How to finance your business acquisition in 2024
On the 8th May, the House of Commons Treasury select committee published a report on the finance hurdles facing the UK’s SMEs. Their verdict? Stringent credit conditions and unfair banking practices are disincentivising risk-taking, innovation and growth.
The Impact Investing Institute, a non-profit organisation that promotes impact investing, told the committee that the success rate of SME applications for bank loans fell from 80 percent in 2018 to around 50 percent as of 2023.
Many SMEs are now not seeking finance at all because they expect to be unsuccessful or are simply not looking to grow.
The reluctance of high street banks to provide funding to SMEs has, the committee was told, created a £96bn finance gap between 2015 and 2022 that has largely been filled by emerging challenger banks and alternative finance providers.
In this challenging funding landscape, where traditional lending sources are increasingly constrained, SMEs seeking to finance business acquisitions must explore alternative avenues. This article explores some of the potential funding options available to SMEs for acquiring businesses.
Possible funding avenues for business acquisitions
Earnouts/deferred consideration
Earnouts are a type of purchase agreement where a portion of the purchase price is contingent upon the performance of the business after the sale. These arrangements are often tied to post-deal EBITDA targets but can also be driven by revenue or other KPIs, depending on the specific circumstances.
They become particularly common whenever market conditions create a value gap between seller price expectations and buyer confidence levels – for example, when interest rate increases combine with tight credit markets.
During the first three quarters of 2023, nearly one-third of private deals in the US included an earnout, up from 21% during the same period a year earlier.
Leveraged buyouts
A leveraged buyout (LBO) occurs when a buyer acquires a company by using a significant amount of borrowed funds, with the target company’s assets or future cash flows serving as collateral for the loans.
Business press headlines may give the impression that most leveraged buyouts are management-led deals for multi-billion pound companies, however asset-based LBOs are widely used in SME acquisitions.
They allow buyers to commit considerably less capital, however they can create an unsustainable debt burden if the company fails to meet its performance expectations. The high debt-to-equity ratio brings with it significant risk.
One of the largest LBOs ever undertaken was the $8.7bn buyout of PetSmart in 2015 by BC Partners. The British buyout firm believed that it could improve the company’s market share by capitalising on its neglected online platforms. Under BC Partners’ direction, PetSmart increased its revenues by more than 40%.
Third-party equity financing via private equity firms
On this form of financing, the private equity firm contributes a significant portion of the acquisition cost in the form of equity capital through a special purpose vehicle (SPV) or an acquisition company. This equity contribution can range in value, depending on the size of the transaction and the firm’s investment strategy.
In addition to the equity contribution, the acquisition vehicle also secures debt financing from various sources, such as banks, institutional investors, or through the issuance of high-yield bonds.
Private equity has been playing an increasingly important role in the M&A market in recent years, despite a dramatic slowdown in 2023.
PE firms typically have access to large amounts of capital, as well as more creative financing solutions, such as private credit markets and seller’s notes. They also typically have the know-how to execute deals quickly and efficiently.
The months ahead look particularly conducive to greater PE-backed deal volume with dry powder reserves sitting at a historical high of $70-80bn in Europe.
Asset-backed loan
Asset-based lending is a form of business financing where a company’s assets are used as collateral to secure a loan. In this lending approach, lenders evaluate the value of tangible assets owned by the business, such as inventory, accounts receivable, real estate, or equipment, to determine the eligibility for financing and the loan amount.
This form of finance is suitable if the target company has valuable assets that can be easily liquidated, such as the factory equipment, plant, and buildings belonging to manufacturing companies, or the inventory belonging to major retailers or ecommerce players.
One possible hurdle is finding a financier who will agree on the buyer’s valuation of the target company’s assets.
Mezzanine financing
Mezzanine financing is typically used where the risk associated with a transaction is considered too high for the borrower to secure sufficient capital through conventional business loans.
It is a hybrid of debt and equity funding. The loan is structured such that if the repayment period elapses without the borrower fully settling the debt, the lender has the option to convert the outstanding balance into an equity share in the company.
In alternative mezzanine financing arrangements, the lender receives not only interest payments on the loan but also a share of the company’s profits or revenue.
While mezzanine lenders typically impose less restrictive covenant requirements, their equity participation can impact returns.
The Blackstone Group’s acquisition of Hilton Hotels in 2007 for $26 billion involved a large mezzanine financing component, which was one of the largest mezzanine financings at the time.
Where to go from here…
Creating funding structures to support M&A transactions is complex and requires specialist lending skills.
Partnering with a reputable broker like Hilton Smythe can not only simplify the process but can also open the doors to an array of alternative lenders beyond high street banks.
We can arrange meetings with banks and investors to pitch the deal, evaluate debt versus equity trade-offs in proposed finance packages, negotiate flexible lending terms, assist in fulfilling due diligence document requests, and more.
