When acquiring a company or business, one of the main issues for an acquirer is how to finance the acquisition. Except the acquirer is in a position to complete the deal using existing cash reserves, its main sources of funding for the transaction will usually be either (or a combination) of debt finance (by borrowing from banks and other financial institutions by way of loans or debt securities) or equity finance (through the issuance of new shares to existing shareholders and/or third party investors). So, essentially, acquisition finance refers to the different sources of capital for funding an acquisition. It is usually a complex process which requires thorough planning as acquisition finance structures come with a lot of variations and lending sources unlike most other transactions.1
In coming to a decision as to the method of financing an acquisition, several factors can influence an acquirer's choice in this regard namely the comparative cost of debt and equity. For cost of debt, the main factor to be considered is the interest rate at which the acquirer borrow. In other words, the rate a company pays on its debt, such as debt securities and loans2 . On the other hand, the cost of equity is calculated by reference to anticipated shareholder returns such as dividends, capital appreciation and share buybacks.
In addition to the comparative costs as mentioned above, other considerations that can influence the acquirer's choice of financing include its existing capital structure which may enable the acquirer to finance the acquisition by an issue of shares. The acquirer's ability to borrow may also be restricted or limited by its articles of associations or by the terms of existing loan agreements or other debt instruments as they may have provisions which place restrictions on the amount of debt that the acquirer/borrower can incur without the lender's consent.
Other factors to be considered include the rating of the acquirer's shares in the market because if its shares are highly rated, it may be desirable for the acquirer to finance the acquisition with its own equity to take advantage of the high valuation) and the tax implications of the financing option.
Methods of Raising Acquisition Finance
The appropriate type of finance for the acquisition will depend on the size and creditworthiness of the acquirer, the availability and quality of security that can be given, the amount of money required and if applicable, the ability to structure the debt within the acquirer's group in a tax-efficient manner. As stated earlier, the typical financing options are debt and equity and we will attempt to explain them briefly in the following paragraphs.
Debt finance can be broadly divided into:
- Loans: A loan is the simplest and the most common form of debt finance. A loan may come from a single lender, otherwise called a bilateral loan, or a group of lenders, otherwise referred to as a syndicated loan. A syndicated loan is a common source of finance for large acquisitions where each lender in the syndicate commits to make a loan to the borrower on common terms and conditions governed by the facility agreement.
- Debt Securities: Debt securities are any form of financial instruments issued to create or acknowledge indebtedness. They can be by way of bonds, or by issuing short term notes in the debt capital market.
- Leveraged Buyout: This is a unique mix of both equity and debt. In a leveraged buyout, the assets of both the acquiring company and target company are considered as secured collateral. The idea behind a leveraged buyout is to compel companies to yield steady free cash flow capable of financing the debt taken on to acquire them.
- Debt packages: Debt
from different sources may be used to finance a large acquisition,
and lenders will be required to decide how their debt ranks on the
borrower's liquidation. A debt package may include
- Senior debt. This is a loan from a single lender or a syndicate of lenders that ranks ahead of any unsecured and subordinated debt on the insolvent liquidation of the borrower by virtue of security and intercreditor arrangements (subject to legal restrictions and practical constraints).
- Mezzanine debt. This is a debt which ranks behind senior debt but ahead of unsecured and other subordinated debt by virtue of security and intercreditor arrangements and which includes both equity and debt features. It usually comes with a bullet repayment option and may have early prepayment fees. As with senior debt, mezzanine debt can be secured, although the security ranks behind the senior security. It usually comes with an option of being converted to equity.
On equity finance, the main methods by which companies can raise equity finance are as follows:
- Rights issues. This involves an offer of new shares to existing shareholders on a pre-emptive basis in proportion to their existing shareholdings.
- Placings. This involves issuing shares for cash on a non pre-emptive basis to existing or new shareholders. In a placing, the recipients of shares are usually institutional shareholders who are likely to hold the shares as a long-term investment. This process is usually quicker than a preemptive offering because it is usually structured so that it is neither a public offer nor of sufficient size to trigger the requirement for a prospectus.3
Taking Security in Acquisition Finance
Generally, acquisition finance transactions are considered relatively risky by lenders due to the large amount of debt that will need to be raised. For this reason and for the purpose of taking priority, lenders will normally expect a comprehensive guarantee and security package from the borrower and any material subsidiaries. Indeed, the primary purpose of security is to reduce credit risk and obtain priority over other creditors in the event of debtor's bankruptcy or liquidation.4 A properly created and perfected security package will improve the position of the lenders in an insolvency, giving them priority over other creditors of the acquirer/borrower in respect of the charged assets.
When taking security over the acquirer/borrower's assets or accepting corporate guarantees, it is important that the lender considers certain legal issues such as:
The security may be in breach of covenants in existing security documents, such as a negative pledge:
- Company law restrictions on a group company giving guarantees and/or security over its assets in respect of facilities made available to another company in the same group.
- Restrictions in a company's constitutional documents or/and any shareholder agreements.
- The requirement to register security created by a company within a specified period of its creation, which is 90 days5 under Nigerian law, so that it will not be void against a liquidator, administrator, or any other creditor.
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1. Corporate Finance Institute: Knowledge, deals and acquisition finance structures. https://corporatefinanceinstitute.com/resources/knowledge/deals/acquisition-finance-structures/ accessed on 25 August 2020.
2. Investopedia: Cost of debt and cost of equity https://www.investopedia.com/terms/c/costofdebt.asp#:~:text=The%20cost%20of%20 debt%20is%20the%20rate%20a%20company%20pays,being%20the%20cost%20of%20equity accessed on 25 August 2020.
3. UK Practice Notes: "Taking Security: Practical Law Overview 2-107-4032"
4. Goode, Roy and Gullifer, Louise. Legal Problems of Credit and Security. 4th ed. Thomas Reuters (Professional) UK Limited, 2009
5. Section 197 Companies and Allied Matters Act, 1990, Section 222 of the Companies and Allied Matters Act 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.