M&A Blog #06 – debt (Part I – role and trade-offs, categories and key characteristics)
In the last two blog posts, we walked through capital structure and how it impacts M&A activities and vice versa. To be explicitly clear, I am recommending the use of the following ranked capital sources when paying for an acquisition: cash (from the balance sheet), debt (at a reasonable level), and equity. This recommendation is based on the cost of each source of capital to the company. We will now go through a series of four blog posts that dive deeper into debt - specifically, the various considerations one ought to take into account when planning to use debt for an acquisition. When one buys a house, there are differences between a 30-year fixed mortgage and a floating-rate mortgage. Similarly, not all corporate debt instruments are created equal and each comes with pros and cons. In this first debt post, we will review the role and trade-offs, categories, and characteristics of debt.
As we have discussed in past posts, debt is a cheaper source of capital when compared to equity. Equity holders (aka shareholders) have a variable claim on capital and are last-in-line to be paid in liquidation or bankruptcy. Debt holders have a fixed claim on capital and a priority claim over equity holders. When secured by assets (we’ll discuss what this means in debt post Part IV), debt holders often have priority claim over other creditors (suppliers, etc.) as well. Said differently, equity holders trade a fixed claim and payment for a share of the company’s upside performance, while debt holders trade the upside for a priority claim and payment which minimize their downside risks. Each source of capital varies in riskiness and cost, but debt will always be cheaper than equity in the same investment. Thus, debt might add to shareholder value by reducing the level of equity need.
In addition to reducing the cost of capital and enhancing the return on equity to shareholders, the use of debt may reduce agency costs. Meaning, the required debt payments will focus management’s attention on using cash flows to pay down debt over time (as opposed to spending the money on non-high return perks, such as corporate jets, expensive off-sites, and more). Management should be focused on maximizing operating cash flows from the business.
There are downsides to using debt, however, and these trade-offs should be taken into considerations carefully. At a very high level of debt (the so-called highly-levered companies), the likelihood of financial distress is increased. What does a very high level of debt looks like, you may ask. Well, the traditional measure of leverage is Net Debt to EBITDA multiple - net debt is total debt minus cash. An unlevered company (with no/little debt) will typically have less than 1x Net Debt to EBITDA multiple, while a highly-levered (high debt) one typically having 6x or more of the same multiple. Highly levered companies are less able to manage financial shocks, such as lost of a major customer, shock to the economy such as the 2008 Great Recession, etc. If the level of debt is too high, a company may default on debt and even go into bankruptcy.
It is also worth noting that a high debt level reduces the funds available for future acquisitions and in general, constrains a company’s financial flexibility on projects it wants to do. A high debt level means a high debt payment requirement, which shrinks cash flows. All of these trade-offs between using and not using debt should be carefully considered. An ideal level of debt that balances the advantages and disadvantages of using debt exists; and it optimizes cash flow for the company.
There are several different categories of debt and they are listed below based on the seniority of their positions on the balance sheet:
Senior Debt:
Varies in size, typically 1-5 years loans that can be amortized over the loan period, can be secured or not, and provided by banks and other financial companies. They can be prepaid anytime and this flexibility comes with attractive pricing (usually LIBOR + 100-150 bps - though can be swapped to fixed loan). As the lowest cost of capital, their stretch in the capital structure is limited (which is why they are usually used to fund working capital). If used to fund an acquisition, the loan has to be repaid typically within the 5 years period.
Asset-Based Loan (ABL):
Varies in size, typically 3-5 years with the balance due at maturity, secured against Working Capital Assets (account receivable and inventory), and provided by banks and ABL lenders. They can be prepaid anytime and this flexibility comes with attractive pricing (usually just slightly above senior debt pricing at LIBOR + 200-ish bps). There is a fair amount of controls and internal reporting required as lenders would want to know levels of inventory and A/R on regular basis. Like senior debt, their stretch is limited and if used to fund an acquisition, it has to be paid back within the short term of 5 years.
Term Loan:
Typically $5M to $500MM, 5-7 years with minimal / no amortization, secured, and provided by institutional lenders. They can be prepaid based on negotiation, and this flexibility comes with an attractive pricing (LIBOR + 300-350 bps). Its low cost and longer loan period features make this type of debt very attractive as a source of capital for acquisitions - especially for companies who don’t want to pay a lot of interest expense of their debts.
Mezzanine or Sub Debt:
Varies in size (smallest would be $5M), 7-10 years with no amortization (balance paid at maturity), unsecured, and provided by insurance companies, pension funds, and mezzanine private / public funds. They can be prepaid based on negotiation, and comes with a pricing of 14% to 18% interest rate. This type of debt is more expensive than the other three we have discussed, mainly due to its longer loan period and no amortization features. It can make a good source of acquisition capital as it is still cheaper than straight-up equity; and great for companies who don’t want to pay interim loan payments as they can direct the cash to further growing the company during the loan period. The loan will just sit on the balance sheet until it is paid off at maturity (or negotiated prepayment date).
Private Equity (PE):
This particular category is more equity than debt, but is listed here as a comparison. Varies in size (smallest would be $10M), 5-7 years with no amortization, not secured, and provided by institutional LBO (leveraged buy out) funds. There is no prepayment feature and comes with a pricing of 20%-30% cost of capital. It is the most expensive but long term capital, which may come with strategic benefits offered by the PE funds. This source of capital is less reliant on the debt markets and the PE funds typically bring additional acquisition expertise, however, it does come with a loss of control of the company. The PE funds typically would want to have a say on daily management, who the management are, and a board seat. It comes with an equity dilution on the company ownership and forces a timeline for company sale to create liquidity for the PE owner.
It is important to understand the role of debt in funding an M&A transaction. As we have discussed in this post, debt can be used to lower the cost of capital for a deal. It does come with trade-offs that should be carefully considered, mainly how it impacts the company’s ability to absorb shocks and go after other opportunities. We also learn that there are different categories of debt, some more suited for corporate strategic acquisitions than others. We will discuss how these different categories all come together in an acquisition purse / war chest next.
