M&A

Best Methods of Financing Mergers and Acquisitions

financing mergers and acquisitions

Mergers and acquisitions (M&As) are part of the life cycle of any business. They can help businesses expand, acquire new knowledge, move into new areas, or improve their output with one simple transaction – it’s no wonder that M&A activity hit a record high in 2015. But along with these benefits and opportunities comes great expense – for both parties. A standard M&A deal will usually involve lawyers, administrators, and investment banks, and that’s before the actual cost of the acquisition has been factored in.

There’s no doubt about it – mergers and acquisitions are expensive, and without huge amounts of spare cash on hand, companies will have to seek out alternative financing options in order to pay for their transactions.

There are a number of different methods for financing mergers and acquisitions, and the chosen method will depend not only on the state of the company, but also on overall activity in M&A and finance at the time of the transaction.

Read on for an in-depth look at the best M&A financing options on the market today – and the ones which should be avoided…

Exchanging stock

This is probably the most common option when it comes to financing an M&A deal. If one company is seeking to merge with or acquire another, it is safe to assume that they are in possession of a healthy balance sheet with a robust stock offering. In fact, it is this stock pricing that probably led to the M&A activity in the first place.

In a typical stock-exchange transaction, the buyer will exchange shares in their own company for shares in the selling company. Financing M&A with stock is a relatively safe option as both parties share risks between the two of them after the transaction, meaning that careful management is guaranteed. Paying with stock is also advantageous to a buyer if their shares are overvalued on the market, as they will receive more stocks in the seller company per shares exchanged than if they were paying for their transaction in cash. In a merger deal, shareholders on both sides can reap the benefits of a stock-swap in the long term, as they will generally receive an equal amount of stock in the newly-formed company that results from the transaction, rather than simply receiving money for their shares.

However, there is one major drawback to using stock as currency to pay for M&A – stock volatility. No matter how well a company is doing, there is always a risk of a drop in stock, particularly if word gets out about a possible M&A before any deal has been finalized. Stock markets thrive on liquidity, so shareholders can move quickly to sell their stock if they have any reason to feel nervous about the future of a particular company. An unannounced or unexplained M&A deal would certainly raise a few questions in the financial press. Furthermore, global financial events can wreak havoc on share prices, no matter how well the company is doing. Most famously, the global financial crisis knocked trillions of dollars off the value of global stock markets, and the recent Brexit fallout saw the popular London Stock Exchange hit dangerous lows. Stocks are also subject to artificial market movements, such as shorting, although there are regulatory instruments in place to prevent this from having a seriously adverse effect on a company’s value.

This year’s volatility has made 2016 a bad year for stock-financed M&A transactions. In the first 26 trading sessions of this year, the S&P 500 index moved by one percent 16 times. These are enormous swings in comparison to last year’s market, which saw only half the volatility that 2016 has given investors so far. In the first quarter of 2016, according to FactSet, 77 percent of M&A transactions were made exclusively with cash, the highest level since 2013. Only one M&A deal over $1 billion has been financed entirely by exchanging stock.

While it is hard to predict what shares will be worth in the future, it is easy to understand why some companies might be reluctant to sell their shares in exchange for stock rather than cash. Often a compromise is reached whereby the sale price includes a mix of shares and cash, reducing risk on both sides and allowing both parties to maintain a stake in the new company.

Taking on debt

Agreeing to take on the debt owed by a seller is a great alternative to paying in stock or cash. For many companies, debt is the reason behind any sale, as high interest rates and poor market conditions make repayment impossible. In these circumstances, the priority for the indebted company is to reduce the risk of further losses and redundancies by as much as possible by entering into an M&A transaction with a company which can guarantee its debts. Unfortunately, the debt of a company can reduce its sale value significantly, and can even eliminate its price. However, from the creditor’s point of view, it offers a cheap means of acquiring assets.

Furthermore, being in control of a large quantity of a company’s debt means increased control over management in the event of liquidation, as in this instance owners of debt have priority over shareholders. This can be another huge incentive for would-be creditors who may wish to restructure the new company or simply take control of assets such as property or contacts.

Of course, it is possible to trade debt in M&A deals without the threat of bankruptcy. Under the terms of the deal, one company may offer to buy up a certain amount of corporate bonds for a favorable interest rate, or bonds may be traded between companies as a means of spreading risk and cementing a merger. Where a company’s debts are relatively small, the creditor may simply offer to cover their costs as an extra incentive during the latter stages of the transaction. As with exchanging stock, taking on debt can merely be one part of a complex transaction agreement.

