Forms of Acquisition Finance
When people think about investment bankers, the first thing that comes to mind is usually is mergers & acquisitions. However, beyond the strategy and advisory component to effecting a merger, full service investment banks are eager to win acquisition finance mandates – that is providing the funds to purchase the company.
Very rarely do companies have enough cash readily available to make a massive acquisition – Warren Buffett’s Berkshire Hathaway being a notable exception. Usually, a company will need to at least raise temporary bank term debt before the transaction can be paid down with cash flow – this is arranged by the corporate banking division and loan syndications.
More often, they will require some permanent debt in their capital structure by way of bond offerings while larger transactions will require common or preferred equity issuance to preserve credit ratings. All of these capital markets issuances require the services of an underwriter (the investment banker), and fees can be substantial.
For mergers that require significant financing, sometimes the investment bank can make far more money providing financing than the actual M&A success and work fees. When a company is being actively marketed, investment bankers will take the other side for potential buyers with the hope that not only can they win an M&A fee but also be in charge of (as the sole or joint bookrunner) the financing package.
Serving as a financial advisor for a potential buyer can be stressful as the certainty that they will be the winning bidder is variable – however, the payout can be commensurately large should it work out.
Characteristics of Bank Debt – Lowest Interest, Shortest Tenor, Most Senior in the Capital Structure, Most Restrictive Covenants
Bank debt is the most senior form of acquisition finance and subsequently the cheapest. Bank debt is also characterized by having the shortest maturity dates – from less than a year to no more than five years. Banks expect borrowers to pay this down first to extinguish their commitments – they have the shortest maturity date of the other capital sources uses for acquisition finance. The amortization schedule is also staggered instead of a bullet payment at the end – so principal slowly decreases during the life of the loan.
Banks are risk-averse entities and demand the most security on this sort of debt – that is they have first claim on collateral posted for the loan and will otherwise be paid out first should the company be liquidated. To make sure that the financial health of the company does not deteriorate to that point, banks will insist on the strictest legal covenants to make sure that a company does not take on a risk profile it is not comfortable with.
As an example, so long as the debt is outstanding, companies may not be allowed to make certain asset sales and stay within interest coverage covenants (EBITDA is at least 2x interest payments) or leverage thresholds (Debt cannot exceed 2x EBITDA).
Types of Bank Debt – Revolvers and Term Loans
In financing an acquisition, standard bank loans such as a revolving line of credit, term loan or bridge loan can be used.
Revolvers are like credit cards – they are drawn on and then paid down. As long as they are drawn, they will be charged at a higher rate of interest. Revolvers may be set up for the purposes for the acquisition, but companies that undertake a lot of M&A may have revolvers that are regularly used for purchases and then paid down with cash flow from the new businesses.
Term loans are drawn at once or gradually, and once the paydown period begins they cannot be re-drawn on. Usually companies take this in a lump sum and gradually amortize the debt via cash flow.
Benefits and Drawbacks of Bank Debt
Using bank debt has the obvious benefit of being cheap and non-dilutive to shareholders as they do not increase the share count. Interest payments on all debt are tax-deductible, making the returns more attractive.
One additional feature of bank debt is the flexibility – both for paydowns and for sizing. Unlike bonds, which are seen as more permanent capital for the issuer and a longer term hold for fixed income investors, banks want to get bank debt off their books as soon as possible. As such, there are no prepayment penalties for paying down the bank debt used in an acquisition (this may be different for Term Loans that hedge funds invest in that are more similar to debt).
Also, while bond issuances have to garner a certain amount of demand, revolvers make it possible for corporates to draw as little as they need – which is particularly useful for small acquisitions that they just tack on to existing businesses – also known as “bolt-on” or “tuck-in” acquisitions.
On the flip side, bank debt is restrictive due to the aforementioned covenants and short-term in nature. As such, companies cannot take corporate actions that would reduce their ability to meet covenants. Also, bank debt usually is floating rate or variable rate debt – that is when the benchmark cost of borrowing (usually LIBOR) rises, the interest rate rises as well – presumably to preserve the bank’s margins against a rising cost of funds.
