M&A deal financing: risks and recommendations

December 2023 | SPOTLIGHT | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

December 2023 Issue

Global M&A volume for the first nine months of 2023 was just over $2 trillion, with more than 40,000 deals announced in the period, according to data from the London Stock Exchange Group (LSEG). This M&A activity, while hardly record-breaking for either dollar or deal volume, shows the continuing vigour of M&A as a corporate strategy. It also raises the issue of deal financing risks and the need to mitigate them.

M&A transactions occurring in the first three quarters of 2023 ranged widely in size, industry and target country, but they all had one thing in common: they all had to be financed – whether by the issuance of new stock or bonds (or other notes), or by cash from retained earnings or commercial loans. Companies spending, promising or borrowing money to engage in M&A this past year were taking financial risks, and the deal prices they paid showed that these risks were calculated with optimism.

Acquirers normally aim for a return on investment (ROI) above what they paid – and based on recent deal price data they are setting high targets for that ROI. As of 1 October 2023, typical worldwide earnings multiples paid for targets (measured as deal price times earnings before interest, taxes, depreciation and amortisation (EBITDA)) averaged 15 times – well in line with trends of the past 10 years as tracked by LSEG. Premiums paid in 2023 deals also revealed optimism – averaging 27 percent above four-week stock price – also consistent with LSEG-reported trends of the past decade.

These indications of deal optimism are at odds with the inflationary pressures now dogging dealmakers. Acquirers operating in late 2023 and into 2024 must pay more for goods and services in the post-merger period than what they were paying when they were first contemplating their transactions. Inflation puts downward pressure on earnings, which must keep rising to placate capital sources – whether shareholders who want bumps in quarterly earnings per share (EPS) or lenders who have stipulated threshold debt-versus-income ratios in their lending documents.

While the year-over-year average inflation rate experienced by consumers as of September 2023 was only 3.7 percent and the rate experienced by producers was only 3 percent, these hops were on top of previous inflationary jumps. (The 10-year overall inflation rate from September 2013 to September 2023 was 31 percent, reports the US Department of Labor.) Also, when comparing 2023 to 2022 year over year, some sticker shocks were higher than others. Legal services cost consumers 12.4 percent, and producers paid 3.9 percent more for construction and 6 percent more for business services.

Acquirers that have issued corporate bonds at floating rates to finance deals are not immune from the problems. A recent Wall Street Journal article highlighted three companies – Cooper Standard Holdings, Power School Holdings and Sabre – whose interest expense rose by high double digits in 2023 alone. All three are acquisitive companies. Cooper Standard has not done an M&A deal since 2018 but its board has an ‘innovation and business diversification’ committee, indicating some M&A aspirations. Power School Holdings has spent $1.15bn on 15 acquisitions, most recently absorbing Neverskip and School Messenger in 2023. And Sabre has spent $2bn on 14 acquisitions in recent years. The very high interest rates they are paying on their corporate bonds do not make post-merger life easier. Recent reports indicate that banks holding some $13bn in debt loaned to Elon Musk for his purchase of Twitter (now X) in 2023 are having a hard time reselling the loans.

Conversely, for acquirers that borrowed money in 2023 to finance their deals, payback can be a challenge. As mentioned, many loan covenants have a threshold for debt in relation to income, most commonly via an interest coverage ratio – the ratio of EBITDA to interest expense coverage may not drop down below a certain level, for example (a ratio of 2, 3 or 4 according to various sources). This means that while borrowing costs rise, so must EBITDA – not an easy feat. For acquirers in the US and elsewhere, stricter limits on deductibility of interest expenses have cut into post-merger earnings.

During the first nine months of 2023, the US federal funds rate rose by a solid 1 percent (from 4.33 percent to 5.33 percent) according to data from the Board of Governors of the Federal Reserve System, with additional increases planned under the ‘higher for longer’ mantra embraced by not only the US Federal Reserve but also the European Central Bank, the Bank of England and other national monetary policymakers, as reported by Reuters. The year-end US federal funds rate is reportedly 5.5 percent. And woe betide the company that is late on a US tax payment. The interest rate now charged by the US Treasury (under new revised rule 2023-17) is 10 percent.

Companies are well aware of the risks that higher interest rates are causing. US Chapter 11 bankruptcy filings as of October 2023 were up 44 percent year over year (78 in 2022 versus 112 in 2023) according to Bankruptcy Watch, and no acquirer wants to join this trend. A recent study from the Federal Reserve Bank of Boston reported a spike in mentions of financial risk starting in the first quarter of 2023.

Given these trends, how can acquirers minimise future financial strains? Outlined below are suggested steps.

At the strategy phase. To the extent possible, before signing the acquisition agreement, predict future financial metrics – including revenue, expenses, earnings and cashflow – as precisely as possible, including worst-case scenarios. Begin preparing the ‘story’ to tell shareholders or lenders to provide a compelling justification for the transaction. This will ensure a higher increase of stock prices and more favourable loan terms.

At the valuation phase. After establishing a fair price, consider giving a premium for a company with a high cash balance and strong cashflow. Pay special attention to the acid test ratio of the company being acquired (the sum of cash plus marketable securities plus accounts receivable over current liabilities).

At the structuring phase. Decide carefully whether the deal will be structured as a stock versus asset purchase, and as a taxable versus nontaxable transaction. Be sure to engage the services of expert tax counsel. Note that merger advisory costs are generally tax deductible.

At the financing phase. Run realistic post-merger cash flow scenarios. What will post-merger cash flow be like if the acquirer pays in cash versus stock, or makes contingency payments versus full payment? If an acquirer borrows money, it needs to ensure the interest rates are as low as possible and that the loan is not callable, or if it is that the terms are fair and include possible refinancing rights.

At the negotiating phase. Acquirers need to ensure the acquisition agreement protects them from being responsible for any material liabilities not disclosed prior to the closing. If the seller will not agree, then try to discount the price to cover that risk.

At the closing phase. For the final pricing at closing (as captured in the acquisition agreement), if an acquirer believes it is more likely that a seller will lose value rather than gain value between the agreement and closing, try to opt for a completion account to determine final price, rather than a ‘locked box’ approach based strictly on the last balance sheet.

At the post-merger phase. Stay very close to the finance team to keep an eye on share prices and dilution (for stock-financed deals) and liquidity (especially for debt-financed deals). Of course, what matters most is actual operations after the transaction – how the leadership and workforce continue to provide needed products and services at fair prices in a changing world. That is more important than sound M&A financing – but impossible without it.

Alexandra R. Lajoux is the founding principal of Capital Expert Services, LLC. She can be contacted on +1 (202) 255 7562 or by email: arlajoux@capitalexpertservices.com.

Alexandra R. Lajoux

Capital Expert Services, LLC