly as it sounds–it requires equity. Equity is not ethereal. It means cash is required. Just like when buying a home, no legitimate lender is going to lend millions of dollars on the acquisition of a business without:

  1. Significant equity skin in the game
  2. Assets to collateralize in the business
  3. Personal guarantees on the part of the sponsor (not always, but frequently)

And while the SBA can require lower equity down, they only do so when the other above factors make up for the differential in the risk.

Second, even those willing to fund independent sponsors are not going to do so without significant vetting on the part of the sponsor. Unlike search funders who may already be backed by the capital, independent/fundless sponsors are more likely to shot at a potential target and then find a way to haul it out of the woods, so to speak.

Third, the deal has to pencil. The debt service coverage ratio needs to reach the level required by the investment committee from the given lending institution with whom you are working.

It does not matter what the cap rate is. It is significantly easier to lose your shirt on an operating business as it is to do so in a real estate deal. Comparing real estate and business cap rates are not a true apples-to-apples comparison as nearly any business would include a higher amount of risk, which means the cap rate should be higher.

Assets don’t matter either. A lender can (and usually will) collateralize those assets, but that does not mean the lender will exclude the need for a buyer to come with some type of skin in the game.

The next time you look into acquiring a business, make sure you come with your gun to the gun fight:

  • Be prepared to discuss all components of a deal, including debt and equity, understanding that most lenders will require a minimum of 20-30% to get comfortable in the financing. This is leverage buyout financing 101.
  • Be prepared with the story. If you are fundless, you will need a pitchbook. If you don’t create it, an investment banker will only s/he will charge more.
  • Pedigree matters. If you do not have the 20-30% for equity, then pedigree matters. Where is your degree from? What experience in the given industry do you have? What are your plans for growth and expansion in this particular business?

When you’re seeking 100%, free-and-clear, no/low-money-down acquisition financing, you are likely best served to find it elsewhere. That’s not what we do.

Acquisition financing rarely procured from a single source. The acquisition of private or public companies requires a considerable amount of borrowed funds to pay for the purchase price of the company. Companies that generate a high level of cash flow attract leveraged buyout (LBO) transactions and become targets for private equity investors to purchase such companies. The article will present the debt structure embedded in a typical LBO transaction and describe the various components of debt financing in the capital stack.

Leveraged Buyout & Acquisition Financing Capital Stack

The LBO capital structure usually consists of 70% debt and 30% equity.[1] Within an LBO capital structure, senior debt is the most senior tranche and is approximately 50% of the capital structure.6 The senior loan is divided between the revolving credit facility and term loan.[2] The revolving loan is tied to current asset levels and is secured by the firm’s most liquid assets such as inventory and receivables. However, term loans are secured by longer-lived assets in the firm and can be tranched in A, B, C and D term loans. Typically, the A tranche, the most senior debt in the payment waterfall is amortized, and is paid off prior to making payments for other debt. Term loan A is usually amortized over a five to seven-year period. The remaining tranches are paid off at maturity and are not amortized.2  The interest rate charged on a senior debt is a floating rate that is equivalent to LIBOR plus (9 or minus) a premium or discount, based on the credit of the borrower.[3]

Senior debt

Senior debt is considered the least expensive form of financing a company via LBO. Overall, senior debt has the lowest cost of capital relative to other tranches in the capital structure. The interest rate on senior debt is typically lower than that of other debt components in the capital structure. In the event of a liquidation, the senior debt must be paid off first before other creditors receive payment. Senior debt is also ranked higher than high-yield debt in the capital structure.[4] The expected returns from a senior debt ranges from 5% to 12%, while the expected returns from mezzanine debt ranges from 13% to 25% and that of equity is usually over 25%.[5]

Unsecured Debt

Unsecured debt, also known as junk bonds, is the next layer in the capital structure. In general, unsecured debt has a seven to ten-year maturity range and is paid off in a single payment. Junior bonds are comprised of five types of loans. The first loan is a second-lien debt and is allocated in the same collateral pool as the first-lien bank debt. The second-lien debt is privately held with collateralized loan obligation (CLO) investors and hedge funds. The second layer of unsecured debt are high yield bonds. [6] The capital structure in LBOs includes 20% to 30% of high yield debt. Although, high yield debt has a higher financial cost than senior debt, high yield debt has less limitations on covenant agreements and interest-only payments with principal payment at maturity. Companies have options to secure better loan terms on high yield debt since the loans are callable by the company at a premium a few years after the LBO occurs.[7] The maturity for high yield debt ranges from eight to ten years and provides early repayment options. In the event of a bankruptcy or liquidation, high yield bonds are paid before preferred and common stock.

