M&A financing: Higher cost of funds effects how deals are structured

Growth through acquisition is a tried and trusted strategy. So far this year, and despite ECB interest rate increases, merger and acquisition (M&A) activity has held up well.

“The M&A market overall is strong in certain areas, less so in others, such as those depending on consumer-oriented discretionary spend, as we are seeing the cost of living and inflation feeding through into M&A activity there,” says Jan Fitzell, partner, mergers and acquisitions, at Deloitte.

Resilience is a key theme and sectors such as healthcare, financial and business services are reckoned to have it.

“There was a time when interest rates were rising and having an impact on capital markets and investor appetite but, with rates beginning to plateau, businesses are realising that this is a new normal and [they are] driving on and doing investments,” says Brian Fennelly, Deloitte’s debt and capital advisory partner.

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Interest from international buyers has remained strong. The fact that Irish companies are more likely to internationalise than their UK counterparts, and at an earlier stage, makes them particularly attractive.

If a company gets such a tap on the shoulder, the most common mistake is being ill-prepared to take advantage of it. In the current market the old maxim of running your business as it if were for sale has never held truer.

Equally, if you’re on the acquisition trail lack of preparation can scupper your chances. “There aren’t many pitfalls that can’t be avoided through preparation,” says Fennelly.

That includes being very clear with your lender about what you need, not just for the acquisition but liquidity for day-to-day operations too.

“You want to grow shareholder equity and protect what you have as well,” adds Fennelly, who advises acquiring firms not to get carried away with overly aggressive growth trajectories “that can cause issues down the line”.

Funding sources for M&A can differ, depending on the buyer type.

“A trade buyer can use internal cash reserves, offer shares in their company – with both the buyer and target company needing to be valued in this instance – or debt, with many of the larger corporations having revolving credit facilities to facilitate their M&A agenda,” says EY Ireland corporate finance partner Fergal McAleavey.

“A private-equity investor typically uses a mix of funding. They invest their limited partners’ capital but generally like to also put leverage into the target to enhance the internal rate of return. In terms of structure, a NewCo can be created through a roll-up, while the management team is incentivised to grow their business/NewCo through a management incentive plan.”

It is important to consider what funding source is optimal for the company’s current strategy, capital structure and future objectives.

“If too much debt is placed on the business there will be future challenges to fundraising but there is a risk of reducing the founder’s control over the company in an equity fund raise,” says EY Ireland corporate finance partner Ronan Murray.

For an acquisitive company, the market interest rate is a key consideration. “Negative rates previously meant that larger companies were encouraged to spend their reserves and it was cheaper to borrow. Due to this, we are likely to see an increase in acquisitions financed by internal resources,” says Murray.

There is an active market of lenders prepared to finance acquisitions that demonstrate cash flows to support a repayment profile, says Colm Sheehan, director, corporate finance, at Crowe.

In the event that a full funding package cannot be delivered using the traditional funding options – internal company resources, debt finance and equity – a level of deferred consideration or “earn-out” is often structured into the deal.

“This gives the purchaser the opportunity to use cash flow generated by the target company to fund the acquisition,” says Sheehan. “Deferred consideration can often be agreed subject to achieving certain profitability targets. This type of structure is also used to maintain a level of commitment from the seller to successfully transition key relationships such as customers, staff and suppliers to the new owner.”

It is important from a deal execution perspective that the proposed funding structure is clearly outlined to the sellers at deal negotiation stage.

“There is inherently more risk attached to a funding proposal that involves third-party finance compared to a proposal that is funded by cash reserves,” Sheehan points out.

In approaching any funder, a robust business plan is vital. “This should clearly set out the funding required, the repayment profile and the security available, as well as the financial projections and assumptions which underpin this,” he adds.

He too warns against the acquiring company over-extending itself in terms of the debt levels it takes on.

“It is likely that a lender will look to take security over the target business and its assets, and potentially cross-security over the existing business. Ensuring that you correctly and prudently project the level of profitability to support the repayment profile is critical. The funding package should support the future growth of the business and have sufficient headroom to allow for unexpected events,” says Sheehan.

“From an acquirer’s perspective, including an element of deferred consideration that is contingent on future performance is a very effective means of sharing risk and getting buy-in from the sellers as the business transitions to new ownership.”

As the lending market continues to become more challenged due to the rising cost of funds, Sheehan reckons we will see purchasers seek to structure deals in ways that make more economic sense for them.

“It is likely that where deals would have been leveraged in the past, there will be a greater degree of contingent consideration attached to bridge the gap between the price a seller is willing to transact at and the price that makes the opportunity viable for a buyer,” he says.