M&A: capital considerations and financing techniques
March 2018 | FEATURE | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
March 2018 Issue
Sourcing financial capital for any endeavour and in any economic climate can be a challenging affair – especially for those tasked with financing a mergers & acquisitions (M&A) transaction. In this space, no money equates to no deal.
However, for those ready, willing and able to take the M&A plunge, there are a number of channels through which a deal can be financed. Such pathways will be based on the state of the parties concerned, as well as their credentials in terms of their overall M&A and finance activities.
“Access to funding for an M&A transaction depends heavily on the industry, the proposed length of term, the financial strength of the resulting combined companies, whether a capital or income play hold for the funder, and the financial strength of the offered covenants and collateral,” says Alison Manzer, a partner at Cassels Brock & Blackwell LLP. She adds that in Canada, funding from both the sponsor and banking sectors has been accessible for M&A transactions – a trend that has continued into the first quarter of 2018.
“If the transaction results in a credit profile and loan structure attractive to investors, then funds are fairly widely available for M&A activity involving Canadian entities as buyer,” continues Ms Manzer. “The availability is reduced if the transaction is highly leveraged because of reduced interest from regulated financial institutions.”
Across the border, the M&A funding window in the US has been wide open for the last 12 months, according to David Barnitt, president and founder of Attract Capital, LLC. “Market conditions have been strong and lenders are competing for good deals,” he says. “The market is very much segmented according to deal size and sponsor type. Banks are focused on larger deals with private equity backing, and business development companies and unitranche providers are focused on mid- to large-sized deals, with middle market mezzanine funds covering the remainder of the market.”
Turning to Europe, Nick Smith-Saville, head of EMEA credit research at Debtwire, confirms that European leveraged credit markets were supportive of M&A deals in 2017. “The volume of leveraged loans backing M&A transactions, excluding sponsor-backed leveraged buyouts (LBOs), rose to €20bn – compared to €16.8bn in 2016 – while the bond market provided €6.3bn of credit to support M&A in 2017, compared to €4.7bn in 2016. Similarly, covenant terms have remained permissive and we have judged several deals, such as the Avantor acquisition of VWR, as aggressive due to the structure of these transactions. That such deals were completed is a sign that the market is supportive of M&A,” he says.
While capital has clearly been plentiful for the most part in recent years, a number of disruptive challenges to the M&A status quo are in the frame. Among these challenges are new business models and technologies, and the phasing in of regulations such as the forthcoming Basel III measures, which aim to strengthen the regulation, supervision and risk management of banks. Basel III, for example, has the capacity to usurp the status of banks as the traditional extenders of credit and providers of loans.
Overall, such factors are likely to have a major influence on the M&A industry, affecting deal terms, capital considerations, financing techniques and structuring alternatives.
Pools of capital
Drilling down, there are a range of factors which determine the scope of the capital available to companies engaged in an M&A transaction, including the state of capital markets and leveraged finance dynamics. One factor that has certainly impacted M&A financing is the greater discipline in leveraged lending multiples.
“Prior credit cycles saw rapid increases in debt multiples for deals,” explains Mr Barnitt. “This credit cycle has seen a more gradual uptick in leverage multiples. M&A financing is widely available from a variety of sources, as more large funds and lenders have moved down market from mega market deals to the middle market deal space. Banks are still predisposed toward asset security but are willing lenders if there is an institutional private equity sponsor in the deal. The non sponsored deal market has received more lender entrants but is still seriously underpopulated relative to the credit gap.”
In Canada, the market for financing M&A transactions is robust, with virtually all sectors having seen a fairly steady increase in activity – involving both domestic and outbound transactions – indicating that required financing is available. “Much of the financing of larger transactions uses the balance sheet and available asset coverage of both the acquirer and the target,” says Ms Manzer. “Banks operating in Canada, whether domestic or international, are financing transactions where the traditional requirements of creditworthiness and collateral coverage are met. There has been no change in these requirements in recent months and none is expected.”
In the energy, mining and real estate sectors in Canada, access to public markets, and the issuance of public securities, continues to provide a viable source of capital for M&A financing, according to Ms Manzer. “There is an industry sector preference for public offerings and emerging sectors, such as the cannabis industry, face challenges in public offerings in Canada. The more traditional offerings in the key sectors for which Canadian public markets are known, mining, energy and real estate, remain readily available for well structured and priced transactions,” she says.
