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 in speeding up the process and cherishing the benefits of acquisition as quickly as possible.
Explanation of Acquisition Financing
In a way, all kinds of financing is done to produce funds when they are needed and create time value for the borrower. Acquisition Financing is no different. Acquirers may have a plan of benefitting from the synergies emerging out of the acquisition and 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, then only is it undertaken and the discount rate is inclusive of the cost of acquisition financing. As the funds so acquired are used for the purpose of acquisition only, they are so termed and in a way earmarked for this purpose.
How does it Work?
As most of financing is done via borrowed funding, most common way of acquiring such funding is through a line of credit which is also known as an overdraft facility in some parts of the fund. It doesn’t disburse actual funds at the time of establishing the line, but it sets up an upper limit of the amount that can be withdrawn.
When the borrower actually withdraws the funds, he is charged interest on the same from the date of borrowing and not from the date of establishment of the credit line. This interest is charged for the time till when the amount and interest is 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 therefore keep the interest burden at the 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, instead of going for a bank loan, acquirers often go for debt instruments such as bonds or debentures for obtaining acquisition funding. This might give the issuers the flexibility to customize the bond contract according to their needs but then 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 of an annuity payment inclusive of interest over a predetermined time 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 maybe 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 being, the financial position of the target company. If the Target company has had a steady cash flow stream and is expected to continue the same for the foreseeable future, then it is easier to obtain funding and several banks and lending organisation or non banking financial corporations can provide the funds. In such a case the rate of interest is also slightly more affordable.
However, if the target company is a distressed one or has not yet reached the steady state on the cash flow front, then the larger banks might refuse to fund. In such cases, the acquirer may approach a private lending firm because their lending criteria are more relaxed. However, the rate of interest is generally higher as the acquisition involves higher risk.
Another important factor is the financial position of the acquiring company. If the acquirer is in a stable financial position and the size of the acquisition funding is not too high, then even if the target is not an established player, banks might offer the funds but still at a higher interest rate, considering target a riskier investment but overall risk being lower considering the size of asset base of the acquirer. The lender might put a specific lien on some of the acquirer’s assets in such cases.
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: Having a line of credit, assures the seller that he will receive the required payment and therefore he is ready to enter into a staggered acquisition. This enables the acquirer to keep the interest cost to the minimum and follow the most optimized sequence of acquisition.
Acquisition financing is, as the name suggests, the process of obtaining capital earmarked for a particular acquisition or for the acquisition purpose in general for companies which 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 kind of financing, and therefore, choosing the right option may help the acquirer in keeping 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 does acquisition financing work along with types and benefits. You may also have a look at the following articles to learn more –