Introduction
Cash payments
Debt financing
Equity financing
Leveraged buy-outs
Comment
At its core, financing involves using a fund which incurs the lowest cost for the borrower and provides the highest rate of return for the financier. As this model constitutes the realisation of the contemplated M&A deal for the borrower and a lucrative investment for the financier, a debt structure will be negotiated to ensure that both parties are satisfied. While this holds true for every project, M&A projects usually require various combinations of financing instrument due to market risks and the complex nature of each transaction for the parties involved. These parties may represent:
- the buy-side and the sell-side of the transaction;
- a third party and one such side; or
- a third party and both sides.
Each party has their own considerations in an M&A deal which are reflected in the financing of the deal as much as in the deal itself.
This article sets out the most common ways of financing an M&A transaction.
The most obvious way to finance a deal is to use the funds already at hand. A cash payment may be the chosen financing method if the cash balance of the acquiring firm is substantial enough to warrant a clean payment. Such payments are simple, largely instantaneous and involve no third parties. However, this independence comes with the risk of liquidity, which an acquiring company requires to continue its ordinary business and generate cash flow through its assets. If the acquiring company loses its liquidity, debt financing of either, or both, the ordinary business and the transaction will become inevitable because using a company's cash to finance a transaction shifts the funds from business operations to the transaction.
Debt financing comes in many different forms but, in essence, these are all variations of a financier supplying capital in exchange for repayment with interest. Even if a company can pay for the transaction in cash, debt financing will buy it time (interest is, in part, compensation for the time value of the money paid by the lender) and not tie up its capital. Further, interest payments are largely tax deductible and a company's debt-to-equity ratio (closely related to leveraging) enhances the returns on investment, while simultaneously increasing the risk.
The structure of debt financing is broadly as follows.
Senior debts
Senior debts are first in the order of payment and last in the order of application of loss. Usually secured by collaterals and held by banks, senior debts are the least risky segment of the debt financing structure but command the lowest yield. Some of the most common methods of financing an acquisition through financial institutions' loans are as follows.
Fixed-term loans
Fixed-term loans are the most basic form of debt financing by a financial institution. The necessary fund is supplied from the financial institution and paid back according to the pre-determined schedule, with a fixed interest rate. As the essential debt financing method, fixed-term loans make budgeting predictable and reduce exposure to fluctuations in the financial markets while forgoing flexibility and downward trends in interest rates.
Variable interest loans
A variation on the basic form of loans, a variable interest loan means that the rate of interest to be charged on the outstanding balance changes with the market interest rate. The exact opposite of a fixed-term loan in effect, variable interest loans offer decreasing interest rates, but borrowers' budgetary planning is contingent on the market's everchanging interest rates. However, if a borrower of a variable interest loan speculates that the market interest rates will increase and the borrower of a fixed-term loan speculates that the market interest rates will be lower than their fixed term, these parties can exchange their interest rates through an interest rate swap.
Revolving credit
First introduced by Strawbridge & Clothier Department Store in the late 19th century for its customers' clothing purchases, revolving credit is an agreement which allows for the loan amount to be withdrawn, paid back and withdrawn again until the agreement's termination. The borrower pays a fee according to the number of times that the funds have been withdrawn. As with a line of credit, interest applies only to the withdrawn amount and not to the total amount permitted to be withdrawn by the institution.
Unitranche loans
Not a separate debt instrument in itself, unitranche loans are different instruments of debt with different seniorities combined into one. Financial institutions make an arrangement between themselves to provide the different instruments of debt as one and offer it to the borrower. Effectively combining senior and subordinated debt, the borrower may access funds with a lower cost of capital and raise more funds more quickly. As several instruments are combined into one, the borrower does not negotiate with every lender and pays only the appointed lender. Lenders then distribute the payment among themselves according to their internal arrangement, with no further responsibility on the borrower's part.