Mezzanine Financing

Mezzanine financing, also known as quasi-equity, is debt subordinated to senior debt and is provided by the bank. Structuring a mezzanine financing in a LBO capital structure is a major consideration since it determines the position of the mezzanine debt in the company’s capital structure. In most cases, investors can agree to contractually subordinate mezzanine debt to the senior debt. However, in less common scenarios, mezzanine debt can take the form of structural subordination. In this scenario, the holding company does not guarantee the mezzanine debt.[8]

Mezzanine debt maturity ranges from five to seven years and is normally issued with a cash pay interest rate of 12% to 18%. Compared to other subordinated debt, mezzanine debt requires a higher return. The more mezzanine financing is used in purchasing a company, the higher the expected equity return for equity holders. [9] Most mezzanine debt issuers prefer shorter maturities due to the high returns associated with the loan. Conversely, some issuers support longer maturity dates to secure more flexible redemption terms for investors.

Equity

Equity represents the private equity’s funds capital and is typically 20% to 30% of the capital structure. Equity has the highest risk reward potential since it is last in line for payment. Thus, equity holders require a high internal rate of return (IRR) on investment that ranges from 20% to 40%.6

 

Senior Debt vs. Subordinated Debt

Senior Debt

  • Senior debt lenders are prioritized in the event of a liquidation
  • Interest rate is lower compared to subordinated debt
  • Economic loss results in less risk compared to subordinated debt and equity

Subordinated Debt

  • Economic loss results in greater risk compared to senior debt
  • Economic loss results in lower risk than with equity
  • Higher interest rate than senior debt.[10]

The following chart is an illustration of a typical LBO capital structure with a bank (senior) debt of 50%, high yield debt is 15%, mezzanine (quasi equity) is 15% and common equity is 20%.

Acquisition Financing

Our expert investment team brings the knowledge necessary to capture the right financing structure with the least expensive cost of capital. Financing is the lifeblood of business. We provide finance advisory solutions across the corporate value chain to ensure companies thrive, even in the most difficult of circumstances.

Acquisition Loans & Corporate Debt

We provide clear solutions for senior, subordinated, mezzanine and other forms of asset-based lending for clients seeking a solution for their acquisition financing needs. In typical fashion, most deals include some mix of both debt and equity with the vast majority being sourced from debt. We work with lenders and issuers to help source the right mix of both.

By purchasing an existing business (or franchise), you establish a strategy that allows for near-instant business start up. But once you’ve assessed your business opportunities and risks, and have settled on one prospect to move forward on, you’ll need to secure financing. At Investmentbank.com, we meet our clients’ diverse needs by providing support, resources, and guidance involving risk management, capital raising, securing financial flexibility, and everything else associated with purchasing an existing business.

We provide corporate finance ideas, advice, and execution as we walk you through the process of determining how best to finance your business acquisition. We share the same vision as our clients: to ensure that every decision made on the way toward an acquisition supports your short-term and long-term business development goals. Closing a small business acquisition loan can be a struggle. The lack of available collateral and low cash flow often impinge on a borrower’s chances of securing a loan. That’s why it’s so important to work with the right lender, within the right loan program.

On business acquisitions less than $5 million, the most typical form of financing is the SBA 7a loan. SBA (Small Business Administration) guarantees 75% of the loan to the lender, meaning if the borrower defaults, the bank will still get back 75% of their capital. This guarantee helps make small business acquisition loans far more achievable. Securing your acquisition loan with the help of Acquisition.net. With our long history in business acquisition financing, we have the resources and expertise to help you properly prepare for your next business investment. This includes finding the right lender and ensuring the financing side of the transaction is in place to aid in an overall smooth transition.

