Mergers and Acquisitions For Dummies (23 page)
Read Mergers and Acquisitions For Dummies Online
Authors: Bill Snow
Understanding the Levels of Debt
Debt can help Buyer make an acquisition by leveraging Buyer's existing capital. The following sections cover the different types of debt common in M&A, so dig in!
Surveying senior lenders and subordinated debt
A
senior lender
is usually a bank that lends a company money, often for the express purpose of financing an acquisition. As the name implies, this lender is
senior
to all other lenders, which means that the senior lender gets paid before the other lenders in the event the borrower goes bankrupt. A loan from a senior lender is called a
senior loan.
Subordinated debt,
often called
sub debt,
is a strip of capital similar to senior debt; however, the lender purposefully agrees to take a back seat to the senior lender. A lender willing to subordinate itself to the senior lender does so in exchange for a higher rate of return.
Mezzanine
debt
(or simply
mezz
) is a form of sub debt that usually has some sort of equity component (usually in the form of a
warrant
, which is the right to buy stock in the future at a low price).
Leverage
Simply put,
leverage
is debt â borrowed money â that helps Buyers make acquisitions. Instead of putting all of their money into play, leverage allows Buyers to spread their money further and make more acquisitions.
Say Buyer has $10 million to invest in acquisitions. Without leverage, he can make a single $10 million acquisition. However, if he borrows another $10 million, he can use the borrowed money to make more acquisitions. In this case, that same $10 million enables Buyer to make two $10 million acquisitions, so he now has $20 million of investments under management. Because he borrowed money to finance half the acquisition amount, he's used 50 percent leverage. Back in the good old crazy days of the mid-2000s, some Buyers were able to put down just 10 percent, meaning that same $10 million could finance $100 million in acquisitions.
PE firms, in particular, like to utilize as much leverage as possible. The less equity a firm has to use, the higher the (potential) return on equity after the investment is sold.
Leverage gives you more bang for the buck as Buyer, but don't use debt excessively; the greater the debt load, the less likely a company will be able to withstand a downturn in the economy. That warning aside, and to paraphrase Alexander Hamilton, leverage, as long as it is not oppressive, will be a blessing to your company.
Looking at lines of credit
A
line of credit
(LOC) is simply a loan from a bank, often used to help finance acquisitions. Unlike a senior loan (see the preceding section), the borrower pays interest on the amount it has used. A company may have a $5 million LOC, but if it has only tapped $2 million to help pay for an acquisition, the company only pays interest on the $2 million, not the full $5 million available.
A
revolver
is a type of LOC designed to help with the short-term cash flow needs of a business. A revolver is helpful to a company whose cash reserves are low (perhaps because it just spent some money making an acquisition) and that needs to pay bills even though its clients are a wee bit slow in paying. Making payroll is usually the main reason for establishing a revolver.
To help during a cash crunch, a company may establish a revolver with a bank. If the company needs cash, it utilizes the cash on its revolver and then repays the revolver as clients remit payment to the company.
Taking a Closer Look at Investors
Investors come in all shapes and sizes. Sometimes they're
institutions
(other companies, often called strategic investors), and sometimes they're people. In this section, I detail the ins and outs of working with institutional and individual investors.
Institutions versus individuals
Most often, Buyers of middle and lower middle market companies are institutions (PE firms or strategic Buyers). Individuals can certainly buy these companies, but due to the size of the companies and the amount of money needed to buy them, individuals buying companies in these markets are somewhat rare.
Individuals seeking to acquire a company may be little more than dreamers with no money. Sellers should take appropriate steps to ensure individual Buyers can back a transaction.
Institutions usually have more money than individuals, greater access to other sources of capital, and a certain level of sophistication as compared to most individuals. The executives at a company or PE firm probably have more experience doing deals, more experience running a business, and greater financial acumen than an individual. Not always, of course, but usually.
Following the financing food chain
Investing in a company isn't as simple as buying stock. Investors may opt to put their investment in the form of debt, which comes in myriad options with varying risk levels. The higher up the food chain the investor's place on the balance sheet is, the more likely that investor gets paid in the event of failure, bankruptcy, or liquidation.
If a business fails, it faces liquidation, meaning its assets are sold to repay its debts. In an ideal world, the value of the sold assets would cover the value of the debts, but often that's not the case. Because of that bitter reality, bankruptcy laws are very clear about who gets what and when. In the US, the liquidation order is as follows:
Employees:
Employees, rightfully, are at the top of the list. In the unfortunate event of a business failure, employees who are owed back wages get paid first.
The IRS:
Not surprisingly, Uncle Sam wants his cut, too, so any unpaid taxes must be paid in full before any of the remaining money is kicked down the food chain.
Secured creditors:
After the employees and Uncle Sam are taken care of, secured creditors are next.
Secured
means the creditor has a lien or personal guarantee against assets, both of which mean that the creditor can go after the owner's personal assets (home, cash, cars, and so on).
Unsecured creditors:
Any money left over after the secured creditors are repaid goes to the unsecured creditors. These folks typically include vendors and suppliers.
Preferred and common stockholders:
If all the creditors are repaid, any money left goes to the equity owners of the business. Preferred stockholders are repaid first, and then what's left (if anything) goes to the common stockholders.
That setup paints a rather ugly picture for common stock, so why would anyone want to own common stock? Answer: Common stock is the only security that affords the owner unlimited upside potential.
Say a company is being liquidated and everyone else in the food chain is owed a collective $20 million before the common stockholders see a dime.
Although that sounds like a huge hurdle, and it is, suppose the assets sell for $100 million. In this scenario, the common stockholders receive $80 million.
Remember:
Please note that for simplification's sake, I haven't included the numerous layers of secured and unsecured creditors, some of whom take precedence over others, or the fees of lawyers and other advisors.
Note, however, that a wealthy individual may be able to act more quickly than a company. An individual Buyer has far less bureaucratic red tape than an institutional investor Buyer.