Paying with cash

Paying with cash is the most obvious alternative to paying for a transaction with stock. Cash transactions are instant and mess-free, and cash does not require the same kind of complicated management as stock would. Furthermore, the value of cash is far less volatile and does not depend on the performance of a company. One exception is when dealing in multiple currencies. Exchange rates can vary wildly, as evidenced by the market response to the yen following the Ban of Japan’s deflation program; and the British pound following the Brexit. Currency exchange fees can also add extra expense to multi-national acquisitions.

While cash payment is the preferred method, the price of M&A transactions can run into the millions or even billions, and not many companies can access this much cash from their own funds.

But there are ways of obtaining cash from others ahead of an upcoming M&A transaction:

● IPO

Initial public offerings (IPOs) are a good way for a company to raise money in any context, but an upcoming M&A transaction is one of the better times to carry one out. The prospect of an upcoming M&A transaction can make investors more excited about the company’s future, as it signals an ambition to expand and a long-term strategy. IPOs always attract market buzz, so by timing the IPO with an M&A transaction, companies can maximize investor interest and drive up early share prices.

Moreover, increasing the value of an IPO with an upcoming M&A transaction also increases the value of existing shares – in fact, existing shareholders could see their stock value rocket overnight. However, due to the same volatility that has driven down activity in stock-financed M&A, IPOs can be a risky way of financing ventures. The market can fall just as easily as it can rise, and newly-minted companies are more vulnerable to volatility as they do not have a long track record to reassure investors.

For this reason, IPOs are falling in popularity – in the first quarter of 2016, IPO activity has fallen by 82 percent by deal value and 52 percent by deal number in comparison with the last quarter of 2015.

● Bond issuance

Corporate bonds are a quick and easy way of getting cash, either from existing shareholders or from members of the public. Companies will typically release a number of bonds covering a defined period of time (anything from one year to twenty years), with a set interest rate (usually less than five percent). In purchasing these bonds, investors are essentially loaning money to the company in the expectation that they will receive a return on their capital over time, but once the investment has been made, their money is locked in and can’t be touched until the maturation date. This makes them popular with risk-averse, long-term investors, who tend to snap them up.

In 2015, bond issuances reached a record high as companies took advantage of low interest rates in the US to fund their expansion plans and investors sought alternatives cash savings. According to analysts , more than $290 billion of debt was raised for M&A purposes last year, almost triple the amount raised in 2014. However, this trend is very much tied to borrowing costs, and bond issuances will only represent good value for money if they can access cheap credit and if they have a clear acquisition goal in sight.

● Loans

Borrowing money can be an expensive affair when undertaking an M&A transaction. Lenders, or owners who have agreed to accept payments over an extended period of time, will demand a reasonable interest rate for the loans they have made. Even when the interest is relatively small, when you are dealing with a multi-million-dollar M&A transaction, the costs can really add up. Interest rates, therefore, are an important consideration in funding M&A transactions with debt, and low interest rates will spike the number of transactions funded with loans. In 2015, for instance, loans became very popular following central banks’ quantitative easing programs, which greatly reduced US interest rates. In the first two quarters of 2015, the amount of debt ($290 billion) used to fund mergers and acquisitions was triple the amount used in that period of 2014.

This year, however, loans are becoming harder to come by, as banks have been left with large quantities of debt as a result of previous deals and cannot afford to fund risky transactions in this year’s volatile climate. This has slowed down all M&A transactions, which have been valued in total at $229 billion, down 21 percent on last year, according to Dealogic, a UK-based financial software company.

However, given that 2015 was the best ever year for M&A transactions, it is not surprising that performance has slowed slightly in 2016.

Other loan options include re-mortgaging (which is only a viable option if the company has a large property portfolio), and bridge financing. A bridge loan is a very short-term loan which is intended to ‘bridge’ the gap between expected payments. For instance, a company may be expecting a slew of invoices dividends just after the M&A deadline. A bridge loan would cover the shortfall by lending the money to the company over a set period of weeks or months. In a way, this is the payday loan equivalent of the business world, and should be approached as a last resort. Interest rates are higher than average, and late payment penalties can be severe. Furthermore, use of a bridge loan in an M&A transaction may raise concerns with the other party, undermining the deal.

Conclusion

Where cash isn’t an option, there are plenty of alternative methods of financing mergers and acquisitions, many of which will result in a speedy and lucrative transaction. The best method will depend on the companies in question, their share situation, debt liabilities, and the total value of their assets. Each method comes with its own risks, hidden fees, and commitments.

But for most companies, the end result will make it all worthwhile, by creating a stronger, more diverse entity which will cover all the initial costs, and more.

Related topics:Advice for Dealmakers
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