Another factor influencing the pools of capital available to companies executing M&A deals is the rise of direct lending funds – a source of capital in the market that seeks to compete with banks in the mid-market space. “At the larger end of the market, funds have flowed into European Union (EU) high yield in recent years and collateralised loan obligations (CLOs) have also attracted capital,” explains Mr Smith-Saville. “These developments have increased competition for investors to deploy capital which have allowed borrowers to push terms which are more favourable to them.”
Due to come into force in March 2019 following several years of delays and postponements, the Basel III international regulatory accord – a global, voluntary regulatory framework on bank capital adequacy, stress testing and market liquidity risk – is expected to have a major impact on the ability of banks to rubber stamp the extension of credit and loans. As a consequence, the terms under which deals are structured and financed will almost certainly be affected.
“Basel III capital requirements have raised the cost of capital for banks involved in the market and, at the same time, there is significant competitive pressure on the yields available,” says Mr Smith-Saville. “As a result, the profitability of leveraged lending for banks has declined. In addition, several large clearing banks in Europe are increasingly partnering with credit funds to allow banks and funds to share risk and rewards in a way which makes sense for both parties.”
Ahead of the game and perhaps the quintessence of Basel III preparation, Canadian banks have already factored in capital requirements and completed the balance sheet structuring necessary for compliance. An early adopter of the requirements of the Basel accords, Canadian financial institutions have made a point of moving quickly to ensure balance sheets respond appropriately to capital requirements.
“Canadian banks do not anticipate there will be any change in their approach to the financing of M&A activity,” suggests Ms Manzer. “Banks continue to operate on a capital sensitive, conservative basis. Creditworthiness of the acquirer and the target, collateral cover and structuring of the transaction all remain key factors to the availability of bank financing. In addition, it is not anticipated that Basel III will change this approach for the Canadian financial institutions, which have already adopted the concepts they believe necessary to comply with the Basel III regulatory accord.”
With the availability of capital a vital precondition for a functioning M&A market, the search for creative and innovative financing structures that can best facilitate the capture of M&A transaction capital is an ongoing challenge.
According to Mr Barnitt, structures and strategies should be tailored to the bespoke needs of each M&A transaction, with adequate working capital and growth capital financing factored in. “Seek structures that provide the right balance of space, time and capital quantum,” he advises. “Unitranche and mezzanine loans are high value added forms of M&A financing that provide equity-like capital at loan-like pricing. Acquisition price consideration should be structured with a back end note or earn out to mitigate risk.”
According to Mr Smith-Saville, one structure that is becoming less attractive is the traditional route of private debt funds only targeting lending into LBO deals backed by a reputable financial sponsor. “This is changing, and funds are increasingly happy to consider sponsor-less deals,” he suggests. “Given banks’ conservatism for deals, companies may find a deep pool of capital which they can tap into to fund deals. For family-owned firms, this could enable them to continue to grow while remaining in control of their company.”
In the Canadian M&A market, access to capital for M&A transactions, whether in the banking sector, public markets or sponsor sector, requires careful consideration of the specific regulatory and investment parameters applicable to the financing sector being considered. “Each of the three primary sources of financing have different sector appetite as to credit risk, return requirements, credit quality and asset cover and supplemental participation through equity or similar,” explains Ms Manzer. “Understanding the requirements of each of the sectors will enhance the ability to successfully access capital in the time-sensitive manner that most M&A transactions require. M&A transactions generally do not have the luxury of time that will allow a scatter-gun approach to seeking out the capital from each of the funding sectors.”
Over the next 12 months, M&A capital considerations and financing techniques are set to evolve as the full impact of US tax reforms, interest rate rises and Basel III banking requirements, among other trends and developments, become clear.
Furthermore, later in 2018, the US Federal Reserve and the Bank of England are expected to raise interest rates, with the European Central Bank (ECB) also expected to rein in its balance sheet. “This may limit further cash inflows to European leveraged finance or even cause cash to flow out of the market,” suggests Mr Smith-Saville. “As a result, pricing may rise or terms may tighten, limiting the attractiveness of debt for companies looking to fund M&A.”
That said, the outlook for global M&A in 2018 is overwhelmingly positive, with deal value forecast to hit £3.2 trillion. Moreover, with the availability of private and public capital apparently plentiful, and an attractive pipeline of target assets waiting to be explored, M&A dealmakers are licking their lips at the prospect of the M&A opportunities ahead.
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