Various studies have indicated failure rates for acquisitions range between 50% and 83%. Given this potential for value erosion, or even failure, why is M&A such a prevalent business growth strategy? In 2020 there were just over 800 UK M&A transactions over £1m, with a total value of £8.6bn, according to the Office of National Statistics. The top 25 deals accounted for 50% of the total value and 400 were acquisitions of independent companies as opposed to group subsidiaries.
The strategy and consulting firm, McKinsey, suggests there are 6 main reasons to pursue an acquisition strategy:
- Scale quicker
- Consolidate excess sector capacity
- Accelerate market access for the buyer’s products/services
- Acquire skills or technology faster or at lower cost
- Improve the performance of the target
- Develop a likely winner quicker
The Blueray Capital Acquisition Finance Guide is designed to help those who are considering acquiring a small-medium sized business (SME) or have embarked on the acquisition process and want to understand the key issues around securing debt finance to support their management buy-out, competitor acquisition, management buy-in or shareholder exit. It’s not meant to be definitive but covers most of the elements involved in the acquisition finance process.
- Buy the right business
What’s the strategic rationale for this deal? Market position? Margin enhancement? Technology? People? There needs to be a compelling logic, which, if communicated clearly, will be of more interest to lenders.
- Pay a reasonable price
The right price is not necessarily the one the vendor accepts, even if you have negotiated them down. Ensure the relevant multiple make sense. If it’s not affordable, potential funding sources will rapidly evaporate.
- Recognise that lenders also want to do great deals
Other things being acceptable, lender appetite for acquisition finance declines from company acquisitions, MBOs, BIMBOs (MBOs with external participants) with MBIs being least favoured. Your great deal is maybe one of 20 currently being considered by the lender’s origination team and credit committee.
- Structure the deal sensibly
Buyers want to pay as little as possible over the longest period. Vendors want the highest price, all paid on completion. Lenders want to see the deal is affordable, within their risk parameters and expect an element of the consideration to be deferred, ideally over multiple years. No one said acquisitions were easy!
- Skin in the game
Don’t listen to the LinkedIn “gurus” who say you can buy a business for £1. You should assume that the acquiring team will be contributing at least 20% (and maybe up to 40%) of the consideration in cash.
- Numbers matter
Have a good finance person on the team. In addition to at least 3 years’ historic financial data you will need to prepare a well-considered, integrated and detailed profit & loss, balance sheet and cashflow forecast for at least 3 years. This forecast needs to bear some relation to historic performance. Revenue growth and margins will not suddenly increase when the new owners take charge. They may do so over time but need to be realistic to sector norms. Things that don’t go down well are hockey stick growth from Year 2, return on sales greater than Apple Inc, large dividends from Year 2, high executive salaries & bloated overhead costs.
- Model various scenarios
The lender will stress test your financial model. How do the post-acquisition financials look with flat revenues for 3 years or declining revenues, or gross margins reduced by 10%, or a combination?
- The cost of funds varies, so budget accordingly
While a secured loan from a mainstream bank may be ~4% over base, it’s more likely your costs will be in the high single figures to low teens. Better to factor that rate in from the start and be pleasantly surprised if a mainstream bank shows interest, than the other way round.
- Loan leverage
Get to know EBITDA, (earnings before interest, depreciation & amortisation), a key multiplier used by lenders to gauge the loan quantum, usually in the 1x to 2.5x range. This is used in conjunction with another metric, CFADS (cashflow available for debt service), which is structuring EBITDA adjusted for change in net working capital, capex and tax.
Introducing DSCR (debt service coverage ratio) which lenders use to assess if there is sufficient headroom between debt repayments and EBITDA. Assume >1.4x in your financial model. Watch the deferred period closely as DSCR applies to total debt repayments, so lender plus deferred vendor payments.
The lender wants to support good deals, experienced teams and solid businesses because that is lower risk than a marginal deal, with an inexperienced buyer and a business with fluctuating profits in a declining, competitive market. Be the former, not the latter.
- Deal costs
Factor in arrangement fees, professional fees, due diligence costs & legal expenses. Due diligence fees are usually paid or underwritten during the process.
Most lenders will take a 1st charge debenture over the business and some look for Director Personal Guarantees. If there are existing debts in the business (including BBL, CBILS & RLS) these will need to be repaid as will any existing lender who has a charge over the business. Tangible assets increase funding sources and potentially enhance terms.
- Cashflow-based loans
Lenders who provide cashflow-based loans offer lending multiples from 1 to 2.5 x most recent EBITDA, not the forecast, post-acquisition EBITDA. Minimum lending thresholds start from £500k with minimum EBITDA at £250k with 3+ years trading.
- Asset-based loans
If the target business has quality trade debtors, property assets, finished goods and plant & machinery it’s a potential candidate for an asset-based loan which may well include an additional cashflow-based element.
- Repayment terms
The normal term loan is fully amortised with monthly repayments of capital plus interest over a maximum term of 5 years. Some lenders offer flexibility in this area, with capital repayment holidays and bullet structures, but it’s prudent to assume the vanilla product.
- It’s all about people
The financials may be great, the strategic logic compelling but if the acquisition team does not have the relevant sector experience and management skills, it’s going to be an uphill struggle. Oh, and did we mention having a great Finance person?
- It takes time
While indications of appetite and indicative offers may be received within a couple of weeks, to secure a credit-backed decision and complete will be a 2/3-month process. Towards the end it becomes all-consuming, so better to have an adviser alongside.
- It isn’t over until it’s over
The deal is not completed until the term sheet is agreed with the vendor, the loan offer received, due diligence successfully completed, credit sanction gained, legal documentation finalised and funds transferred. Don’t celebrate too early!
- Covenant tests
Most lenders insist on covenant tests which may be quarterly and around total Debt/EBITDA; EBITDA/Debt repayments and cash. You should also assume monthly reporting of management accounts, with an increasing tendency towards open banking.
Why use Blueray Capital?
There are a lot of moving parts to an acquisition, whether it’s an MBO, trade purchase, shareholder exit or an MBI. Navigating the issues above will increase your chances of success with lenders.
You may think you can do it yourself. Technically that’s true but there are good reasons to consider using the services of a specialist debt advisory firm, such as Blueray Capital:
- We have good relationships with all the relevant lenders and know their lending criteria and application process requirements
- Applications introduced by advisers are of more value to the lender than a direct approach. Lenders know that we will have already done due diligence on the client, established the transaction is robust, prepared relevant information and presented it in a lender-friendly format. We make the process easier for the lender and they trust us.
- For good quality deals it’s likely that multiple lenders will express interest which provides the client with more choice and potentially enhanced terms. One of our key roles is to establish lender appetite quickly in the process and help achieve optimum terms.
The acquisition finance process usually starts with a conversation with Blueray Capital. We can efficiently assess the options available and, if mandated, work with you exclusively to present you in the best light to our funding partners and guide you through the process to a successful completion.