Financing a M&A transaction: An introduction
Financing a M&A transaction: An introduction
Joris Kersten, Place: Uden/ Netherlands, 27th February 2020
Consultant & Trainer Joris Kersten
I am an independent M&A consultant and Valuator from The Netherlands.
In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world (New York, London, Asia, Middle East). This at leading (“bulge bracket”) investment banks, corporates and universities.
I also provide inhouse training on request (globally). Email for availability to: info@kerstencf.nl
And I have open training programs in business valuation in The Netherlands and different places in the world (e.g. New York, Mumbai, Dubai, Amsterdam and Uden).
My full training calendar can be found at the very end of this article.
And my next upcoming training is: Business Valuation & Deal Structuring @ Uden/ The Netherlands @ 18, 19, 20, 21 and 23, 24 March 2020.
Visit for all info and registration: www.joriskersten.nl
In addition, I write blogs and articles on business valuation related issues, earlier blogs can be found at the very end of this article.
Financing a M&A transaction: Introduction
This blog is an introduction on how to finance acquisitions.
Acquisitions are financed with different finance instruments and different financing structures.
In case you like to see how to model these finance instruments and structures in Microsoft excel, then please check my previous blogs on:
· Blog: Building leveraged buyout models (LBOs):
· Blog: Building a Merger & Acquisitions model to assess “accretion” or “dilution” of a M&A transaction:
· Blog: Excel shortcuts for financial modelling:
Concerning financing of companies there are actually only two types of financing:
1. Uncommitted financing;
2. Committed financing.
Uncommitted financing can be seen a revolving credit facility (“revolver”) or financing of working capital.
In theory this type of financing can be cancelled by the bank every day.
And committed financing is there for a fixed pre-determined period of time.
(Goedkoop & Veken, 2011)
Types of financing
In large acquisitions multiple types of financing are used, ranging from senior debt to junior debt.
Senior debt
Financing forms with the best secured positions are called “senior debt”. The instruments are usually issued by banks.
“Second lien” is a relative new product and is less used in The Netherlands (where I am from and based). Concerning level of security, issuers of second linen instruments are lower in ranking than senior debt issuers.
Second lien instruments are issued by banks and institutional investors.
Junior debt
Junior debt, or subordinated debt, are loans with the least level of security.
A form of junior debt that is used a lot is “mezzanine financing”. Concerning level of security, it lies in between senior debt and equity, because mezzanine means “in the middle”.
Another form of financing is PIK loans (“payment in kind”). Withing these type of loans interest is not paid in cash but added to the face value of the loan, and paid in the end.
(Goedkoop & Veken, 2011)
Buying assets or shares
When you buy the assets/ liabilities of a company the goodwill that is paid can be amortized by the buyer. And the results of the target and the buyer are automatically consolidated.
The costs (consultants) of the acquisition are in general deductible for tax, direct or on the longer term.
Because of the amortization of goodwill by the buyer, the “book profit” (goodwill for buyer) is taxed for the seller.
So it could be the case that the price of an acquisition is higher with an asset/ liabilities deal. This because of tax payment of the seller, on the profits made on the book value of the assets.
With a share deal goodwill can not be amortized for tax purposes by the buyer. And the costs (consultants) of the takeover are not deductible for tax purposes either.
(Goedkoop & Veken, 2011)
Private equity vs. a strategic buyer
In case of a strategic buyer, the bank will not only look at the possibilities to finance the target. They will then obviously also look that financing capacity and structure of the buyer.
Corporate finance consultant (or investment bankers) assess this by building a so called “M&A model” in excel.
And when a corporate finance consultant (or investment banker) assesses the possibilities for a financial investor to finance a deal they build a so called “LBO model” in excel.
These financial investors, also called financial sponsors (private equity), are used to do deals with high levels of debt. This in comparison with strategic parties who are in general more reluctant for this.
When a company takes on high levels of debt this has big influence in how to run the company afterwards.
