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Leveraged Finance
What is leverage finance?
There is a lot involved in acquiring a company. An important part of this is acquisition finance, also known as leveraged finance.
Leveraged Finance literally means leveraged financing whereby usually the financing is provided on the basis of the cash flows present in the company and to a lesser extent on the basis of the assets present in the company. The reason why parties use leveraged finance is, on the one hand, to enable an acquisition – after all, the Seller wants to receive as much cash as possible upon transfer – and, on the other hand, the leverage created optimises the Buyer’s desired return. In addition, such financing can help with a lower contribution in case of an acquisition. How this leverage works, we explain below:
Suppose the shares of a company are bought for €4.0 million. It is acquired by raising debt of €3.0 million. This means that, after transaction, the shares are worth only €1.0 million. For convenience, we assume that the buyer has put in his contribution of €1.0 million as share capital. By paying off the €3.0 million debt over the next few years, the value of the share capital increases by €3.0 million and thus creates value.
These are important reasons why many acquisitions are not made entirely from their own resources. ‘Financing’ the company to be acquired can therefore be done in various ways. In most cases, the ultimate goal is to minimise your own contribution (aka equity) by raising financing. The aim of this is to use borrowed capital to achieve a higher return than the annual interest rate, i.e. leverage. We are specialists in attracting the optimal structure for a company and are happy to explain the possibilities in more detail.
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Table of contents
Leveraged finance
1. Various options in leveraged finance
Besides these three major banks, there are also several other lenders offering (acquisition) financing. These parties generally only provide financing if one of the major banks also provides financing and will subordinate themselves to the major bank. This type of financing is commonly referred to as mezzanine financing. Parties providing this mezzanine financing are mostly private equity providers or smaller banks, such as AEGON, Dutch Mezzanine Fund, Riverbank and FundIQ.
If the desire is to repay less or to finance redeemable because of a buy-and-build strategy, one solution may be to seek financing from mezzanine only or from a debt fund. Depending on the size, such a party may provide redemption-free financing. In recent years, many different parties have entered the market, all with different solutions in this area. The disadvantage is that they tend to be expensive, but they offer a lot of flexibility and are willing to provide higher financing than a major bank would.
Not part of leveraged finance, but still a financing tool concerns the seller’s loan. This loan is subordinated to the major bank and any mezzanine financing and helps to make the transaction possible. In the seller loan, the selling party provides a loan to the buying party. This is usually a subordinated loan on both the funding from the major bank and any mezzanine provider. A seller’s loan can also be seen as a ‘deferred payment’.
Leveraged finance
2. Sample calculation 1: Reducing own contribution
If all the components; funding major bank with mezzanine financing and a vendor loan (loan with seller) make up the purchase price, your final contribution for the acquisition will be limited as much as possible. And there will be great leverage.
As an example, we take a company to be acquired with a value of €4.0 million. Here we assume a combined loan from a major bank and a mezzanine provider. In addition, the seller provides a vendor loan of €1.0 million. The financing amounts to €2.0 million.
This means that instead of €4.0 million, your own contribution is only €1.0 million. Your contribution in this example is 4x lower compared to the purchase price. By paying off the loans from future cash flows, returns are made. As explained earlier, the €1.0 million contributed is worth €4.0 million after debt repayment.
Leveraged finance
3. Sample calculation 2: Increase returns
In this example, we show the principle of leverage (apart from returns made based on debt repaid). Here, we again use the example above and assume that the company worth €4.0 million makes a profit of €1 million a year. We assume in this fictitious example that the profit remains the same in the coming years.
- You pay the full purchase price of €4.0 million from your own funds. In this way, you earn an annual €1.0 million return on equity. This represents a 25% return on your equity.
- You finance this acquisition with €3.0 million and contribute €1.0 million from equity. Assume you pay an average of 5% interest on this €3.0 million financing, you will pay €150,000 in interest annually. You additionally earn a return from the business of €1.0 million and thus keep €850,000 per year. Your return in this fictional case is €850,000 per year based on €1.0 million equity. Your return is therefore 85% on your equity.
