Financing M&A deals

The Irish M&A landscape continues to be underpinned by a significant level of liquidity. We are seeing deal flow sustaining at a very high level in the SME space, as both private equity investors and multinationals continue to view Ireland as a great place to do business.

Notwithstanding this, rising interest rate costs present a headwind that will challenge a leveraged transaction. We anticipate that there may be a valuation gap developing between buyer and seller as the cost of finance of any deal has increased significantly in the past 12 months. We would expect this to normalise as more evidence of deal multiples in a high interest rate environment become available.

From a transaction execution perspective, managing a tight and efficient process is critical. The level of due diligence that a prospective purchaser is performing has increased due to inherent uncertainty, particularly around inflation risk. Any company embarking on a sales process should retain an experienced financial advisor who will maintain momentum in the deal, which is often the key to a successful outcome.

What drives acquisition?

There are many factors that drive a corporate acquisition:

• Growth is one of the more common drivers, where a business sees acquisition as an opportunity to build scale quickly. Acquisitions can fast-track growth, which can be much slower via organic means.
• Cost synergies can be another driver of M&A activity, where value is created by the combination of two businesses into a larger operation with greater economies of scale and enhanced profitability.
• Strategic acquisition: a target company may have particular capabilities and market intelligence that would make the acquisition a sound strategic fit.
• Competitor: a buyer may seek to acquire a competitor company to increase its market share and dilute the competitive threats in the market.
• Cash flow: an acquirer may have excess cash flow that it needs to deploy to deliver a return on investment, and the most attractive investment is a company acquisition.

In the present climate, the insurance sector in particular has seen considerable M&A activity driven by consolidation for growth and cost economies. We have also seen new entrants to the Irish market looking to buy a solid platform to fuel further growth opportunities. For example, Orpea entered the nursing home market in Ireland in 2020 when it acquired a 50% interest in Brindley Healthcare. It has since gone on to become the largest nursing home operator in Ireland following a series of further acquisitions.

Sources of funding

Typically, sources of finance can be broken down into the following buckets:

• Internal company resources: available surplus cash held by the acquiring company.
• Debt finance: notwithstanding the current interest rate challenges, borrowing debt to support a company acquisition is commonly used. There is an active market of lenders prepared to finance acquisitions which demonstrate quality cash flows generated which support a repayment profile. Senior debt, invoice discounting and mezzanine debt are frequently used in funding M&A activity.
• Equity: a company can raise equity via private equity firms or a friendly investor to support an acquisition. While this is less common for SMEs, it is a growing area of financing for well-managed businesses.

In the event that a full funding package cannot be delivered using these traditional sources of finance, it is often the case that a level of deferred consideration (or earn-out) is structured into the deal. This gives the purchaser the opportunity to use cash flow generated by the target company to fund the acquisition. Deferred consideration can often be agreed subject to achieving certain profitability targets. This type of structure is also used to maintain a level of commitment from the seller to successfully transition key relationships (such as customers, staff and suppliers) to the new owner.

It is important from a deal execution perspective that the proposed funding structure is clearly outlined to the sellers at deal negotiation stage. There is inherently more risk attached to a funding proposal that involves third-party finance compared to a proposal that is funded by cash reserves.

In approaching any funder, a robust business plan is vital. This should clearly set out the funding required, the repayment profile and the security available, as well as the financial projections and assumptions which underpin this. Other important considerations for a funder are the track record of the management team and the general outlook for the sector. By involving a professional advisor in raising funding for an acquisition, our clients benefit from a critical analysis of the business as well as insight into the appropriate forms of finance available.

Choosing the right form of finance is vital. The acquiring company should not over-extend itself in terms of the level of debt it takes on. It is likely that a lender will look to take security over the target business and its assets, and potentially cross-security over the existing business. If the level of debt is not supported by future cash flows, there is a risk that the existing business will be impacted. Ensuring that you correctly and prudently project the level of profitability to support the repayment profile is critical. The funding package should support the future growth of the business and have sufficient headroom to allow for unexpected events.

From an acquirer's perspective, including an element of deferred consideration that is contingent on future performance is a very effective means of sharing risk and getting buy-in from the sellers as the business transitions to new ownership.

Future trends

As the lending market continues to become more challenged due to rising cost of funds, purchasers will seek to structure deals that make more economic sense for them.

It is likely that where deals would have been leveraged in the past, there will be a greater degree of contingent consideration attached to bridge the gap between the price a seller is willing to transact at and the price that makes the opportunity viable for a buyer.

If you are considering the sale or purchase of a business, we can help you maximise your investment. Talk to our team today.

This article has also been adapted as part of the recent Irish Times Corporate Finance Special Report.