The large levels of interest and principal that need to be paid requires a very careful monitoring of the returns and liquidity of a company.
This is why strategic parties are often more reluctant than private equity parties to take on very high levels of debt (even when this increases the return on equity a lot, the good old “leverage”).
And private equity parties are far less reluctant with this because they are (relatively) masters in this game.
In order to understand the key (corporate finance) issues for “strategic parties” when they buy a company; leverage ratios (credit ratings) and earning per share (EPS) accretion or dilution, I advise you to carefully read my blog on the M&A model:
And in order to understand they key (corporate finance) issues for “private equity parties” when they buy a company; leverage ratio’s (credit ratings) and internal rate of return (IRR), I advise you to carefully read my blog on the Leveraged Buyout model (LBOs):
Buyout structure & debt pushdown
In a typical buyout; when a private equity party buys a company, often a new company is set up. These are called “Newco” which stands for “new company”.
This newco takes over the shares in the company (target) and often the management also gets shares in the newco.
With respect to structuring of the financing of the acquisition, we need to look at the newco and to the operating company (this is the company bought).
And these "operating companies" are often called “opcos”.
As you can imagine a bank prefers to finance a takeover at the opco level. This since these opcos actually possess the assets for production, accounts receivables, inventories and other assets.
In other words, the money is, and is made, in the opcos! So in case of a bankruptcy, the bank can sell the assets of the opcos in order to make (some of) their money back.
Because banks want to finance the money in the opcos, in most buyouts a “debt push down” is used.
This means that a part of the financing need in the newco (to pay for the acquisition) is pushed down to the opcos.
And then from here the money is paid back up to the newco through a dividend pay-out (in order to be able to pay for the acquisition).
When we look at the total financing needs in the newco, to pay for the acquisition, this consists out of three components:
· The price for the shares (market value of equity of the target);
· The level of the debt that needs to be re-financed (this is together with the equity value the: enterprise value);
· Transaction costs (e.g. investment bankers, corporate finance consultants, credit bank, lawyers, tax tawyers, accountants etc. etc.).
And this financing need is then further spread over the newco and opco(s).
As mentioned, you can study my former blogs on the “M&A model” and “LBO model” to get familiar with how this is technically modeled in excel.
(Goedkoop & Veken, 2011)
Covenants
When a bank issues “committed financing”, like discussed above, than they can not call back the debt whenever they want.
But the banks still want to be able to take control when for example financial performance gets bad. And for that “covenants” are taken up in the credit agreements.
The credit agreements (LMAs) mention in this perspective covenants as “positive undertakings” and “negative undertakings”.
Positive undertaking are circumstances that the taker of the debt should live up to, like certain legal rules.
And negative undertakings are circumstance that the taker of the debt should prevent to happen, like for example selling important assets of the company.
Example 1, three of the most used financial ratio covenants with acquisition finance are:
Leverage ratio:
This ratio looks at the relation of debt over EBITDA, and this number needs to be smaller than a certain number set in the credit documentation.
E.g. 6 times EBITDA with a US LBO, 5 times EBITDA with a UK LBO and about 3 to 3.5 times EBITDA with financing in The Netherlands where I live.
Interest coverage ratio:
This ratio tells something on how many times a company can pay the interest out of EBIT(DA).
Debt service capacity ratio (DSCR)
This ratio tells something on how many times a company can pay the interest + principle out of EBIT(DA).
Example 2, a few restriction-covenants that are used a lot are:
No further debt
No additional (bank) financing can be attracted without consent of the current issuing bank(s).
Negative pledge
No security-rights of assets can be given to other third parties.
Positive pledge
Security-rights of assets need to be given to the bank (the bank who issued current debt) when they request this, and when they do not have the security-rights yet.
Cross default
Banks can call back the debt immediately when the company does not pay interest and/ or principle or violates the covenants.
Dividend restriction
No dividend can be paid out to the shareholders when the company for example did not achieve certain ratio’s yet.
