Financing of M&A transactions

published on 16 November 2022 | reading time approx. 5 minutes

M&A transactions are usually not financed by equity alone. In addition to equity, buyers use debt capital or resort to alternative financing structures such as vendor loans, earn-outs, equity rollovers, or sale and leaseback transactions. Particularly for medium-sized companies facing succession, the often complex financing structures are largely unknown and pose a challenge to sellers in terms of how to deal with and negotiate with institutional capital providers.

ACQUISITION FINANCING INSTRUMENTS »
DEBT »
MEZZANINE »
UNITRANCHE »
VENDOR CONTRIBUTIONS »
ALTERNATIVE STRUCTURES »
MARKET PARTICIPANTS »
CONCLUSION »

In view of a large number of expected business successions in the coming years, companies increasingly need a better understanding of how different sources of financing work.

As a rule, buyers use other instruments besides equity to solve the following challenges:

The available equity is not sufficient to acquire a company;
Expected returns on equity can only be achieved with the help of debt capital (leverage effect);
Information asymmetries and any conflicts of interest between the buyer and the seller should be reduced to a minimum.

This article will take a closer look at the various sources of acquisition financing and present relevant market players.

Acquisition financing instruments #instruments

The success of a company is largely determined by the financing structure adopted during the takeover. This makes it all the more clear that a sustainably successful acquisition financing is indispensable in M&A transactions. Various financing options are available for this purpose, which in combination are intended to solve the three challenges mentioned above:

Debt

The senior tranche is comparable to the classic bank loan. In English, the senior tranche is also called the “first lien”. It is senior to the company's other loans and is fully securitized. Senior tranches can be structured as regularly repayable or as a bullet repayment (at maturity). Interest depends on interest rates agreed earlier. Likewise, a base interest rate (Euribor or Libor) can be agreed, plus an interest margin (margin grid).
Unlike the senior tranche, the junior tranche is a subordinated loan. It is often taken out as an additional source of debt financing or structured with the senior tranche. The junior tranche is subordinate to the senior tranche in terms of enforcing the collateral and servicing the debt, but should still be serviced before the shareholder loan and the equity. In addition, the junior tranche is serviced yet before the mezzanine capital. The subordinated nature of the loan in terms of its servicing increases the risk of loss. Thus, junior tranches are subject to a much higher interest rate. A base interest rate plus an additional margin is common.

Mezzanine

Mezzanine financing. The term mezzanine comes from the Italian word “mezzo”, which means “half”. Mezzanine capital can be assigned to both debt and equity of a company and is therefore to be understood as a hybrid form of financing. Mezzanine financing thus combines the characteristics of equity and debt and is usually structured as a profit participation right or silent partnership. Mezzanine financing is particularly suitable when access to bank loans is not guaranteed. This type of financing is also particularly attractive in situations where the buyer in an M&A transaction does not want to surrender voting rights or company shares to finance the transaction. When looking at the risk rating, it should be noted that the mezzanine financing is placed before the senior debt. Therefore, in most cases, financing providers demand a participation in the increase in value (equity kicker) as well as a fixed interest rate. Mezzanine financing must be serviced before equity.

Unitranche

Capital structures can include multitier financing from several institutions. In unitranche financing, the loan structure is blended into a single loan and remains senior due to its lien on securities and shares. The unitranche can be understood as a combination of senior and junior tranches. Especially in leveraged buyouts (LBOs), unitranche financing is becoming increasingly attractive. Since 2013, the market share of unitranche financing structures as part of LBOs of medium-sized companies has been steadily increasing. A particular advantage of unitranche financing is the limitation to only one debt provider.

Vendor contributions

Vendor contributions are used to fill funding gaps and can be quick and pragmatic to implement. It is also typical of vendor contributions that sellers continue to participate in the future growth of the company, so that the interests of the buyer and the seller are approximated. The three most common vendor contributions are discussed below: Vendor Loans, Earn-Outs and Equity Rollovers.

Vendor loans are seller loans in which the seller of a company in an M&A transaction cofinances the purchase price of the company. A vendor loan is common when financial institutions are not willing to provide higher amounts of money to a company. This form of lending is often accompanied by higher interest rates. The higher interest rate level compensates the seller for the higher default risk of the borrower. A vendor loan often has a positive impact on the M&A transaction process, as trust is created between the buyer and the seller.
Earn-Outs describe a provision or agreement whereby the purchase price is structured depending on the company's performance. In most cases, it is an arrangement where the buyer pays a variable purchase price component in addition to a base purchase price. The amount of the variable purchase price component is determined on the basis of parameters that include the future growth of the target company. Earn-Out clauses thus contain the buyer's obligations to pay a purchase price under certain conditions, which determine whether the purchase price to be paid will be increased by an additional component and by how much. The seller also benefits from the additional variable purchase price component and the growth of the company. This is especially the case if the seller has accepted a base purchase price that may have been below the base purchase price he had expected. The advantage here is that the risk of an incorrect assessment of the purchase price is minimised on both the buyer and the seller side and risk is distributed.
Equity Rollovers. Here the seller undertakes to give part of the proceeds from the sale of his shares in the company to the acquiring company and thus to provide part of the equity. Similarly to an earn-out, the interests of the buyer and the seller are convergent. Furthermore, the buyer can profit from the leverage effect by equity rollover if the transaction was financed using debt capital.

Alternative structures

Sale & leaseback financing offers the buyer the opportunity to sell their own business property and lease it back at an agreed rate. This type of financing enables the buyer to raise the necessary capital for an M&A transaction without having to raise additional funds. Similarly, in an M&A transaction, it is possible for the buyer to sell and lease back the target's real estate. In this case, a sale and leaseback transaction with a real estate investor is implemented already during the M&A transaction process.

Market participants

Banks continue to act as classic providers of debt capital in M&A transactions. Using their leveraged finance divisions, larger commercial and investment banks in particular can offer a wide range of debt capital structures. In recent years, however, market shares have been ceded to more risk-friendly debt funds.
Debt funds are similar in structure to a private equity fund, but differ in that they act as debt capital providers. Debt funds are usually the only debt capital provider in a transaction, while in traditional bank financing different tranches are provided by several banks. Financing with the help of debt funds thus reduces complexity. In most cases, conditions and repayment profiles can also be negotiated in a more flexible manner and depending on performance.

Source: Houlihan Lokey, 2021

Mezzanine capital providers are usually specialised funds or investment companies.
Most often in sales to private equity investors shareholders step in and provide a part of capital for the sale of their own company. Such forms of financing are also often chosen if the seller's underlying business plan is highly dynamic and thus the aim is to tie the seller to his company in the longer term.
Alternative providers of sale and leaseback financing are usually generalist real estate investors or specialist sale and leaseback funds.

Conclusion

Well-structured acquisition financing enables payment of the purchase price, generates leverage for equity investors and minimises conflicts of interest between the buyer and the seller. Depending on the industry and situation of the target as well as external factors such as the economic situation and interest rate environment, financing can take a variety of forms.