Key concepts in acquisition finance

What is acquisition finance, and how do credit professionals play a pivotal role in the process? Philip Waddilove, Financial Trainer at the GICP explains all.

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Acquisition finance is a specialized field of corporate finance. It is a strategic tool used by companies to raise the necessary capital to acquire another company or its assets, for the purposes of market expansion, product diversification or the realization of other synergies that can lead to increased company value. This type of financing can be obtained through various channels, such as bridge facilities, bank loans, bonds, private equity, or using cash reserves.

Unlike other forms of financing, acquisition finance is specifically tailored for mergers and acquisitions. It often requires larger sums of money than other types of financing. Therefore, it demands rigorous due diligence and careful credit structuring.

When a company identifies a target for acquisition, it must choose the most suitable form of financing based on several factors such as their own credit rating, the size and nature of the acquisition, industry conditions, and the overall economic climate. For example, a company with robust cash flow and a strong balance sheet might opt for debt financing due to its ability to secure lower borrowing costs, while a company with weaker financials may lean towards equity financing to prevent over-leveraging.

Credit analysts employed by corporate and investment banks play a pivotal role in acquisition finance, with their findings influencing the terms of the financing, including the interest rates, repayment schedules, and covenants that will govern the agreements.

Assessing creditworthiness is a fundamental aspect of acquisition finance and involves a thorough examination of the financial health of both the acquiring and target companies.

Analysts pore over financial statements and consider key ratios to help lenders and other fixed income investors understand the financial risk associated with the acquisition finance.  The ratios provide a snapshot of the company’s financial leverage, liquidity, efficiency, and profitability; all critical factors when determining the viability of an acquisition.

Credit rating agencies also contribute to the acquisition financing process by offering an independent evaluation of the credit risk involved. A significant downgrade in credit rating can result in higher borrowing costs or difficulty in securing financing, which underscores the importance of maintaining a strong credit rating for companies engaged in acquisitions.

Credit analysts may also evaluate the risks and potential returns of the acquisition; examine the strategic fit between both entities or make forward-looking projections of the combined entity’s future financial performance. Analysts utilize historical financial data to build models that forecast income, expenses, cash flows, and the capacity to repay debt. Stress-testing these projections against various economic scenarios allows for an assessment of the combined entity’s financial resilience.

Credit analysts identify potential risks in the transaction and recommend strategies to mitigate them, the result is that lenders often set out covenants in financing agreements. These covenants can impose financial constraints, such as the maintenance of specific financial ratios, or other limitations, like restrictions on debt incurrence, shareholder distributions, or the disposal of assets. The acquiring company must carefully navigate these covenants as they can significantly impact operational flexibility and strategic choices following the acquisition.

The structure of an acquisition financing (such as bridge, loan, debt and equity capital markets components) will depend on several factors including the size of the deal, the company’s credit ratings, and market conditions. Credit analysts play a key role in determining its optimal structure.

As new industries emerge, and businesses go through their life cycles, acquisitions will remain an important part of company strategy.  Professionals in this area will be asked to synthesize and parse meaning from ever more granular data, utilizing new technology to help them do so.  Regardless, understanding the processes and fundamental risks of these transactions will remain important to a credit analyst seeking to further their careers in this area of finance.

Successful acquisition financing hinges on a detailed and systematic approach to credit analysis, and the role of credit professionals is critical.  Keeping abreast of market trends, regulatory changes, and new risk management techniques will serve those credit professionals well.