M&A Fundamentals – Understanding the Role of Debt and Equity in M&A Transactions
The capital structure of a company can be made up of two broad types of financial instrument- debt and equity. Both of these classes of capital have a major impact on the way an M&A transaction unfolds. We will explore this further in a later article on M&A deal structure. This article explores the different forms of debt and equity used in a company’s capital structure and some of the ways they might be used in an M&A transaction.
STOCK – Ordinary Shares & Preference Shares
Ordinary or ‘Equity’ stockholders are the owners of the company. Ordinary stock usually has equal shares in dividends and voting rights although some companies may have classes of shares with disproportionate voting rights to help founders or key stakeholders maintain control of the enterprise. The shareholder’s liability in the event of a company failure is limited to the nominal value of the shares. They are entitled to any surplus after settlement of liabilities on a winding up.
An M&A transaction is a change of control process. Conceptually the simplest way to affect an M&A transaction is to buy a majority of the voting ordinary shares from the existing owners.
The owners of ordinary stock break into a number of discrete groups with different motivations.
Founders – are primarily motivated by entrepreneurial drive. Founders are typically the dominant shareholders in M&A transactions involving smaller privately held or early-stage companies.
Institutional – these are typically pension funds, mutual funds or insurance companies and can be characterised as long-term investors looking for capital growth or income. These types of investors are often the most important shareholders in M&A transactions involving the purchase of large companies listed on stock exchanges.
Private Equity or Venture Capital – are typically investors seeking a high return (30%+) from a large stake in a private company over 3–5-year timeframe. M&A is the core business process of this type of investor – both buy-side M&A at the start of their ownership and sell-side M&A when they secure the returns on their investment through an M&A sale transaction.
Retail – are members of the public with small shareholdings in companies listed on stock exchanges held as part of a diversified portfolio of investments. They have little or no involvement in M&A activity as the success or failure of an offer for a listed company will be determined predominately by the institutional investors.
Preference stockholders are generally entitled to have their dividends paid before ordinary stockholders and have first equity call on any surplus on winding up. Dividends are usually fixed and accumulate if payments are missed. For these rights the preference stockholders usually forgo voting rights. Some preference stocks are convertible to ordinary stock or carry the right to capital repayment in the future (redeemable). In an M&A context convertible preference shares often form part of the capital structure in venture capital transactions. The conversion event might be linked to the success or failure of the M&A transaction.
DEBT – Institutional Finance and Bond Finance
Often provided by banks or similar institutions this type of debt is attractive to companies who want to raise finance without giving up ownership. It has the added benefit that interest payments are deductible against tax (often referred to in M&A circles as the “tax shield”). All bank debt is secured against an asset or class of assets that the bank is entitled to sell if the borrower cannot meet repayments.
Common types of debt finance you will come across in M&A transactions include:
A term loan must be repaid over a fixed length of time. The borrower pays interest on the outstanding balance and must pay off the face value of the loan by the end of the term. Typical terminologies used in term loan agreements are:
- Amortised if paid off in instalments over term or bullet if paid at end of term;
- interest can be fixed or floating (usually based on LIBOR or base rate);
- Senior or subordinated refers to ranking on liquidation.
A commercial mortgage is a specialised type of term loan secured against commercial land and premises.
A grouping of terms loans where a lead arranger sets terms for all lending banks. Very common in large scale M&A transactions.
Revolving Credit Facilities
With this type of loan, the borrower pays a commitment fee to access the ability to draw down funds as required across a 2-to-5-year period up to a defined limit. Interest is paid only on the drawn down amount. Any outstanding loan must be repaid at the end of the term.
A similar form of loan to a revolving credit facility. A very flexible form of finance linked to checking account but unlike a revolving credit facility repayable on demand.
A tax effective way of acquiring a fixed asset. The finance provider buys the asset and charges the company a rental for its use. Can be tricky in M&A as the bank legally owns the asset and not the target company. A company reporting under a mainstream GAAP will show these assets in its balance sheet with a balancing loan for the rental obligation. In countries with weak or no statutory reporting requirements leased assets can easily be left out of a balance sheet. This means the buyer in an M&A transaction might not have visibility of all the assets necessary to run the target business or might find out after closing that all the necessary assets do not belong to the target of the M&A transaction.
Sale and Leaseback
Essentially this falls under the heading of leasing but is specialist subset of that form of lending. In a sale and leaseback the company sells one of its existing assets to the bank and then leases it back. This source of capital is commonly used by buyers to raise funds for an M&A transaction. In this approach to funding an M&A transaction any of the target’s assets suitable for leasing are sold to the bank at the same time as the closing and the money released paid to the sellers as part of the consideration for the M&A target.
Invoice Factoring or Discounting
This type of lending has some similarities to a revolving credit facility except the lender gives an advance against the company’s receivables as they are invoiced. The payment from the customer is used to pay off the advance. This type of funding is very useful to companies that offer credit terms to customers. In a factoring arrangement the lender actually takes possession of the invoices.
DEBT – Corporate Bonds
Larger companies can bypass institutional lenders and create their own debt instruments, known as bonds, and sell them directly to investors. A bond is a tradable debt instrument issued by an individual company. Company bonds are traded on exchanges in the same way as shares. A bond may trade at a premium or discount to its face value depending upon the prevailing rates of interest and the length of time to its redemption.
Bonds are usually categorised by the following features:
A bond repayable within 5 years is usually deemed short-term. Some large companies issue bond with terms as short as 90 days to fund working capital. Bonds with 5-10-year terms are deemed medium term and longer than 10 years long term.
Conversion Rights – Is there an option to convert to equity?
Some corporate bonds can be converted to equity if certain conditions are met. This might allow the lender to participate in a larger pay-out if the company is acquired in an M&A transaction.
This is the technical term for the rate of interest on a bond. Interest paid on the bond can be fixed or floating (linked to a base rate). The coupon is linked to the nominal (face) value of a bond. This means the rate of interest paid to an investor will be impacted by the price that the bond is trading on its market. For example, if a $100 bond with a coupon of 5% is trading at $90 on the exchange the buyer of the bond at $90 will receive ($5/$90) x 100 = 5.56%.
Corporate bonds can be fixed to a specific asset or have a floating charge across all the assets of the issuing company.
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