True to form, a typical merger, acquisition or corporate capital event includes some type of outside financing. Rarely do completed M&A transactions include 100% debt or 100% equity. Furthermore, the structures on both debt and equity are rarely boilerplate. In many cases, acquisition financing deals include cash, straight equity, preferred equity, senior debt, subordinated debt and convertible debt. The color and flavors of both debt and equity are nearly endless. Some of the more interesting deals include a varied mix of multiple forms of each.
Thanks to small business lenders, smaller deals are typically subscribed by the likes of traditional SBA financing, banks and small business lenders. Similarly, some of the largest public financing deals include capital sourced from large institutional funds, pensions, trusts and family offices. Unfortunately, there is often a gap in the financing for the middle market, particularly when it comes to small business loans for acquisition finance. Bridging the gap in some of these middle market transactions represents one of biggest challenges for companies, but a large opportunity for those that fill the void. For companies looking to grow by acquisition the need for sourcing proper financing is often the most important bridge to cross in the business growth cycle.
North of $5,000,000
While it is certainly true that the lion’s share of acquisition financing deals include companies in the bottom end of lower mid-market (where deals perhaps $5,000,000 to $10,000,000 in valuation), that does not mean that they represent the highest quality deals or the most fundable deals. It typical just means that banks and other main street lenders have outside incentives to provide financing to the smaller end of the market.
When it comes to quantity, the majority of buyers and sellers traverse and operate in a financing world smaller than $5,000,000. In fact, most are likely below the $1,000,000 mark. They are those that are buying small, local companies with a local customer base.
In fact, many of these main street style businesses will be greatly impacted by the latest equity crowdfunding rules that—within a matter of months—will allow for the raising of up to $1,000,000 annually from local investors without too much heavy burden. But I digress.
What of the companies above the $5,000,000 mark? What about the companies whose capital raising needs include a large portion of the deal with debt needs outside the realms and terms provided by typical SBA financing?
Fortunately, a host of private equity, mezzanine, family office and SBIC funds work in this middle market arena, providing the requisite capital for growth by acquisition. They’re not nearly as well known to many operators who have not spent time working “in” their companies and not “on” their companies from the financing side. And, while they are out there, the differences in how they structure, lend and term out their financing varies greatly from fund to fund that it helps to have a navigator to traverse the waters.
Putting Some “Skin in the Game”
When it comes to financiers bringing debt to a transaction, most typical outside debt lenders prefer the acquiring party to bring some of his/her own equity. Akin to a typical home loan, rarely will a financial firm provide a large capital investment to a fundless sponsor with no true “skin in the game.” Lenders will often require 25% down in the form of equity from the issuing company. Similar to buying a home, the financier wants to see the borrower tied to the success of the deal, for good or for ill. For many funds, investors have rules they require from any company or individual seeking financing. Fortunately, that doesn’t mean acquirers will not be able to find outside private equity to provide the skin, but that is typically a separate discussion.
The Cost of Capital
While the cost of capital continues to fall—thanks in part to Fed easing, relaxed regulation by the JOBS Act, and technological advancements in the financial services sector—the cost of acquisition financing still does not hold the same low interest rate terms as the SBA and others. In fact, many acquisition financiers, because they play in an underserved segment of the market, are able to charge higher, mezz-like rates to companies looking to finance an acquisition using some form of debt. They charge more because they can. That is only one of the reasons it is important to understand the lay of the land before heading into the jungle of acquisition finance.
The world of acquisition financing is layered with complexity. With the financing world awash in capital and more private equity firms chasing fewer deals, the opportunities to source the right patient capital is better than it has been in a very long time. In short, it is a seller’s market. That is true for those looking to sell companies as it is for those looking to issue debt or equity to alternative lenders with a growth by acquisition plan as the guise. Those with capital to play the game are able to write checks for some truly great private opportunities. This often means they have greater control and can set the terms. Finding multiple parties to participate can certainly drive down the cost of capital, but it also can help weed out the partners that are simply looking for return without a long-term view of the growth opportunities your issuance presents.
Playing the acquisition financing game in the middle market is certainly an option, but issuers should proceed with eyes wide open.