Leveraged finance
4. Advantages & disadvantages of leveraged finance
Advantage: The biggest advantage of using an acquisition financing is that you, as an entrepreneur, can reduce your own contribution as much as possible and thus significantly increase your return on equity. In addition, you keep part of your capital available for other investments.
Disadvantage: A disadvantage of leveraged finance is that you will obviously have to repay the financing in the future, which also puts you at risk. The greater the debt, the greater the leverage, the higher your risk when the results of the company to be taken over are disappointing. Of course, both the provider of the financing and the Match Plan specialists always check carefully whether the company to be taken over can bear the financing costs in the future.
Leveraged finance
5. Step-by-step plan - Leveraged finance
Structuring and raising the optimal financing structure requires good knowledge and experience, the right network and the ability to adequately manage the entire process. Our director debt advisory Leon Koorevaar has extensive experience in leveraged finance and thus optimising debt packages from his banking past. See below the different steps:
1. In-depth discussions with you about your company on the one hand as Target on the other hand for the analysis of the (group of) companies;
2. Drawing up a financing memorandum based on information received from you about both your company and Target. The financing memorandum is drawn up to present the intended acquisition to potential financiers in a well-organised manner;
3. Selecting (potential) financiers;
4. Approaching funders.
5. Establishing confidentiality with (potential) funders;
6. Sharing the financing memorandum with the (potential) financiers;
7. Holding (joint) discussions with the (potential) financiers;
8. Further exchange of information and one or more in-depth discussions with (potential) financiers;
9. Receiving, assessing and discussing the indicative financing proposals from the various financiers;
10. Advising on choice of financier(s);
11. Conducting negotiations with the selected financier(s) if they have issued an indicative financing proposal;
12. Drafting and coordinating the suspensive conditions of the financing;
13. Negotiating the (bank) documentation;
14. Closing, including signing the documentation and monitoring funds received;
15. Preparation of a monitoring tool for the purpose of providing an update to the funder.
Leveraged finance
6. Different applications of leveraged finance
In recent years, Match Plan has built a large network within both major banks, alternative financiers, private investors and private equity funds. Through high-quality knowledge of the applicable financing frameworks, Match Plan knows how to realise sophisticated structures.
We can assist with the following debt advisory issues:
- Acquisitions
- Growth
- Buy-and-build strategies
- Refinancing
- Financial Restructuring
- Club deals and/or LMA documentation
- Recapitalisation and/or superdividend
Leveraged finance
The role of leveraged finance for Private Equity
Many investment companies (Private Equity) create returns by raising finance. After all, an investment company can reduce its own capital contribution with every euro financed by an external party. In addition, this financing creates a higher return on the capital contributed. This is because the financing is repaid based on the company’s future profits. Assuming an equal value of the company, the equity value will have increased by the debt repaid.
A simple calculation example to illustrate: A company is acquired for a purchase price of €10 Million. This is paid for by a capital contribution from the investment company of €3 Million on the one hand and by bank financing of €7 Million on the other. This pays the purchase price of €10 Million. After 5 years, the investment company decides to sell the company again for the same purchase price of €10 million. At that point, the bank financing is fully repaid, and the investment company will receive €10 million for the company whereas it bought it 5 years earlier for €3 million. This has enabled the investment company to realise an annual return of around 27% without taking into account any growth in the business.
Leveraged finance
7. Added value - Optimal financing structure
Match Plan’s specialists start by looking at the most appropriate financing structure for the organisation to be acquired on your behalf as an entrepreneur. Here, we look not only at the classification of the financing per financing provider, but also at the possibility of combining different financiers and financing forms.
A major bank often offers various forms of financing, such as linear repayment financing and/or redemption-free financing. In addition, ‘Mezzanine’ providers often offer tailor-made solutions based on the specific acquisition. Match Plan’s specialists know the financing landscape very well and have extensive contact with both the major banks and the various ‘Mezzanine’ providers.
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