With interest rates declining, it’s a good time to revisit the topic of debt used in mergers and acquisitions.
In M&A, financing is a key component that can make or break a deal. While most acquisitions involve an infusion of equity, obtaining debt financing is critical, especially in private deals where new owners seek to gain more control and take advantage of tax shields.
Here are the major types of debt used to finance private M&A deals, along with their features, advantages and drawbacks.
Senior secured loans are a common form of debt used in M&A. These loans are typically secured by the assets of the company being acquired or in some cases, the assets of both the acquiring and target companies. Because they are backed by collateral, senior secured loans carry the lowest risk for lenders and usually have lower interest rates compared to other forms of debt.
These loans often feature covenants that the borrower must adhere to during the life of the loan. They may include financial covenants, such as maintaining certain leverage ratios, or operational covenants that limit activities, like selling off assets.
As senior secured loans are backed by assets, they typically carry lower interest rates, making them less costly for borrowers. Also, lenders are more willing to extend larger amounts of credit when collateral is offered as security. Lastly, interest payments on senior secured loans are tax-deductible, which can create a tax shield that reduces the overall cost of borrowing.
But if the business struggles or fails to meet its debt obligations, the lender can seize the assets pledged as collateral, thus dooming the entity. Often the covenants in senior loans can be restrictive, limiting the company’s operational flexibility and strategic decision-making. And in all cases, excessively high leverage puts pressure on cash flow, increasing the risk of default.
Mezzanine financing is a hybrid of debt and equity. It is typically subordinated debt, paid after senior debt in the event of bankruptcy, but before equity holders. Because mezzanine debt is riskier for lenders, it carries a higher interest rate and often includes an option for the lender to convert some debt into equity in case of default or a positive liquidity event.
In many M&A deals, mezzanine financing is used to fill the gap between senior secured loans and the buyer’s equity contribution. It is often structured as interest-only debt, with a balloon payment due at the end of the loan term.
Unlike senior secured loans, mezzanine debt does not require collateral, making it more flexible for companies that may not have sufficient assets to pledge. Mezzanine financing also offers flexibility in structuring payment terms, which can be customized to suit the needs of the buyer and the acquisition.
While it often carries an equity component in the form of warrants, mezzanine financing dilutes ownership less than issuing new equity, allowing the acquirer to maintain more control.
Some of the downsides are that the higher risk for lenders means higher interest rates, making mezzanine debt more expensive than senior debt. Since mezzanine debt is subordinated, it carries a higher risk in case of bankruptcy, so lenders may demand stringent conditions or oversight to mitigate these risks. Lastly, balloon payments at the end of the loan term can create significant cash flow pressure if the acquisition goes sideways and the debt can’t be refinanced.
Seller financing occurs when the seller agrees to finance a portion of the purchase price. This debt is typically subordinate to all other forms of financing and often comes with flexible repayment terms negotiated directly between the buyer and seller.
We see seller financing in smaller, private M&A deals where the seller may need to facilitate the transaction by offering favorable financing terms.
Since the buyer and seller negotiate terms, seller financing often comes with more favorable interest rates and repayment schedules. Seller financing can help the buyer close the deal faster and reduce the need for external financing — potentially lowering the overall transaction cost.
Seller financing is often unsecured, meaning the seller bears the risk if the buyer defaults on the loan. Also the seller remains financially tied to the business after the sale, which is not desirable if the seller was looking for a clean break. And there’s nothing but headaches if the buyer can’t meet payments.
In sum, senior secured loans offer lower costs, but come with collateral and covenant restrictions. Mezzanine financing provides flexibility, but at a higher price and you need to choose your partner well. Seller financing can be a useful tool for smaller deals, but carries its own set of challenges. For example, be prepared to get nothing from seller financing if your buyer hits a rough patch.