Corporates can hedge out their interest rate risk if they prefer fixed rate debt for budgeting, which banks can do separately or embed the pricing into the debt via an option. These are done through a simple interest rate swap, but can only be effectively done for debt that is meant to be outstanding for a known period of time. For more information, read this post about hedging interest rates.
Bridge Loans – Equity Bridges, Bond Bridges and Asset Sale Bridges
Bridge loans are a different form of bank debt (and the favorite for investment and corporate bankers) which are meant to serve as a “bridge” to another financing form. For instance, when the transaction is due to close the company will not have raised bonds or equity yet, so it needs to have the cash on hand to deliver to the seller. They cannot raise bonds or equity beforehand, because if the transaction does not close for whatever reason, they are saddled with additional capital they do not need.
This is why many transactions meet their “conditions precedent” by having secured financing from a bank. In the interim, they take a bridge loan from the bank which is “taken out” by the proceeds from the future bond or equity issuing (or pre-planned sale of assets).
Banks like bridge loans as they are short in duration and come with fees – they do not have to keep the credit on their books, which they have to hold capital against, whereas one-time fees from the bridge loan issuing and the subsequent share or bond offerings are pure revenue coming in the door.
To protect the bank, should equity or bond offerings fail, bridge loans have provisions that make the interest rate go up the longer it is outstanding – compensating them for their risk.
Loan Syndication for Bank Debt – Bilateral Facilities, Club Deals, Syndicated Loans
Depending on needs, corporates can have a very narrow to very wide bank syndicate for providing funding.
On one end, a corporate can engage with one lender only in a bilateral transaction. As these are negotiated between two private parties – the borrower and the financial institution – terms and pricing (the interest rate) are more flexible than in a syndicated facility. For creditworthy customers, the interest rate will likely be lower than using a syndicated facility. For less creditworthy customers, they may not even be able to do anything other than a bilateral deal with strict terms.
Bilateral facilities are usually constrained by size. For larger acquisitions, only the largest banks can afford to foot the bill for the entire deal size due to internally imposed risk limits for exposure to a single entity.
However, for acquisitions that come with substantial capital markets activity and necessitate raising public debt and equity later, investment banks may be eager to cut the entire cheque for the lion’s share of fees from DCM, ECM and M&A.
Bilaterals, since they do not need to be coordinated with multiple lenders and law firms, can move much more quickly than anything syndicated. With a bilateral loan (or sometimes a club deal), an acquisition can be closed fairly quickly. A good example of using a bilateral loan in this manner is Canadian Natural Resources’ acquisition of Devon Canada’s assets, where they received $1 billion dollars from a bank to effect the transaction in short order.
Club Deals – Syndicated Loans
Club deals are medium size loans where borrowers usually tap their core bank group (main 3-5 relationship banks) for loans. Pricing and terms may not be as low as for a negotiated bilateral agreement, but are generally a few basis points off of a syndicated revolver. Often, club deals will be put together when there is already a large syndicated revolver and companies do not want to go back to all of their banks for additional credit.
Although the administrative agent (bank that coordinates activity between the borrower and the rest of the syndicate) for the main syndicated loan will often also serve as the administrative agent for the club deal, all banks will be much more involved in this financing and will usually all be given Joint Bookrunner or Joint Lead Arranger titles for league table credit.
Global Syndicated Loans
Large syndicated loans with various banks are the standard for transformative transactions and all participants big and small will result in some sort of fee revenue via DCM, ECM or trading products. Pricing is also most standardized – so borrowers will expect to pay what other recent BBB+ comparable companies in their industry group priced at for similar acquisitions recently.
The administrative agent (the bank that coordinates activity between the borrower and the other lenders) takes on a very active role here and may receive additional fees to the other borrower for this service, although it is sometimes thrown in for free as the administrative agent is usually going to be taking an outsized proportion of the other investment banking revenues.
The largest syndications can have something like 50 banks committing to lending up to 5 years.
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