Acquisition Financing – Debt vs. Equity?

One of the most common questions we receive nowadays is how to finance the acquisition. Unfortunately, there is no simple answer to that as it depends on a vast number of factors.

Two of the most common forms of financing acquisitions are the use of debt and/or the issuance of equity (or to use your own excess cash from the balance sheet).

Of course, the equity versus debt decision relies on different aspects including, but not limited to, the current economic environment, the business’ existing capital structure, the business’ life cycle stage, the type of buyer you are, as well as the goals you foresee to achieve in the future.

Cost of Debt

Funding an M&A transaction using debt can be alluring since it is characteristically low-priced for the company to raise equity. This usually conveys a much higher rate of return expectation from the investors. The cost of debt is limited to an extent and a lot safer than equity if the company does not do well at a point of time as there is a lot to call into play. Additionally, debt financing has tax benefits and the increased leverage can lift up the company’s return on equity as well. Moreover, no additional shares are issued and consequently, there is no dilution of ownership.

However, there are some noteworthy points to mention as the downfalls of debt financing. The issuance of too much debt will demolish a company’s credit rating or hurt its balance sheet (depending on the final structure, a debt push-down scenario can change this situation). This, in turn, would hinder its ability to borrow money in the future and would lead to an upsurge in the company’s cost of debt. Debt issuance may also be restricted by existing lender covenants that set a limitation on the amount of loan the firm can undertake.

This might make it impossible for some companies to borrow enough money to make a large acquisition. It is also important to consider the different types of debt available.

The most common forms are listed as follows:

Senior Debt (either financed through Banks or Debt Funds): This is the first type of credit facility one would think of. Senior debt has less complexity, the highest priority, and the lowest risk. Thus, this type of debt typically carries or offers lower interest rates depending on the collateral it is secured. Subordinated senior debt, depending on the tranche level, requires a higher interest rate given their lower priority in the schedule.
Bonds: They are fixed income instruments since bonds traditionally pay a fixed interest rate (coupon) to debt holders. Variable or floating interest rates are also quite common these days. On the downside, bond placements and advisory fees often turn out to be more expensive than other debt types, due to intense capital market procedures and investors´ roadshows.
Mezzanine Financing: Depending on its structure it could be considered equity as well. It has the highest return on equity expectations and is mainly used to fill the missing gap in the realm of acquisition financing. It is a cohesive form of financing which includes both equity and debt tranches. Mezzanine financing can be compared with a subordinated debt, though it comes with the option of being converted to equity. There are lots of formats including, but not limited to, cash-in-kind, PIK, and Warrants, etc.

Cost of Equity

Despite the higher cost of equity, all-equity financing is still very common in M&A transactions due to the flexibility of the investors or the availability of the excess cash. Unused available funds create opportunity costs and can eventually crumple shareholders’ return on equity. Some of the benefits of equity include (i) no obligatory interest payments, (ii) no principal that must be repaid, and (iii) no preventive covenants related to its issuance. Financing an M&A transaction with equity has no impact on a company’s credit rating, therefore allowing them to raise debt in the future if needed.

Equity offerings can, however, have negative side effects. Issuing stock might hurt a listed company’s earnings per share and return on equity as it becomes less leveraged. In addition, the volatility of a listed company’s share price can cause uncertainty about the exact acquisition valuation, which in turn can increase the amount of time needed to reach a closing or even destroy the planned transaction.

Nevertheless, public companies use equity financing as their preferred form of payment in M&A transactions and debt still plays an important role because of its cost-effectiveness as well as the advantage of leverage.

Furthermore, if you are a large sovereign fund, private equity firm or a private company and have excess cash available, it can still make sense to finalize the acquisition as an all-equity deal.

Given that there are advantages and disadvantages to each form, many buyers use a combination of the two. Our experts at MP Corporate Finance have been supporting clients for years to find the best suitable tailor-made financing structures for their M&A transactions.