What is Acquisition Financing?
Acquisition Financing refers to the initial capital sources obtained to fund the purchase of a target business, (i.e. the mix of debt and equity in the capital structure).
Table of Contents
- How Does Acquisition Financing Work?
- Acquisition Financing: Capital Structure of an LBO
- LBO Capital Structure: Sources and Uses of Funds
- LBO Capital Structure Mix: Debt and Equity Components
- Acquisition Financing Formula
- Acquisition Financing Calculator
- Step 1. Entry LBO Model Assumptions
- Step 2. LBO Acquisition Financing Calculation
- Step 3. LBO Capitalization Ratio Calculation
How Does Acquisition Financing Work?
In the field of M&A, acquisition financing is the process by which an investment firm, such as a private equity firm, obtains capital to fund a merger or acquisition.
Unlike other forms of transactions, acquisition financing often requires a blend of different funding sources, including equity financing (e.g. common stock, preferred equity), debt financing (e.g. bonds, loans), and mezzanine financing (e.g. convertible debt), particularly when non-traditional lenders are engaged.
The challenge in acquisition financing boils down to securing the optimal mix of financing that minimizes the cost of capital (WACC).
Companies seeking to acquire other businesses must analyze the financing structure to ensure there is alignment with their strategic objectives (and a sufficient cushion to adapt to unforeseeable circumstances).
At its core, the term “acquisition financing” refers to obtaining capital to facilitate the purchase of another company (i.e. the subject of the acquisition).
Companies actively in pursuit of M&A focus on identifying and implementing the most efficient and optimal financing and deal structure to support their long-term strategic goals and maximize value creation.
Acquisition Financing: Capital Structure of an LBO
A leveraged buyout (LBO) is a transaction where a financial sponsor – i.e. a private equity firm – purchases a business, with debt constituting a significant proportion of the acquisition financing.
Historically, the percentage of debt raised relative to the total capitalization ranged from 60% to 80% of the total purchase price. But over the course of time, the reliance on debt to achieve the target return has decreased in the private equity industry, albeit the debt component still remains a core value driver of returns in LBOs.
The participants in LBO transactions, such as private equity firms, family offices, and the lending institutions that underwrite the debt financing (e.g. corporate bank lenders, institutional investors) are nowadays more risk-averse and systematic when performing credit risk diligence.
Therefore, the capitalization of LBOs in the 1980s – wherein the traditional debt to equity ratio (D/E) typically consisted of an 80% to 20% split – has since undergone a structural shift downward to 60% to 40%.
- Minimum Equity Contribution (%): In fact, requiring a minimum equity contribution of at least 25% of the total capitalization has become the standard among lenders and other institutional investors in an effort to protect their downside risk.
- Covenants: The lenders that underwrite the debt financing can place restrictions that set parameters that the borrower must abide by, such as a maximum leverage ratio (i.e. Total Debt / EBITDA), or prohibit certain actions to reduce the risk of capital loss. However, the increased number of institutional investors that offer less restrictive debt financing has led to more covenant-lite loans.
The acquisition financing of LBOs tends to be cyclical and fluctuate based on several internal and external variables:
- Internal Factors: Historical Profitability, Free Cash Flow Generation (FCFs), Asset Base (i.e. Liquidity), Credit Profile, Debt Capacity, Credit Rating
- External Factors: Current State of the Credit Market, Interest Rate Environment, Economic Outlook, Industry Risks (e.g. Threat of New Entrants), Competition in Market
LBO Capital Structure: Sources and Uses of Funds
The “Sources and Uses of Funds” section of an LBO model outlines the total cost of the acquisition – i.e. the estimated financing required to purchase the target company, including the incurred transaction costs and financing fees – followed by the specific details regarding where the capital will be obtained.
Since the “Uses” side estimates the total amount of capital that must be raised from external financing sources (and the equity contribution by the sponsor), it should be intuitive to start here prior to the “Sources” side. As an analogy, if a buyer was interested in purchasing an item from a store, the first course of action is to determine the pricing of the item before figuring out a plan to budget and obtain enough funds to purchase the item.
- Uses of Funds: The “Uses” side summarizes the total amount of capital necessary as part of funding the acquisition. Of the total capital needed to complete the buyout, the purchase price constitutes the most significant percentage, as one would reasonably expect. Unique to each acquisition, the transaction fees paid to investment banks for their advisory services and the financing fees paid to lenders can vary substantially based on the circumstances of the buyout and must not be neglected.
- Sources of Funds: The “Sources” side of the schedule starts with the financing commitments formally obtained by the lenders who are interested in participating in the LBO and the initial equity contribution by the sponsor. Other sources of capital include rollover equity by the existing management team and co-investors that tag along in the LBO, but with far less risk is undertaken relative to the lead sponsor in most cases.
If the two sides of the “Sources and Uses” table are equal, the financial sponsor (and other participants) has enough funds to proceed with the acquisition. However, obtaining the necessary capital is not enough by itself for the completion of an LBO to make sense economically.
Instead, the initial outlay of cash by the sponsor – the required equity contribution – is utilized to determine if the fund’s minimum return threshold is met, i.e. the “hurdle rate” set by the firm, which is usually about 20% under a base case scenario.
