LIFE-SIGHT: Financing acquisitions (Summary)
Acquisitions need two things: money and ambition. Without ambition they won't happen. If there is, cash runs out. This article is about the options of a hungry buyer to tap outside funds for buys.
Equity injections. In these debt-strapped times, equity has become the main currency of buyouts. Private Equities have less access to bank loans and strategics draw on corporate credit lines, rather than raising debt for takeovers. "Equity funding" means either (1) retained earnings, (2) initial or follow-on offering through the stock exchange, or (3) private placement of shares to minority investors. Private placement financed acquisitions are rare in Central Europe as both Private Equity and strategic investors look for majority control when investing in targets.
Senior Debt. The highest ranking debt instruments, mainly from banks or bond issues. Senior bank debt is typically well secured by assets, cash flows and sometimes the target's shares too. Issued senior debt is more flexible, but often also secured. In 1990s Hungary utilities like MOL or Matáv and regularly issued debt, but recently the state has crowded out private borrowers. The exceptions are high yield issuers such as Business Telecom or E-Star, which were sold last year to retail investors on the back of heavy advertising.
Junior (subordinated) debt. These are subordinated to senior debt, legally and structurally (paid back later than the seniors). All but disappeared following the 2007-2008 financial crisis, when banks and hedge funds pulled out of this high risk activity. Junior loans (CLOs) and subordinated debt instruments (CDOs) were often structured with "bullet" repayments, assuming they would be rolled over upon repayment of senior debt and never repaid. Therefore only their interest payments were accounted for in the cash flows of buyouts, inflating valuations. The never-repayment theory fell in 2009 when many junior debt lenders and investors were wiped out post Lehman. A CEE example was the highly leveraged buyout of Invitel, where private equity investors recovered losses by picking up discounted sub debt in the secondary market.
Mezzanine. Like in-between floors in US hotels, mezzanine is a midway financing between equity and debt. Offered by specialized mezzanine funds, expecting higher returns than debt holders, but less than private equities. The risk profile is commensurate to return, i.e. mezzanine may recover its full investment even if equity holders are wiped out. This happened in the case of the Danubius Radio buyout, where Mezzanine Management ended up with the equity of the company, after its underperformance resulted in the write-off of the stake of the private equity investor.
Seller note. Used for financing acquisitions of overleveraged or un-bankable SMEs. The sellers step into the shoes of bankers and agree to receive part of the purchase price over time, secured by the shares of the company he sold. Unfortunately, if the buyer cannot or will not make the business successful, the shares will lose most their value. Therefore this approach requires the sellers' confidence in the competence and integrity of the buyer, who is in the driving seat post closing. Terms are often similar to what the banks would have offered, had they been able to lend.
Earn-out: When buyers link part of the purchase price to future performance of the company. Used when the continued support of the seller is essential, or when there is a big price gap between the parties. For the buyer it is financing serviced by future profits; for the seller: price-adjustment for future performance.
Milking assets. When banks cannot lend any more, asset base financing might help increase buyout funding. One method is the sale-and-leaseback, where marketable properties and equipment are sold to and leased back from a specialized finance company, which attach higher financeable value to certain assets than generalist banks. The same works with the factoring of receivables, where banks stop at 40-60% of face value, while factoring companies often finance 100% of the VAT-free invoice amount.
Asset sales. After exhausting debt capacity, we can try to raise more financing by selling little-used assets, such as vacant properties. Buyers, in any event, dislike investing in non-core assets that burden their balance sheet for a marginal payback. When buyers question the quality of stocks and receivables, sellers may do well to keep and sell them post-deal for their personal accounts. Sadly, buyers rarely agree, as such seller actions could impact their image or confuse consumers.
Istvan Preda
IMAP MB Partners
Senior Debt. The highest ranking debt instruments, mainly from banks or bond issues. Senior bank debt is typically well secured by assets, cash flows and sometimes the target's shares too. Issued senior debt is more flexible, but often also secured. In 1990s Hungary utilities like MOL or Matáv and regularly issued debt, but recently the state has crowded out private borrowers. The exceptions are high yield issuers such as Business Telecom or E-Star, which were sold last year to retail investors on the back of heavy advertising.
Junior (subordinated) debt. These are subordinated to senior debt, legally and structurally (paid back later than the seniors). All but disappeared following the 2007-2008 financial crisis, when banks and hedge funds pulled out of this high risk activity. Junior loans (CLOs) and subordinated debt instruments (CDOs) were often structured with "bullet" repayments, assuming they would be rolled over upon repayment of senior debt and never repaid. Therefore only their interest payments were accounted for in the cash flows of buyouts, inflating valuations. The never-repayment theory fell in 2009 when many junior debt lenders and investors were wiped out post Lehman. A CEE example was the highly leveraged buyout of Invitel, where private equity investors recovered losses by picking up discounted sub debt in the secondary market.
Mezzanine. Like in-between floors in US hotels, mezzanine is a midway financing between equity and debt. Offered by specialized mezzanine funds, expecting higher returns than debt holders, but less than private equities. The risk profile is commensurate to return, i.e. mezzanine may recover its full investment even if equity holders are wiped out. This happened in the case of the Danubius Radio buyout, where Mezzanine Management ended up with the equity of the company, after its underperformance resulted in the write-off of the stake of the private equity investor.
Seller note. Used for financing acquisitions of overleveraged or un-bankable SMEs. The sellers step into the shoes of bankers and agree to receive part of the purchase price over time, secured by the shares of the company he sold. Unfortunately, if the buyer cannot or will not make the business successful, the shares will lose most their value. Therefore this approach requires the sellers' confidence in the competence and integrity of the buyer, who is in the driving seat post closing. Terms are often similar to what the banks would have offered, had they been able to lend.
Earn-out: When buyers link part of the purchase price to future performance of the company. Used when the continued support of the seller is essential, or when there is a big price gap between the parties. For the buyer it is financing serviced by future profits; for the seller: price-adjustment for future performance.
Milking assets. When banks cannot lend any more, asset base financing might help increase buyout funding. One method is the sale-and-leaseback, where marketable properties and equipment are sold to and leased back from a specialized finance company, which attach higher financeable value to certain assets than generalist banks. The same works with the factoring of receivables, where banks stop at 40-60% of face value, while factoring companies often finance 100% of the VAT-free invoice amount.
Asset sales. After exhausting debt capacity, we can try to raise more financing by selling little-used assets, such as vacant properties. Buyers, in any event, dislike investing in non-core assets that burden their balance sheet for a marginal payback. When buyers question the quality of stocks and receivables, sellers may do well to keep and sell them post-deal for their personal accounts. Sadly, buyers rarely agree, as such seller actions could impact their image or confuse consumers.
Istvan Preda
IMAP MB Partners