Subordinated debt
Subordinated to the senior debt, these debts are paid only after the senior debts have been paid. Being a riskier segment of the debt financing structure, subordinated debts are moderate to high risk instruments but have a higher yield than senior debts. Subordinated debt accommodates financing instruments such as, on a scale of debt to equity;
- high-yield bonds – also referred to as 'junk bonds', high-yield bonds are not of investment-grade quality but offer high interest rates;
- mezzanine debt – in the same way that a mezzanine floor sits between two main floors, this type of subordinated debt is an intermediate form of debt and equity. These debt instruments have embedded options for conversion to equity if the stipulated conditions occur, exposing the lender to both equity and debt but offering high returns with successful navigation through the deal;
- payment-in-kind instruments – these pay interest or dividends to holders of bonds, notes or preferred stock in the form of additional securities or equity rather than cash; and
- seller's financing – 'seller's financing' means that the transaction is financed by the seller and it is the seller which holds the bond. This type of financing usually comes in the form of a seller's note, deferred payment or earn-outs and is mostly used in combination with a cash payment. The seller takes a portion of the payment upfront and the outstanding amount plus interest is paid within a certain period. If the target's performance is dependent on that of the seller, the payment may be made through earn-outs within a certain period, during which the seller assumes the running of the business and takes payment from the target's profits, while gradually resigning from the position.
Under this option, the acquiring company will either raise capital for the transaction through an equity offering or directly offer the equity to the target. Stocks may be offered directly to the target's owners as a method of enabling the transaction, especially if the target relies on its owner's proficiency to perform lucratively. Equity financing either reduces the need for cash or eliminates it completely, thus preserving the acquiring company's liquidity. But this comes at the cost of diluting the shares of the initial owners of the acquiring company.
Another common method of realising M&A deals is stock swaps. Stock swaps are carried out through determining a swap ratio between shares of the companies and exchanging the shares between the owners of the companies accordingly.
The structure of equity financing is broadly:
- preferred stocks – these are higher in seniority to common stock, meaning that holders of preferred stocks have higher priority in the distribution of dividends and might also have rights in the company's management; and
- common stock – common stock is the most junior part of the capital structure and is the first to bear the losses and the last to receive yields.
Leveraging means utilising debt rather than equity to achieve higher returns on capital, while simultaneously running the risk of a higher loss. A company's capital profitability is the earnings per capital and acquiring the required operational funds by debt rather than contributing more capital through offering equity (diluting dividends and control over the company) means higher returns for fewer equity holders. However, as offering equity involves exchanging the rights over the company and dividends for funds rather than creating an obligation of later payment, leveraging imposes greater obligations on the company.
A leveraged buy-out essentially involves borrowing funds from a third party for an M&A transaction by pledging the target as collateral. The debts incurred from borrowing are then paid from the target's profits. If the target generates more profits than the cost of the debt and its primary, the capital profitability maximises because the profits are shared among fewer equity holders. However, if the target is unable to ensure enough profitability to pay off the debt, the leverage also applies to losses. Energy Future Holdings' decision to file for bankruptcy protection in 2014 due to a stark drop in natural gas prices came as a surprise, as the acquisition of Energy Future Holdings by Goldman Sachs, TPG Capital and KKR for $45 billion is the largest leveraged buy-out in history. Because of the speculative nature of this financing method and its reliance on a steady flow of cash from the target (with market risks weighing in too), leveraged buy-outs are restricted or outright banned in some countries.
The above instruments may be used to mitigate risks in M&A transactions and achieve the lowest cost of capital while simultaneously maximising earnings. Each instrument's considerations of liquidity, systemic risk, third-party involvement, dilution of equity and other aspects of both financing and the course of the M&A transaction are best responded to by using these instruments complementarily. These instruments can not only be used in combination, but also implemented in several phases.
Meeting the obligations of financing depends on its structuring as much as adequate cash flow. A well-structured financing thus ensures that the available cash flow is enough to pay the demands of the capital raised. However, parties must remember that using these financing methods to their fullest potential requires knowledge of local financing regulations and a deep understanding of the markets in which each company operates.
For further information on this topic please contact Kaan Demir at Kayum & Demir by telephone (+90 212 291 1002 ) or email ([email protected]). The Kayum & Demir website can be accessed at www.kayumdemir.av.tr.
