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Acquisition Finance – The Thrust of Deal Making Activity

There was a plethora of deal-making activity in 2021. The value of M&A globally topped $5 trillion, the Medline Industries $30 billion LBO deal was the largest since 2008 and a record-breaking 602 SPAC IPOs were filed in 2021.

The availability of acquisition financing serves as a catalyst for deal-making activity. Cheap sources of debt and bullish investor appetite have seen both corporate asset valuation and funding reach astronomical heights in the last year. This blog provides an overview of the various forms of acquisition finance and considers whether such voluminous activity will continue into 2022.

Acquisition financing covers a broad range of finance structures where an existing company purchases all or some of the shares or assets of a public or privately held company. The fundamental choice between the use of debt and equity will be considered within the context of the cost of finance and the expected return on the invested capital.

In the narrative of risk and return analysis, investments in debt instruments carry lower risk compared to investments in equity instruments. As such, the return correlation ensures that debt financing has a lower return than equity. The implication is mirrored by the cost of financing which will suggest that the cost of debt financing is lower than the cost of equity financing and the pursuit to minimize a cost of capital will the use of debt finance as an initial preferred choice.

Debt Financing

The main methods of debt financing are loans and the issuance of debt securities. There’s a range of instruments and approaches to structure that could be considered for any given deal. Here, we’ll provide an insight into Senior debt; Second lien debt; Mezzanine debt; Unitranche debt; High yield debt and Bridging debt.

Senior Debt – This first level of debt financing is provided as secured funding. Senior debt loans can be granted in tranches such as A, B and C, with tranche A usually structured as an amortizing loan and tranches B and C as bullet loans. Given the nature of such debt, it will always attract the lowest interest rate than any other debt instrument in the capital stack.

Second Lien Debt – This is also a form of secured debt usually framed on the same security package as the senior debt. It provides a layer of funding between senior debt and junior debt facilities. Despite being secured, second lien debt lenders have a subordinated call on the pledged collateral. Due to this additional risk, second lien debt will attract a higher interest rate.

Mezzanine Debt – This is an interesting instrument as it has characteristics of both debt and equity. Mezzanine debt investors get the benefit of having contractually mandated interest payments while also benefiting from some type of equity-related incentive such as an option (warrant) on shares.

Unitranche Debt – This is a form of debt funding that comes as a single package comprising of both secured and unsecured debt elements, often with blended interest rates. Unitranche debt facilities are usually provided by non-traditional lenders such as private debt funds. This form of debt financing will carry higher interest rate margins but can assist in expediting deal execution.

High yield debt – The term high yield refers to debt issued with a credit rating below investment grade. The high yield bond issuance process is often more fluid and less exact than other types of debt securities. This is because issuers have to be interrogated more due to the higher risk. In practice, the deal structure can be re-worked many times. 

Bridging Debt – This is temporary debt funding typically only used as a funding facility when there is a clear anticipation of receiving more long-term funding. The use of bridging debt can be expensive as higher rates of interest is attached as part of the terms. However, it can be a very useful source of finance in the expedition of deals and IPOs. 

Equity Financing

When equity financing is used for funding M&A transactions a buyer can either offer its shares or offer cash which would be generated from the proceeds of an equity offering. 

The cost of equity is higher than the cost of debt, however, the use of equity is still very common.

Benefits for M&A transactions being funded by equity include no mandatory interest and principal payments; no restrictive covenants and no impact on credit rating which will be advantageous for raising more debt in the future.

When issuing additional shares consideration must be given to the impact eps and the return on equity. If there is any significant volatility in the acquiring company’s share price the exact acquisition valuation can be uncertain, or the planned transaction can even be curtailed.

Bouncing on the see-saw of the debt and equity financing pendulum, the funding of M&A transactions and deal-making activity, in general, is expected to continue apace this year. A poll of 1,300 executives at corporations and private equity firms on their expectation of M&A activity in 2022 and 92 percent of respondents said they expect deal volume to increase or stay the same [1]. 

With the thrust of deal activity expected to be at least the same in the coming year, the demand for acquisition finance and funding solutions will run coequal.

If you would like more information on our M&A and Capital Markets learning solutions then feel free to get in touch at info@amttraining.com

 

References:

[1] Institutional Investor