Private Equity Acquisition Financing

A myriad of options exist for sourcing private equity investment, particularly if your company is profitable and growing.

Private equity groups, family offices and other sophisticated investors can provide either majority and minority interests in the right business. We help to ensure both the issuer and investor get the best deal possible.

Mezzanine & Unitranche

Mezzanine, unitranche and other subordinated debt structures are used often in financing acquisitions, particularly those that lack the tangible assets required by many senior lenders in a deal. We help source the right mix of non-bank, secondary and tertiary debt solutions to finance your next acquisition.

Finding success when it comes to sourcing the right capital partner for financing your acquisition requires a knack for knowing what questions to ask and which groups to solicit.

Full Suite of Acquisition Financing Options

  • Senior Bank Loans
  • Asset Based Loans
  • Equipment Financing
  • Government Guaranteed Debt
  • Unitranche Financings
  • Mezzanine and Subordinated Debt
  • Preferred Stock
  • Growth Equity Financings
  • Private Equity Recapitalizations
  • ESOP Financings

Financing Growth & Exits

Our network professionals assist clients with arranging financing to address a variety of business and transactional needs including:

  • Working capital to support sales growth or a new product line
  • Funding equipment and facilities purchases
  • Acquiring a business, a manufacturing plant or a product line
  • Buying out a partner, a controlling shareholder or the older generation of a family business
  • Refinancing/restructuring existing debt
  • Exiting real estate investments with sale leasebacks and other similar structures

Weighing Acquisition Financing Options

Companies looking for acquisition financing have several different options to choose from, with a line of credit and traditional bank and SBA loans being the most common. We understand that it typically takes more than soliciting these lenders in order to shore up the capital needed to buy your targeted company. In fact, acquisition financing lenders tend to come to the table with their own set of qualifying criteria, divergent from structures provided by typical bank lenders.

Navigating these complex waters is simplified with the help of a knowledgeable professional. In order to successfully secure acquisition financing at the lowest cost of capital, it helps when issuing companies work with advisers who both understand the unique structuring criteria of non-bank lenders and who have direct access to thousands of financing lenders across a variety of industries. That is why companies looking for acquisition financing turn to us for their capital needs.

We implement a comprehensive strategic solution to ensure a successful outcome for our clients. Often this includes a varied and creative mix of both debt and equity and is completed through targeted underwriting and strategic deal syndication. We leverage our expertise within capital markets, while relying on the relationships forged with our highly qualified lenders, in order to fully support our clients’ ventures, regardless of their specific sector.

We are active in each step of the corporate finance process beginning with preparation of a compelling presentation of the client’s business plan and funding requirements. As a firm, we maintain relationships with thousands of funding sources. Appropriate lenders and investors are targeted and introduced to the client and its financing requirements. The firm acts as an intermediary between the capital source and our clients. In doing so, we facilitate smooth interchange between our clients and the appropriate lenders and investors. After Term Sheets have been issued, we follow the transaction though to its conclusion, advising on deal terms, assisting with negotiations and due diligence. We also coordinate closely with legal counsel in managing the transaction until a successful close.

We source the right capital financing solutions for both buyers and sellers

Being able to identify valuable opportunities worth investing in can be a challenge, when much of the deal flow in privately owned companies isn’t readily accessible. This challenge limits the number of deals PE firms complete or are even aware of.

We make it possible for private equity firms to maximize their investment opportunities by digging deeper than what limiting strategies – like participating in broad auctions – offers. We source new portfolio company opportunities, as well as add-on opportunities, for existing portfolio companies.

Our experience spans nearly every niche and industry. The strategy we employ to identify investment opportunities is multifaceted. While traditional methods of prospecting (phone calls, for example) are still effective, our most valuable resource is our network of professionals (including accounting firms, attorneys, consultants, brokers, sell-side intermediaries and investment bankers).

Over time, our network of professionals has come to view Acquisition.net as a valued source for discreetly presenting high-caliber qualified buyers.

