Debt Financing

Business Insights

Raising the money for a Management Buy Out or a Merger or Acquisition.

In a Management Buy Out it is will be rare for the managers of a company to have the capital for the acquisition themselves, so funds will need to be sourced if a realistic offer for the business is to be made, likewise for companies seeking to expand by means of a merger or acquisition. The usual route is to borrow the money at an agreed rate of interest from a third party, thus incurring a debt.

Debt is a fact of business life, from start-up companies to large organisations; even the healthiest of balance sheets will have some element of debt. The most popular source for debt financing is the bank, but debt can also be issued by a private company or even a friend or family member.

The bank is usually the first port of call, providing they are willing to accept the risk. Careful presentation of your business case is crucial here as many otherwise perfectly good proposals fail at this first hurdle. The assistance of a reputable financial advisor or credit broker can prove invaluable in preparing your application.

In the case of a Management Buy Out, much will depend on the individuals involved, their level within the company and how successful they have been in building the business, when the bank is calculating their risk. The bank will often be unwilling to lend the whole amount needed, and expect the management team to invest an amount of capital that is significant to them personally, depending on the funding source/banks determination of the personal wealth of the management team.

The bank then loans the company the remaining portion of the amount paid to the owner. Companies that proactively shop aggressive funding sources should qualify for total debt financing of at least four times (4X) cash flow.

If a bank is unwilling to lend, the management will commonly look to private equity investors to fund the major portion of the finance required. A high proportion of transactions are financed in this way. Private equity investors will invest money in return for a proportion of the shares in the company, though they may also grant a loan to the management. The exact financial structuring will depend on the backer's desire to balance the risk with its return, with debt being less risky but less profitable than capital investment.

Private equity houses will require that the managers each make as large an investment as they can afford in order to ensure that the management are locked in by an overwhelming vested interest in the success of the company. It is common for the management to re-mortgage their houses in order to acquire a small percentage of the company.

MBO's are particularly appealing to private equity firms who can provide the capital while ensuring that a capable management team is already in place. Usually, these situations occur when an owner is retiring and has developed a capable management team, or for large conglomerates who are looking to sell non-core divisions or assets.

Most likely you’ll turn to a combination of debt and equity financing to fund your venture, but a word of warning; it may sound obvious, but when deciding on the proportions make sure that you can manage the debt. It is tempting to borrow again to fund expansions and stock acquisition over and above the original debt but the more a business borrows the greater the lender’s perceived risk and the higher your interest rates will become.

On the topic of high interest rates, many borrowers turn to Mezzanine financing because the debt is unsecured (no collateral is required). The trade-off is a high interest rate, in the 20- 30% range. The high interest rate is not the only catch however, because the lender has the right to convert the debt into equity in the company if the company defaults on payments. Despite the high interest rate, mezzanine financing appeals to entrepreneurs because it offers quick liquidity, and even though it can be converted to equity, the issuing bank usually does not want to be an equity holder, meaning they’re not looking to control the company.

Professional advice is essential, a properly qualified accountant, broker or professional financial advisor will be able to steer you towards the most suitable loan to finance your aspirations.