Today’s companies have more options when it comes to debt financing, ranging from traditional bank loans to venture debt facilities. Using debt to help finance an acquisition can offer several benefits, including reduced cost, lower complexity, greater speed and enhanced acquisition capacity. In this article, we explore the 6 of the most common types of debt financing options that buyers in an M&A deal will obtain.
1. Senior Debt (Bank Loan): Fixed Term Loan or Revolver
The fixed term loan is credit for a fixed amount to be funded, and paid back, according to a pre-determined schedule. A revolving loan allows a borrower to drawdown, pay back and re-borrow a capped amount of credit at its own discretion. Loan agreements can feature some combination of the two depending on the purchaser’s up-front financing needs and future working capital requirements.
2. Senior Debt (Bank Loan): Single Lender or Syndicated
Syndicated loan is usually a multi-lender transaction, where lenders (usually banks but sometimes including non-bank investors) contract with a borrower to provide a loan on common terms and conditions governed by a common document (or sets of documents). Each lender acts on a several basis, whereby if a lender fails to honor its obligations as a member of the syndicate, the other syndicate members have no legal duty to satisfy these obligations on that lender’s behalf. A syndicated loan may be arranged on an underwritten or best-efforts basis, or by way of a club deal.
This form allows lenders to participate in larger financings without requiring high capital outlay or risk exposure. A syndicated loan is often led by one lender acting as agent, a role which typically includes negotiating and administering the loan.
3. Asset-based Loans (ABL)
This flexible form of finance leverages business assets such as debtors, stock, plant & machinery and property, frequently accompanied by a cash flow loan to generate higher levels of funding. With ABL, even the assets of the target company being acquired can be taken into account. These facilities go far beyond providing funding support towards the initial purchase, they also generate substantial ongoing working capital to help the management team drive further growth.
4. Mezzanine Debt or Mezz Financing:
Governed by IFRS 9 ‘Accounting for Financial Instruments’ Mezz Debt is a hybrid instrument. It is a high risk instrument that bridges the gap between debt and equity financing. This is because such debts possess embedded derivatives (equity instruments) known as warrants. This debt is a commonly utilized for leveraged buyouts and acquisitions. Mezzanine financing entails higher risk for the lender than senior debt and therefore carries a higher interest rate. However, its repayment terms are highly flexible and can be tailored to a company’s needs. Mezzanine financing is suitable for target companies with a strong balance sheet and steady profitability. Flexibility makes mezzanine financing appealing.
5. Leveraged Buyout (LBO):
An LBO is an acquisition finance structure in which debt is used as the main source of funding for the purchase price. This structure allows a purchaser to make large acquisitions while contributing relatively little of its own capital. Security is taken in the assets of the purchaser and the assets of the target being acquired. Lenders, cognizant of the risks associated with high leverage, will often insist upon strict operating and notice covenants. For this reason, purchasers typically only engage in LBOs of mature companies with stable, predictable cash flows. While high-profile LBO failures have illustrated the risk inherent in this approach, if used successfully purchasers can realize a higher return on equity than they would if ‘ordinary’ levels of debt were used.
6. Seller (or Vendor take-back) Financing:
Seller’s financing is where the acquiring company’s source of acquisition financing is internal, within the deal, coming from the target company. Buyers usually resort to the seller’s financing method when obtaining capital from outside is difficult. The financing may be through delayed payments, seller note, earn-outs, etc. A portion of the purchase price is paid on closing and the seller agrees to defer and finance the balance of the purchase price. Post-closing, the purchaser owns the business while making principal and interest payments to the former owner. Sellers are most likely to offer financing at a lower cost to sweeten (and expedite) the deal.
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