Raising Capital for Acquisitions

Combining tried and true strategies with consistent execution, Acquisition.net is uniquely outfitted to help our clients – within a number of key niches – raise the capital they need. Regardless of what stage your business is in – from startup to growth, recapitalization, shareholder liquidity and full-management buyouts – we’ll construct a customized strategy that will yield your desired results.

Our close relationship with venture capitalizes, private equity firms, buy-out investors and others give us the leverage we need to match our clients with a capital lender well-suited for their needs and who’ll share in their goal of consistent growth and long-term success.

We serve a variety of roles as we look to raise capital for our clients. Our experience allows us to effectively serve as CFOs, VPs of Finance, and Directors, as we develop campaigns that identify and target accredited investors, and review and refine any financing plans (if necessary).

By ensuring that a mutually beneficial agreement (between investor and business owner) is established, we greatly minimize the risks typically associated with raising capital. We stand alongside our clients every step of the way as they look to create the level of momentum necessary to guarantee success.

Build Lasting Value

Acquisition financing will often provide our clients with more capital than a traditional bank loan, at a fraction of the cost of an investor. This, of course, comes as very good news to our clients.

But the key ingredients to success with acquisition financing are:

1. Finding the right lender to align with your vision and mission

2. Acquiring the proper amount of business acquisition financing

We’ve built our reputation on helping our clients successfully gain access to the capital they need in order to purchase other companies and meet their long-term goals. Our time-tested workflow ensures that the process of attaining your required capital is streamlined, thus helping you get the capital you need, when you need it, in order to move forward with your acquisition.

The capital structure of companies includes leveraged loans, high yield bonds and equity. In a typical LBO transaction, senior debt is ranked as the first layer of debt in the company’s capital structure.

Senior debt has the lowest risk and cost of capital; however, high yield and mezzanine debt have higher risks since the debt are not secured and are tied to the assets of the company. In general, a company’s capital structure comprises of approximately 50% senior debt, 15% high yield debt, 15% mezzanine debt and 20% equity.

Citations

[1] RAJAY BAGARIA, HIGH YIELD DEBT: AN INSIDER’S GUIDE TO THE MARKETPLACE, (2016).

[2] Joseph V. Rizzi, The Capital Structure of PE-Funded Companies (and How New Debt

Instruments and Investors Are Expanding Their Debt Capacity), 28 Journal of Applied Corporate Finance 60-68 (2017).
[3] Macabacus, Capital Structure of an LBO, (2018), http://macabacus.com/valuation/lbo/capital-structure
[4] MARIYA STEFANOVA, PRIVATE EQUITY ACCOUNTING, INVESTOR REPORTING, AND BEYOND: ADVANCED GUIDE for Private Equity Managers, Institutional Investors, Investment Professionals, and Students, (2015).

[5] Corry Silbernagel & Davis Vaitkunas, Mezzanine Finance, http://pages.stern.nyu.edu/~igiddy/articles/Mezzanine_Finance_Explained.pdf

[6] DONALD DEPAMPHILIS, MERGERS, ACQUISITIONS, AND OTHER RESTRUCTURING ACTIVITIES: AN INTEGRATED APPROACH TO PROCESS, TOOLS, CASES, AND SOLUTIONS, (2017).
[7] Street of Walls, Leveraged Buyout Analysis, (2013), http://www.streetofwalls.com/finance-training-courses/investment-banking-technical-training/leveraged-buyout-analysis/.
[8] Arthur D. Robinson, Igor Fert and Mark A. Brod, Simpson Thacher & Bartlett LLP, Mezzanine Finance: Overview, (2011), www.stblaw.com/docs/default-source/cold-fusion-existing-content/publications/pub1004.pdf?sfvrsn=2.

[9] Corry Silbernagel & Davis Vaitkunas, Mezzanine Finance, http://pages.stern.nyu.edu/~igiddy/articles/Mezzanine_Finance_Explained.pdf.

[10] Geoffrey R. Peck & Todd M. Goren, Developments in Unitranche Financing, Practical Law The Journal, 53-60, (2014).

Jenn Abban contributed to this report.

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Sky Richardson
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