Acquisition finance plays an important role in corporate strategy, enabling businesses to expand, consolidate market share, or enter new markets through the acquisition of other companies.
However, acquisition financing can be a complex undertaking and requires a solid understanding of the various financial tools, risk assessment, and strategic planning.
Let’s uncover the fundamentals of what acquisition financing is, exploring how to finance a business acquisition, and the methods banks use to gauge viability and manage associated risks.
What is Acquisition Finance?
Acquisition finance definition: Acquisition finance is the capital that is obtained for the purpose of buying another business.
The ultimate aim of acquisition financing is to facilitate mergers and acquisitions, allowing businesses to expand their operations, enter new sectors, or consolidate their industry position.
Acquisition finance is not a single type of business loan, but rather a broader category of financing options specifically tailored for funding the acquisition of another company or business entity.
While acquisition finance can involve loans as a component, it encompasses a range of financial instruments beyond traditional business loans. These may include various debt and equity financing options, such as senior debt, subordinated debt, mezzanine financing, common equity, preferred equity, and convertible securities – or a combination thereof.
The choice of financing depends on factors such as the size of the acquisition, the financial health of the acquiring company, the desired extent of leverage, and the risk tolerance of investors.
What are the Main Types of Acquisition Finance?
The main types of acquisition finance can be broadly categorised into debt financing and equity financing.
Debt financing provides leverage and tax benefits but increases financial risk, while equity financing offers ownership control but dilutes existing shareholders.
Debt Financing:
Debt financing options include:
• Senior Debt: This involves borrowing funds from banks or financial institutions with the highest priority claim on assets in case of default. Senior debt typically offers lower interest rates but requires strong collateral and a stable cash flow.
• Subordinated Debt: This type of debt ranks below senior debt in terms of priority of repayment. Subordinated debt often carries higher interest rates and may have flexible repayment terms, making it attractive for risk-tolerant lenders and investors.
• Mezzanine Financing: Mezzanine financing is a blend of debt and equity financing, offering a combination of subordinated debt with equity features. It fills the gap between senior debt and equity, providing higher leverage and potential upside for investors.
Equity Financing:
Equity financing options include:
• Common Equity: Involves issuing shares of ownership in the company, giving investors voting rights and a share of company profits. Common equity represents the highest risk and potential return for investors.
• Preferred Equity: Equity with priority over common equity in terms of dividends and liquidation preference. Preferred equity often offers fixed dividend payments and may not carry voting rights, providing stability for investors.
• Convertible Securities: Securities such as convertible bonds or preferred stock that can be converted into common equity at a predetermined price. Convertible securities offer the flexibility of debt with the potential upside of equity, appealing to both debt and equity investors.
Each type of acquisition finance has its own characteristics, advantages, and considerations. Understanding these differences is crucial for determining the most suitable financing strategy for your unique situation.
How to Finance a Business Acquisition
There are 7 key steps in the business acquisition finance process:
1. Assess your financial capacity: Evaluate your financial position, including cash reserves, existing debt obligations, and available credit lines. Determine how much capital you can contribute towards the acquisition.
2. Identify acquisition targets: Research and identify potential acquisition targets that align with your strategic objectives and financial capacity. Consider factors such as industry, market position, growth potential, and synergy with your existing business.
3. Conduct due diligence: Perform thorough due diligence on the target company, to assess its financial health, operational performance, assets, liabilities, and potential risks. Engage legal, financial, and operational experts to review relevant documentation and identify any red flags.
4. Estimate your financing needs: Calculate the total cost of the acquisition, including purchase price, transaction fees, working capital requirements, and any anticipated restructuring or integration costs. Determine how much financing you’ll need to complete the deal.
5. Explore financing options: Research and evaluate the various acquisition financing structures available and consider factors such as cost, terms, flexibility, and impact on ownership and control.
6. Secure financing: Work with lenders, investors, or financial institutions to secure the necessary funding.
7. Negotiate and finalise terms: Negotiate terms and conditions with lenders or investors, finalise legal documentation, and close the acquisition according to the agreed-upon terms.
