When a company decides to make an acquisition, it may not be a planned event. However, finance directors need not be caught short of funding, says Sophie Roell.
It is Friday afternoon and the financial director of a major corporate is just winding down for the weekend. Perhaps he’s already on the golf course. And then the telephone call comes: the board of directors has decided to proceed with a major acquisition. Now the company needs money – and a lot of it – or its acquisition plans may not be going far.
It is a scenario that happens all too often, according to bankers who advise companies on acquisition planning and financing.
To some extent it is unavoidable in an event-driven industry – where a company’s decision to try and buy a target company may be less the result of long-term planning than a competitor’s announcement that it’s bidding for that target.
But it is also a function of the fact that the decision to proceed with an acquisition is often made at the highest levels, by a CEO and chief financial officer – and not necessarily the financial director and/or treasurer who will be in charge of actually raising the money.
So, as M&A comes out of the doldrums with a few mega-acquisitions already announced – Cingular Wireless’s bid for AT&T Wireless, at $41bn, is set to hit the record books as the biggest cash deal ever – bankers have some advice for companies likely to hit the acquisition trail: be prepared.
“When companies construct an annual plan, they do operating budgets by business line, detailed consolidated income statements, and estimated earnings per share,” says Jim MacNaughton, managing director at Rothschild in New York. “They are less likely to sit and discuss capital objectives and constraints under widely alternative scenarios – or ‘what ifs’ – assuming two or three hypothetical acquisition opportunities appear.”
Jim MacNaughton: 'Sometimes a company will do a transaction to protect its market position'
Balancing act
For companies, figuring out how much they can spend on an acquisition is a complex balancing act. These days, with interest rates so low, debt is invariably cheaper than equity. Add to that the fact that in many jurisdictions, the interest expense on acquisition debt is tax deductible – resulting in a lower after tax cost of borrowing – and it is no surprise that debt is the preferred form of financing in the current economic environment.
But even though banks are flush with cash right now, when a company ponders how much money it can raise for an acquisition, it shouldn’t be thinking in terms of the maximum amount it can conceivably borrow.
“One of the guiding principles should be a firm’s optimal capital structure,” says Mark Thorum – executive director of ABN AMRO’s Financial Markets Advisory Group. “Essentially, it is a mixture of debt and equity that maximises shareholder value while recognising internal constraints. It’s not solely a function of how much money you can borrow – rather the impact on the post-acquisition capital structure and other attendant factors.”
Mark Thorum: 'A company needs to make sure that it doesn't run afoul of what its peers are doing'
Eye on the target
According to Mr Thorum, most large public companies have a target capital structure and credit ratings in mind: and the determination of debt capacity (which he defines as the maximum amount that can be borrowed while remaining within a pre-selected credit rating or risk profile) is done to fit in with those objectives.
For example, a company’s board may have decided that it wants to maintain a strong investment grade rating: “One approach is to benchmark pro forma financials against the industry specific median scores for a set rating category,” says Mr Thorum. Commonly used financial ratios for benchmarking purposes include Net Debt to Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA), Funds from Operations to Net Debt, and EBITDA to interest coverage.
Peer group and industry norms play a substantial role – from which it may not be wise to deviate. Indeed, research indicates that more than 50% of a company’s capital structure can be determined by its industry sector. Mr Thorum explains: “A company needs to make sure that it doesn’t run afoul of what its peers are doing – particularly if it’s in a highly competitive business such as retail. If it’s very leveraged, and the competition is not, it runs the risk of being more vulnerable if the competition cuts margins.”
Ready for anything
Another key consideration is maintaining financial flexibility for unforeseen circumstances – such as a downturn in the economy or perhaps another acquisition opportunity coming along.
And yet it’s not always possible for a company to behave with utter financial prudence. One instance where it may have to be more aggressive is if the acquisition is of vital strategic importance, perhaps in protecting existing business.
“Sometimes a company will do a transaction to protect its market position or share – because if it fails to do so that business line is strategically vulnerable,” Mr MacNaughton at Rothschild says. “Under that circumstance, a company might be willing to accept greater short-term dilution in earnings or credit ratings than if the acquisition transaction is being done more because it is a good financial transaction but is not a strategic imperative.”
Leveraging impact
But really leveraging up and going the high-yield route – so common in the 1980s when even blue-chip companies took on staggering debt loads to fund acquisitions – has real disadvantages, particularly in the current regulatory environment.
According to Mr Thorum, if a firm is very leveraged, lenders will typically require stricter financial covenants and limit additional acquisitions. He says: “As we get more into a Basel II environment, you’ll find there’s much, much more liquidity for investment grade companies than there is for smaller, non-investment grade firms. Essentially the company will need to balance the interest of its various stakeholders with its own strategic agenda.”
When it comes to actually raising the funding, it is normally a two-step process. In a large acquisition initially three or four lead underwriting banks will probably provide an acquisition bridge. That’s because in many countries, certainty of funding is a prerequisite for making a public offer, so quick and quiet credit approval from banks to put up the money is essential for the deal even to get started.
If the finance director has been good about keeping banks updated on possible acquisition plans, that loan is likely to be forthcoming.
“There is substantial liquidity in both the bank and debt capital markets, so to the extent that the acquisition makes sense from a strategic perspective, raising the requisite funds shouldn’t be a problem,” Mr Thorum says.
Time to think
The acquisition bridge, which can last as long as three years, buys a company time to decide on how it ultimately wants to finance the deal. For companies that want to go down the public debt route, it also gives them time to have a dialogue with the credit rating agencies, which can be vital to the future cost of borrowing.
Standard & Poor’s is widely viewed as more user-friendly for issuers, by being very explicit about what kind of debt ratios it expects from companies to maintain ratings at certain levels. But all the agencies offer companies a ‘rating horizon’ – a period of, say, 18 to 24 months following an acquisition, when a company’s financials can deteriorate without adversely affecting the credit rating: provided that the company is clear about its planned de-leveraging strategy, and outlines its intention to return to its target capital structure within a certain timeframe.
In practice, more debt doesn’t necessarily equate to a lower credit rating. As Mr Thorum points out, financial ratios only represent about half of a rating agency’s considerations: “Oftentimes a stronger business profile – strengthening your market share or broadening your product mix – may mitigate the impact of debt financing an acquisition. Moreover, a clearly articulated strategy to de-leverage either through free cash flow and/or divestitures may assuage the concerns of the lenders,” he says.
Instead of being a hurdle, financing an acquisition may even be a good opportunity for a company to extend the duration of financing and to diversify its investor base. By refinancing the acquisition bridge in the very deep, very liquid public bond markets a company has a chance to bring on board longer-term, institutional investors.
Risky business
Mr Thorum admits there are numerous risks involved in any major acquisition: “There are legal/regulatory issues, raising the financing (often on a highly confidential basis), interest rate and/or currency hedging risks, refinancing risk, etc. There’s also the potential for a rating downgrade. But if a company manages these processes properly, it can pretty much mitigate all of these risks.”
Is there a common mistake companies make? “Keep your lenders abreast of your financial and strategic objectives,” Mr Thorum advises. “Many firms have historically focused more on equity investors due to share price considerations. Financial directors should maintain an active dialogue with core bank and institutional debt investors as well. This will facilitate access to the debt markets on a timely basis and at attractive spreads.”
Rather than being a problem, perhaps having the finance director on the golf course that Friday afternoon would in fact be the perfect scenario. If the people he’d picked to tee off with were actually the company’s bankers, he wouldn’t even need to pick up his cell-phone to start raising funds.