(Goedkoop & Veken, 2011)
As mentioned, in case you like to see how to model these finance instruments and structures in Microsoft excel, then do not forget to check my previous blogs on:
- Blog: Building leveraged buyout models (LBOs):
- Blog: Building a Merger & Acquisitions model to assess “accretion” or “dilution” of a M&A transaction:
- Blog: Excel shortcuts for financial modelling:
Hope you found this blog informative, there is lots more to come on: Valuation, M&A, private equity, start up valuation etc etc. And please let me know when you like to see certain topics covered at info@kerstencf.nl.
Source used for this blog
· Book: Bedrijf te koop – Handboek voor koop, verkoop en buyout van bedrijven. Arthur Goedkoop & Ad Veken. Publisher: Business Contact. March 2011.
The book is very broad, but quite detailed, on all the aspects of M&A. I really recommend you to read the book when you are involved in M&As. Unfortunately the book is only available in the Dutch language.
And to check out my previous blogs on: Net debt, discount rates, football field valuation etc. please find the links below! Wish you a fantastic week! 😊
Earlier blogs on “net debt” (cash & debt free)
Article 1: Valuation: Introduction to "net debt" (cash & debt free)
Article 2: Valuation: Net debt (cash & debt free)
Article 3: Valuation: Adjusted net debt – Cash like items
Article 4: Valuation: Adjusted net debt – Debt like items
Will be published in week of 2nd March.
Earlier blogs on the “cost of capital”
Article 1: Valuation & Betas (CAPM)
Article 2: Valuation & Equity Market Risk Premium (CAPM)
Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)
Article 4: Valuation & the cost of debt (WACC)
Article 5: Valuation & Capital Structure (WACC)
Article 6: International WACC & Country Risk – Part 1
Article 7: International WACC – Part 2
Article 8: Present Values, Real Options, the Dot.com Bubble
Article 9: Valuation: Different DCF & WACC techniques
Article 10: Valuation of a company abroad
Article 11: Valuation: Illiquidity discounts, control premiums and minority discounts
Article 12: Valuation: Small firm premiums
Earlier blogs on “Business valuation to Enterprise Value”
From June until August I have written the following blogs on valuation:
1) Leveraged Buyout (LBO) Analysis:
2) M&A Analysis – Accretion/ Dilution:
3) Discounted Cash Flow Valuation:
4) Valuation Multiples 1 – Comparable Companies Analysis:
5) Excel Shortcuts & Business Valuation:
6) Valuation Multiples 2 – Precedent Transaction Analysis:
Earlier blogs on Wall Street
Article 1: Wall Street – A general introduction
Article 2: Wall Street – The Federal Reserve banking system
Earlier blogs on Financial Modelling
Scoping a financial model built primarily for business valuation:
Training agenda Joris Kersten:
- Financial Modelling in Excel (5 days): 2, 3, 4, 5, 6 February 2020. Location: Riyadh/ Saudi Arabia;
- Business Valuation & Deal Structuring (6 days): 18, 19, 20, 21 and 23, 24 March 2020. Location: Uden/ The Netherlands;
- Financial Modelling in Excel (4 days): 20, 21, 22, 23 April 2020. Location: Uden/ The Netherlands;
- Business Valuation & Deal Structuring (5 days): 22, 23, 24, 25, 26 June 2020. Location: New York City/ United States.
- Business Valuation & Deal Structuring (5 days): 19, 20, 21, 22, 23 July 2020. Location: Dubai/ United Arab Emirates.
- Business Valuation & Deal Structuring (5 days): 3, 4, 5, 6, 7 August 2020. Location: Mumbai/ India.
- Business Valuation & Deal Structuring (6 days): 28, 29, 30, 31 October 2020 + 2, 3 November 2020. Location: Amsterdam/ The Netherlands.
- Financial Modelling in Excel (4 days): 16, 17, 18, 19 November 2020. Location: Amsterdam/ The Netherlands.
All info on these open training sessions can be found on: www.joriskersten.nl
And 130 references on my training sessions can be found on: www.joriskersten.nl