Engage a Business Finance Broker:
While financing a business acquisition can be a daunting prospect, a business finance broker can help streamline the process.
By leveraging their expertise and industry connections, brokers can grant you access to a broader range of lenders and help you to compare offers, navigate complex financing options, and identify the most suitable financing solution for your specific needs.
A broker can also negotiate favourable terms on your behalf and provide expert guidance and support throughout the loan application and approval process – saving you time, effort, and potentially money in the long-run.
How Banks Assess Viability & Risk
There are several key factors and financial ratios critical to a bank’s assessment of the viability and risk of acquisition finance.
1. Does the proposed acquisition make sense?
• Why is the current owner selling the business (e.g. retirement, health reasons etc?).
• Will they enter a restraint of trade arrangement (what is the duration? etc.).
• Critically, is the business complementary with the acquiring business’s current core trading activity?
• Is the acquisition for 100% of the issued shares or units of the acquired entity?
• Is the acquisition entity’s Earnings Before Interest Tax and Depreciation [EBITDA] positive? – In other words, does it make money?
2. Purpose and structure of the acquisition:
• Strategic rationale: Banks examine the strategic reasons for the acquisition, such as market expansion, diversification, or vertical integration. This helps them understand the potential for synergy and growth.
• Deal structure: The mix of debt and equity in the deal is important. A higher proportion of debt might lead to a higher interest burden, impacting cash flows and repayment capacity.
3. Assessing credit worthiness & financial health of the acquiring company:
• Assessment of financial statements: Banks scrutinise historical financial statements of the acquiring company to evaluate its financial health. Key metrics include revenue trends, profit margins, and net income.
• Credit history: A good credit score and a solid credit history increase the chances of securing favourable loan terms.
• Debt levels: The current level of indebtedness of the acquiring company is reviewed, with the Debt-to-Equity Ratio (D/E) being a crucial metric [>=35%]. A high D/E ratio might indicate higher risk and affect loan approval.
4. Valuation and due diligence:
• Accurate valuation: Banks require a precise valuation of the target company, often performed by professional valuers. The Price/Earnings Ratio (P/E) and Enterprise Value/EBITDA (EV/EBITDA) ratios are commonly used to assess whether the target is reasonably priced.
• Comprehensive due diligence: This includes legal, financial, and operational due diligence to uncover any hidden liabilities or operational inefficiencies.
5. Repayment capacity:
• Cash flow projections: Banks review projected cash flows to ensure the acquisition will generate sufficient revenue to meet debt obligations. The Interest Coverage Ratio (ICR), which measures the ability to pay interest from earnings, is a key indicator.
• Debt Service Coverage Ratio (DSCR): This ratio indicates the company’s ability to service its debt with its operating income. A DSCR above >=1.25 is often preferred.
6. Collateral and security:
• Asset quality and liquidity: The quality and liquidity of the assets offered as collateral influence loan terms. Tangible assets like property, plant, and equipment are preferred over intangible assets.
• Loan-to-Value Ratio (LTV): This ratio assesses the loan amount against the value of the collateral. Banks prefer a lower LTV to minimise risk.
• Security: Banks would generally look for related entities’ corporate guarantees, directors’ guarantees, general security agreements and other security deemed appropriate for the transaction.
7. Economic conditions:
• Market and economic environment: The broader economic climate impacts bank lending policies. Factors such as economic stability, inflation rates, and market conditions can influence both the availability and cost of acquisition finance.
Looking for Acquisition Finance in Australia?
By evaluating the various financing options, comparing providers, and understanding the criteria banks use to assess the feasibility of acquisition deals, you’ll be better placed to secure the right financing for your needs.
To engage an acquisition finance broker, or to discuss your business financing needs, please contact our friendly team.
Please note that the information provided here is general and does not constitute financial, tax, or other professional advice. You should consider whether the information is appropriate for your needs and seek professional advice before making any decisions.
