Most people buying a lower middle market business put in some equity and borrow the rest. The equity gets the early attention because it decides who owns what after closing. The debt often gets less thought until the letter of intent is signed, and from then on it tends to set the pace of the deal. What follows is written for owner-operators buying a competitor, search fund buyers and independent sponsors, and covers how acquisition financing usually works at this size and where it tends to slip.
The main types of acquisition debt
Senior term loans from banks
A bank term loan secured on the assets of the business is the traditional starting point. Banks are usually the cheapest source of acquisition debt. In return they tend to want principal repaid from early on, tighter covenants and a business with a long record of steady cash flow. Many will also want the company's operating accounts, and on smaller deals some ask the buyer for a personal guarantee. The term loan often comes with a revolving credit facility to cover working capital swings after closing.
Unitranche loans from private credit
A unitranche loan rolls what would otherwise be a senior loan and a junior loan into one facility, with one set of documents and one interest rate. Private credit funds are the main providers. Buyers like it for its simplicity, and in many cases a unitranche lender will lend more against the same earnings than a bank, with less required amortization before maturity. That comes at a price. Unitranche pricing sits above bank pricing, and early repayment usually carries a fee in the first years.
Many unitranche lenders hold the whole loan themselves or share it with a small group. That can make life easier later when you want an amendment or need to add debt for a follow-on acquisition, because there are fewer parties to persuade. Some are split behind the scenes into first-out and last-out pieces held by different lenders. The borrower still sees one loan, though the split shapes who makes decisions if the business hits trouble.
Asset-based lending alongside
Where the target has meaningful receivables, inventory or equipment, an asset-based loan (ABL) can carry part of the acquisition debt. An ABL lender advances against a borrowing base, a percentage of eligible collateral that is recalculated as the collateral changes. You will often see an ABL revolver from one lender sitting next to a cash flow term loan from another, with an intercreditor agreement setting out which lender has first claim on which assets. Distributors and manufacturers are the usual fit. A software business with few hard assets will get little out of one.
How lenders size acquisition debt
Cash flow lenders start from EBITDA, though rarely the figure in the seller's marketing materials. They build their own adjusted number and then run it through a handful of tests.
- Leverage. Total debt as a multiple of EBITDA. The multiple a lender will accept depends on the lender and the sector, as well as on the size of the business and how predictable its earnings are. Bigger companies with recurring revenue support more. A small company with two customers making up half its sales supports less.
- Fixed charge coverage. Whether cash flow after capital spending and taxes covers interest, scheduled principal and other fixed payments with room to spare. For capital-heavy businesses this is often the test that limits the loan.
- Interest coverage. A simpler check of operating earnings against interest, watched closely when base rates are high.
- Equity in the deal. Lenders want to see the buyer's own money at risk. A thin equity cushion makes most of them cautious whatever the ratios say.
The largest loan on offer is not always the best one. A smaller facility with cheaper pricing, looser covenants and lighter amortization can leave the business with more room to operate in its first two years, which is when acquisitions tend to turn up their surprises.
What lenders want to see before they commit
A credit committee is being asked to lend to a business that is about to change hands. Most of its questions come down to whether the earnings will hold up under a new owner. The answers usually come from:
- A quality of earnings report from an independent accounting firm, testing the seller's adjustments, revenue recognition and working capital.
- A financial model showing the business after the acquisition, with the proposed debt, a downside case and covenant headroom in each year.
- An integration or transition plan covering the first year: who runs the business, which systems change, which customer and supplier relationships need to be handed over.
- Background on management, meaning the buyer's own experience and which of the seller's people are staying.
- Legal, tax and commercial diligence findings as they come in.
The quality of earnings work carries the most weight, because everything else is sized off it. Take a hypothetical seller who presents $5 million of adjusted EBITDA, including $1 million of add-backs. If the accountants accept only half of those add-backs, the lender is now sizing against $4.5 million. Whatever multiple it was prepared to lend at, it now applies to a smaller number, and the buyer has to cover the shortfall with more equity, more seller financing or a lower price. Ordering it early saves a lot of awkward resets.
Timing acquisition financing against the purchase agreement
The safest order is to speak with lenders before or right after signing the letter of intent, so you know roughly what debt the business supports while the price can still move. Ideally you want a commitment letter, or at least a term sheet with credit approval behind it, before you sign the purchase agreement.
Sellers often resist a financing condition in the purchase agreement, and a buyer who signs without one is taking the risk that the debt falls short. Lender diligence runs alongside the buyer's own and adds weeks, sometimes more, so the closing date in the purchase agreement should allow for it. Any seller financing and the buyer's own equity are negotiated separately by the buyer and its other advisors, but the lender will want to approve how they sit relative to its loan, and it will usually insist that any seller note is subordinated.
Why deals get re-traded on financing
A re-trade is when the buyer goes back to the seller after signing the letter of intent to ask for a lower price or different terms. On the debt side, the usual causes are fairly predictable:
- The quality of earnings comes in below the number the price was based on.
- Trading softens between the letter of intent and closing, and the lender's latest figures look worse than the ones it approved.
- Diligence turns up customer concentration, a lost contract or a working capital need nobody had priced in.
- A lender's credit committee declines late, or approves on tighter terms than the term sheet suggested.
- The process runs long, exclusivity expires and both sides start to lose patience.
Most of these can be anticipated. Getting the earnings work done early and sounding out more than one type of lender will bring the problems to the surface while there is still time to adjust the structure quietly, before anyone's position has hardened.
Running the lender process
Kenward Partners helps buyers arrange the debt for acquisitions, working with banks, private credit funds and specialty lenders in the U.S., UK, Europe, Canada and Australia. That usually means preparing the lender materials, approaching the lenders who fit the deal, comparing terms on a like-for-like basis and keeping the financing in step with the purchase agreement through to closing. If you are looking at an acquisition and want a view on how the debt might come together, we are happy to talk it through.
