Acquisition Finance

By Jamie Johnson

What is acquisition finance?

Acquisition finance refers to the different funding sources to fund a merger or acquisition. Very rarely, an acquisition will be funded fully through cash, so this article will discuss the different options firms have in raising the required capital.

A brief note on asset acquisitions

Most of this article will discuss the issues for share acquisitions (purchasing the shares of a target company). Nonetheless, this is not always what a buyer targets. Sometimes, instead of a target company, the business will purchase a specific asset of another business.

This is beneficial from a buyer’s point of view in order to select the best assets and avoid any potential liabilities. However, this is ultimately not very common because the target firm is left with liabilities. Consequently, these sorts of agreements either take longer to form or never come together. Given that these types of transactions are rare, the rest of the article will mainly assume that the finance is for a share acquisition.

Which parties are involved in acquisition finance?

There are three parties involved in acquisition finance: banks, a target company and a buyer.

Banks will often be the primary source of funds for the transaction. Sometimes, there may be institutional investors or hedge funds who provide the capital instead.

A target company is a firm that is being acquired in the transaction at hand.

The buyer is the actor who wants to purchase the target company. They will often perform due diligence on the target company. This is where they investigate the target company to see if there are any issues with it that they should be aware of.

Methods of financing an acquisition

This article will focus on debt finance and equity finance.

Debt finance

Often there are three main tranches (layers) to the debt that the buyer takes out in order to purchase the target company: senior debt, junior debt and mezzanine debt.

Senior debt is repaid to a bank first if the buyer has an issue with defaults or liquidation. It is usually secured, which means that the bank can claim an asset that the buyer has if it goes into insolvency proceedings. Assets could include shares, inventory, intellectual property rights, real property or movable assets.

Junior debt is typically not secured. It has lower priority for repayment than senior debt but it is also typically accompanied by a higher interest rate.

Mezzanine debt comes below senior and junior debt in the priority of repayments. Often this can be converted into an equity stake in the case of default. It also typically has a higher interest rate.

The inter-creditor agreement will often co-ordinate these three tranches by establishing the priority of repayment.

Equity finance

There are three primary sources of equity finance for an acquisition: a rights issue, an open offer and a vendor placing.

A rights issue involves asking existing shareholders to buy more shares in the company. The shares on offer will typically be proportional to the equity stake they currently have in the firm. They are not required to purchase these shares.

An open offer involves shareholders being able to buy shares at a price below the market price. This is different from a rights issue because the shareholder cannot sell the rights that they get from buying more stocks to others.

Vendor placings involve the buyer offering shares in its company to the target in exchange for shares in the target at a pre-agreed ratio.

Why might a firm choose debt finance over equity finance?

A firm might choose debt finance for three reasons: interest payments are tax-deductible, the firm would avoid the dilution of existing shareholders’ rights, and the firm might have lower interest payments.

Interest repayments, unlikely dividends, are tax-deductible. Thus, they may save the buyer money.

Debt finance also avoids the dilution of existing shareholders’ rights. This is important for the management of the firm because shareholders usually have the right to vote in the election for the board of directors.

In some cases, the firm might have a good credit rating. This means that banks are confident with the firm and accept a lower rate of interest from it. Thus, the cost of debt is lower.

Why might a firm choose equity finance over debt finance?

A firm might choose equity finance over debt finance for three reasons: their shares might be valued highly, they might have a gearing ratio that is too high, and there could be legal impediments.

The market values the equity of some firms particularly highly. If this is the case, then they might be able to raise a large amount of capital by only issuing a small number of shares.

In some cases, a firm might have a gearing ratio that is too high to justify more debt. Gearing is the ratio of debt to equity in a firm. If the current ratio is too high, they might struggle to get banks to agree to provide a loan to the firm.

In some cases, there could be legal impediments to the firm raising more debt. The company’s articles of association or pre-existing loan agreements might prohibit the firm from raising debt above a certain level.

Relevant risks for the acquirer

The main risk for the acquirer is that the target company ends up costing the buyer a significant amount. This would mean that it would struggle to repay any of the finance it has raised. There are two main reasons for why this could occur.

Firstly, the target company might come with hidden costs that the buyer did not find during due diligence. For instance, it might have a defined benefit pension scheme with a deficit. The buyer would then have to spend money filling this deficit.

Secondly, the benefits of the target company might not be as high as the buyer initially thought. So, if they do not make as much money as projected, they might struggle to repay the finance that they raised.

Case studies

July 2020 - Ardonagh completed a £2bn refinancing. This provided it with a £300m fund for international expansion, which it intends to undertake by pursuing over 35 acquisition opportunities. The chief executive, David Ross, stated that he supported the use of private financing for refinancings as opposed to public listings because this avoided the stringent disclosure requirements that come with shareholders.

February 2020 - Vectra S.A. was provided lending from a syndicate of banks in order to acquire Multimedia Polska S.A. The syndicate was led by BNP Paribas. Vectra is one of the largest cable operators in Poland. The acquisition will make it the biggest cable provider in Poland with 1.7 million subscribers.

September 2019 - a consortium of banks led by Natixis and Société Générale provided lending to Segula Technologies (a French engineering firm). This was so that they could buy parts of Opel’s development centre. In total, Segula would gain 2,000 employees over the deal from Opel, which is headquartered in Germany.