Introduction to Acquisition Financing
Acquisition Financing is the terminology used for obtaining capital or funds to complete the acquisition of a business entity by another business entity, thereby creating time value by providing the funds required to strike the deal and make the process smooth therefore enabling the acquirer to speed up the process and cherishing the benefits of acquisition as quickly as possible.
Explanation of Acquisition Financing
In a way, all kinds of financing produce funds when needed and create time value for the borrower. Acquisition Financing is no different. Acquirers may have a plan of benefitting from the synergies emerging from the acquisition; therefore, delaying the acquisition is never desired. Having the required resources at disposal eases up this burden for the acquirer, and they incorporate the costs of such funding into the cash flow estimates from the given acquisition.
When the acquisition has a positive NPV, it is only undertaken, and the discount rate includes the cost of acquisition financing. As the funds so acquired are used for acquisition only, they are so-termed and, in a way, earmarked for this purpose.
How does it Work?
As most of the financing is borrowed, the most common way of acquiring such funding is through a line of credit, also known as an overdraft facility in some parts of the fund. It doesn’t disburse actual funds when establishing the line, but it sets up an upper limit of the amount that can be withdrawn.
When the borrower withdraws the funds, he is charged interest on the same from the date of borrowing and not from the date of establishing the credit line. This interest is set when the amount and interest are not repaid. This reduces the interest burden of the borrower as he can conduct the acquisition in a staggered manner and pay for only the time during which the money is borrowed. The acquirer may acquire the assets it wants to sell off in the first phase to immediately pay off the loaned amount and keep the interest burden at a minimum.
Types of Acquisition Financing
Apart from the most common method of bank loan, there can be other ways of receiving the capital
1. Bonds or Debentures
In those markets where the debt market is quite established, acquirers often use debt instruments such as bonds or debentures to obtain acquisition funding instead of a bank loan. This might give the issuers the flexibility to customize the bond contract according to their needs, but it also depends on the number of takers for such an instrument. So considering the market sentiment, the issuer has to oblige with the covenants of the debt instruments.
2. Owner Financing
At times, the target company owner provides the funds for the acquisition in exchange for an annuity payment inclusive of interest over a predetermined period. This is done when the target company owner or the seller is reasonably sure that the company has a cash flow stream good enough to generate the required annuity payments; however, she doesn’t have further inclination to continue working may be due to lifecycle or maybe due to other impediments being faced by her.
3. Sources of Acquisition Financing
The source of acquisition funding may vary based on various factors. One of these is the financial position of the target company. Suppose the Target company has had a steady cash flow stream and is expected to continue for the foreseeable future. It is easier to obtain funding in that case, and several banks, lending organizations, or non-banking financial corporations can provide the funds. In such a case, the interest rate is also slightly more affordable.
However, the larger banks might refuse to fund if the target company is distressed or has not yet reached a steady state on the cash flow front. In such cases, the acquirer may approach a private lending firm because their lending criteria are more relaxed. However, the interest rate is generally higher as the acquisition involves higher risk.
Another critical factor is the financial position of the acquiring company. Suppose the acquirer is in a stable financial position and the size of the acquisition funding is not too high. In that case, even if the target is not an established player, banks might offer the funds but still at a higher interest rate, considering the target a riskier investment but overall risk being lower considering the asset base of the acquirer. In such cases, the lender might put a specific lien on some of the acquirer’s assets.
Benefits of Acquisition Financing
Benefits are given below:
- Speedy Acquisition: We have all heard to strike the iron when it is hot. So if the acquisition is not completed within the time frame desired by the acquirer, it may give the competitors the time to enter the market and eat out of the first mover’s advantage of the acquirer. Therefore funding makes resources available as per the need of the acquirer.
- Enables Phase Wise Acquisition: A line of credit assures the seller that he will receive the required payment and is ready to enter into a staggered acquisition. This enables the acquirer to keep the interest cost minimum and follow the most optimized acquisition sequence.
As the name suggests, acquisition financing is the process of obtaining capital earmarked for a particular acquisition or for the acquisition purpose in general for companies that regularly undertake the same. It adds value by providing the required funds when they are most needed and therefore prevents the delay in the acquisition process.
There are various modes of acquisition financing, as in any financing; therefore, choosing the right option may help the acquirer keep the funding cost to the minimum. Further, it gives the acquirer an incentive to go for only those targets, which can lead to a positive NPV, but it may also make the acquirer more risk-averse. So it is a trade-off that the acquirer needs to weigh before entering into financing.
This is a guide to Acquisition Financing. Here we also discuss the introduction and how acquisition financing works with its types and benefits. You may also have a look at the following articles to learn more –