Previous Page  |  Home  |  Contact  |  Site Map 

Capital Ideas for Middle Market Businesses

Mergers and Acquisitions Financing

The Significant Role Financing Plays in M&A Transactions

By David Sinyard, Managing Director and Principal
Atlanta Office
Corporate Finance Associates

question marks

The role that finance plays in mergers and acquisitions (M&A) is significant. When private equity firms recapitalize a company, a significant amount of the capital is originated in the form of senior debt. Banks and specialized finance companies focus on these types of transactions. As part of the recap transaction, the private equity firm will approach several lenders with the proposed deal, seeking the most aggressive response in terms of the amount that can be lent and the terms which include interest rate, term and principal repayment. Lenders will advance a multiple of EBITDA. Typically, the buyer will seek as much leverage as possible so that their equity check is limited. Let’s also remember that the interest paid is deductible as an expense of the business. For example:


Why is this of interest to a business owner who is trying to sell or recap his business? In addition to the private equity firm performing due diligence, the lender will as well. This means an additional burden on the business owner as the needs of the lender may differ from that of the equity provider. If the loan is from a bank, federal and state regulators may impact the transaction by limiting the amount of this type of financing that banks can provide. Regulators may impact the appetite of the various banks and may restrict them from originating these loans.

The negative impact of regulators has resulted in the expansion of non-bank lending sources. They come in a variety of forms –for example credit companies, Small Business Investment Companies (SBICs), Business Development Companies (BDCs), as well as private equity and hedge fund sponsored entities. Each of these has different lending parameters. As they are not regulated their deals can be more aggressively underwritten. The debt originated by these groups will be more expensive than senior lenders. There also may be some differences in the covenants required by the lenders.

The business owner considering a sale or a recapitalization needs to understand the debt markets. As interest rates increase (as has been the case since the election in November) the cost of financing has increased and is expected to continue to increase. I am the member of the Asset and liability Committee of a $550 million community bank located in Atlanta. We are very interested in interest rate movements as they affect profits and the value of the investment portfolio of the bank. In particular, several interest rates are worth paying attention to and we meet with our advisors every 90 days to review anticipated market movements. Prime, which is tied to the Fed Funds rate is currently 4%. An increase of .25% is expected in June, and another .25% increase is anticipated in December 2017. The 10-year Treasury is currently trading around 2.3%. this rate will likely increase slowly through the rest of 2017 to 2.5% by year-end and to 2.7 by December 2018.

While these rate increases do not appear significant, the result is that more cash flow is required to service the senior debt resulting in less cash flow for the equity investor. The more expensive the debt, the lower the cash flow available, which in turn will impact the valuation of the business.

Let’s use a simple example. A business generates an EBITDA of $5 million and is valued at a 6 multiple - $30 million. A senior lender agrees to lend 3 times EBITDA - $15 million at a rate of Prime + 2 which today would be 6%. Assuming interest only, the annual interest payment would be $900,000. A .5% increase, which is what the market is anticipating, would mean an additional $75,000 in interest payable annually. At a 6 multiple, the reduction in value of the cash flow is $1.25 million – a meaningful number.


NOT ON OUR DISTRIBUTION LIST?
If someone forwarded this newsletter to you and you would like to continue to receive future issues, please sign up now.