The following is a guest post from Katie Smalley, a member at Bass, Berry & Sims PLC. Opinions are the author’s own.
When evaluating a potential acquisition, it is essential to consider how the target and the acquisition structure will integrate into your company’s existing debt facilities.
In addition to analyzing how the target will fit within your business operations, understanding the key components of your existing debt agreements that pertain to acquisitions can help identify potential obstacles early in the negotiation process and facilitate a smooth closing.
Four primary components within most debt facilities are typically implicated in acquisitions:
- Acquisition restrictions and requirements
- Debt incurrence restrictions
- Pro forma target financial incorporation
- Additional collateral pledge and joinders
Below is a general overview of each component and how CFOs can collaborate with legal counsel to anticipate pressure points during a potential acquisition.
Acquisition restrictions and requirements
Debt facilities vary widely in how they address acquisitions. While some provide broad rights for borrowers to pursue and complete various acquisitions, others may require lender consent for even minor transactions. Accordingly, understanding how your facility handles acquisitions is critical to identifying potential issues early.
In conjunction with legal counsel, CFOs can help identify acquisition-related requirements — often embedded within “investments” covenants — and develop a complete picture of how a proposed transaction can be executed within the bounds of an existing financing. Some facilities impose individual or aggregate caps on acquisition consideration, whether over the life of the facility or on an annual basis. Monitoring the utilization of these “baskets” is essential over time.
Even in more borrower-friendly agreements, facilities often require notice of material acquisitions and certifications of pro forma compliance. Being mindful of the timing and content of such notices is critical, especially since deals often gain momentum quickly.
Debt incurrence restrictions
If an acquisition involves any form of deferred consideration (e.g., seller notes, earnouts or purchase price holdbacks), it’s crucial to understand how those obligations fit into your existing financing. Most loan agreements treat these payment obligations as “indebtedness” and are therefore restricted under debt financing agreements.
Identifying this “hidden” indebtedness early allows for a clear understanding of lender expectations. Even where permitted, such indebtedness is often capped and must be subordinated to the senior facility. Knowing these limitations helps manage seller expectations during negotiations.
If the senior facility includes leverage ratio tests, it’s also important to evaluate how deferred consideration will affect these covenants. Although earnouts generally do not count toward leverage until vested and payable, negotiating appropriate earnout structures at the outset will be critical to preserving covenant headroom down the line.
Pro forma target financial incorporation
For facilities with financial covenants — such as leverage or fixed charge coverage ratios — understanding how the target’s financials will be incorporated into future covenant testing is vital. Even in facilities without financial maintenance covenants, leverage calculations can impact pricing as well as flexibility for incurrence-based events that turn on leverage metrics.
Most negotiated facilities allow for the “pro forma” inclusion of a target’s assets and EBITDA (including historical results) for testing purposes. However, integrating target financials can be challenging, particularly if the target does not follow GAAP. Obtaining a quality of earnings report during due diligence can support more accurate financial modeling and pro forma adjustments.
Also consider what EBITDA addbacks your credit agreement allows in connection with acquisitions — such as cost savings, synergies and transaction expenses — to more accurately project the combined entity’s financial performance. Utilizing appropriate EBITDA addbacks associated with an acquisition will present the most favorable financial metrics under your senior debt facilities.
Additional collateral pledge and joinders
After closing, it’s easy to overlook post-closing requirements like joining new entities as credit parties and pledging newly acquired assets. Understanding these obligations ahead of time can help avoid technical defaults for missing deadlines.
Most facilities require any wholly owned subsidiaries — whether acquired or newly formed — to become credit parties. This applies in both equity acquisitions and asset deals where a new acquisition vehicle is formed. If the credit agreement does not include standard joinder forms, legal counsel can coordinate with the lender’s counsel to prepare the necessary documentation.
Even if a new entity is not contemplated in a particular acquisition, it is customary for financing documents to include an obligation to provide documentation and possessory collateral for newly acquired assets to protect the senior lender’s security interest.
Carefully review any financing documents (security agreements in particular) for any requirements to provide (1) information regarding and pledges of newly acquired IP; (2) landlord waivers for additional leased locations; and (3) control agreements for new deposit accounts, which are some of the most common types of deliverables that arise in acquisitions.
Carefully considering how a potential acquisition will fit within your company’s existing debt facilities early in the acquisition process will allow you to proactively identify and address potential issues. Engaging legal counsel and maintaining open communication with your lenders can streamline the negotiation process and help facilitate a successful close.
