When traditional M&A financing falls short: Exploring the alternatives

As the British economy continues to flounder, many businesses are faced with a limited number of growth options, with inflation, high interest rates and low consumer confidence meaning that companies may struggle to achieve their organic growth objectives.

Against this backdrop, one of the few reliable routes to growth is through M&A. However, businesses seeking to grow through acquisitions may, again, run into difficulties, with the UK’s economic uncertainty meaning that businesses may lack sufficient reserves of capital and also making M&A financing conditions tighter – with depleted financing options seen as one of the key barriers to dealmaking during 2023.

Given this state of affairs, some prospective buyers may need to look beyond the traditional routes of M&A financing (which is not to say that these are no longer viable options) and explore a wider array of financing sources.

While it may be tricky to secure funding in the current climate, there are no shortages of options available to those looking to finance deals, with a recent PwC report noting that “the amount of funding available for deals is larger and more diverse than ever.”

Here, we take a look at the types of acquisition financing that buyers can turn to and assess their viability and how best they might be used in the current dealmaking environment. While by no means an exhaustive list, this can serve as a resource for buyers considering their options as they seek to grow through acquisitions.

The main options:

Debt – One of the most common sources of funding for private M&A transactions is debt financing, in which companies raise funds for acquisitions by borrowing via debt instruments, including bank loans, bonds and other debt securities.

Debt financing is a vital component of leveraged buyouts, in which the buyer will borrow a considerable amount of the total acquisition consideration from a third party. Once the acquisition is completed, the buyer can use the acquired company’s assets or cash reserves to repay the debt. Leveraged buyouts are very common in acquisitions made by private equity firms.

However, despite the popularity of debt financing and its central place in the global M&A market, this is one of the forms of acquisition financing that has been most impacted by the current global economic uncertainty.

With interest rates and inflation soaring globally so far this year, debt financing providers have become more cautious about how they deploy their funds and the cost of borrowing to finance acquisitions has become higher.

Recent data from Refinitiv highlighted the increasing difficulty of securing finance for leveraged transactions as one of the key factors behind a decline in private equity acquisitions so far this year and, as a direct result of this, one of the main reasons behind an 11 per cent fall in global deal volume during the first half of 2023.

According to Osborne Clark, debt financing for M&A “collapsed” during the second half of 2022 as a result of the combined pressures created by the war in Ukraine, political instability both in the UK and worldwide, spiralling inflation and interest rates, weakening consumer demand, regulatory constraints and supply chain disruption, among other issues.

In the retail sector, debt financing has become harder to come by and – as a result – buyers are increasingly looking to use their own funds to finance acquisitions. According to a recent report from RPC: “Despite the overall resilience of the retail M&A landscape, the rise in interest rates has impacted how deals are financed. Successive rate rises have led some businesses to pay cash if they can afford to, rather than fund acquisitions through more expensive debt.”

Equity – Private companies can also attract outside investment for M&A transactions in the form of equity financing – which is a way for buyers to raise M&A funds by attracting investment from parties such as private equity firms, venture capital firms, angel investors, existing shareholders or other private investors.

Unlike debt financing, where the buyer must make regular interest and capital payments, equity financing means that investors take on an ownership stake, with the appreciation on this investment (generally when they sell their stake after a few years) serving as the eventual return on their outlay.

Equity financing also means that buyers can share the risks that could arise from a transaction with their investors – which could prove to be a valuable asset in the current climate, where there is potentially more risk inherent in M&A transactions. Of course, the flip side of this is that the rewards of a successful acquisition are also shared with investors.

Strategically, equity financing can also deliver considerable upsides for buyers. While parties providing debt financing are unlikely to take on much of a role in an overall M&A strategy, equity financing means that investors have a greater stake in the success of an acquisition and are more likely to invest resources such as expertise, contacts and general strategic guidance to buyers – something that could prove an incredibly valuable asset to buyers.

The takeaway here is to look for equity financing that can also bring something else to the table apart from capital

Of course, there are other considerations for buyers thinking about equity financing, most notably that their own ownership will be diluted, potentially meaning they no longer have the level of control over decision making that they previously enjoyed, as well as seeing their share of returns from the business diminished (although the hope will be that overall returns are far greater following the equity investment).

While buyers will generally benefit from the added capital and expertise that equity funding can provide, there may still be an adjustment period as the existing owners or directors acclimatise to the involvement of a third party in the business’ decision making.

Owners will also need to be prepared for investors to ultimately seek to realise a return on their investment. For example, if a business secures equity investment from a private equity firm, then the investor will typically seek to exit their investment within 3-5 years. This could lead to a sale of the business to another new owner or even an IPO that takes the business public.

With debt financing severely limited in the present economy, equity financing arguably represents the most readily available source of financing for businesses seeking M&A funding. With private equity continuing to sit on record levels of funds since the COVID-19 pandemic, PE firms in particular have been seen as being the likeliest route for businesses to attract financing.

This was reflected in CMS’s 2023 M&A outlook released in late 2022, in which 87 per cent of respondents said that financing conditions would become more difficult and 40 per cent said that private equity would be the most readily available source of M&A financing in 2023.

This was further borne out by RSM UK’s Real Economy Report, released earlier this year, which revealed that 47 per cent of mid-market businesses polled said that they would seek private equity funding during 2023, up from 36 per cent last year.

RSM M&A partner John Bryant said: “There is currently a significant amount of capital available for private equity investors to deploy, so looking further into 2023 we expect private equity to continue to be highly active in transactions.”

"Therefore, it remains an attractive option for many companies seeking capital to grow, enter new markets and make acquisitions, and seeking strategic partners who can help navigate the current climate."

Remember that PE firms are unlikely to be interested in forms with less than £10 million in annual revenues, unless there is a very strong strategic motive.

While private equity M&A activity remains above pre-pandemic levels, economic and political instability have seemingly taken a toll on investment appetite, with KPMG reporting in its mid-year private equity snapshot that PE activity during H1 2023 was down 24.2 per cent year-on-year, with 689 deals compared to 909 during the first half of 2022.

Despite this relatively sharp drop, the numbers for H1 2023 remain well above pre-pandemic figures, showing that private equity funding remains a major source of M&A. As KPMG note in their report: “Demand is still there, but the pre-conditions for successful M&A are not, due to continued uncertainties like high inflation, rising interest rates, and debt costs.”

Cash reserves – Of course, some buyers may not need to target outside investment in order to finance acquisitions and may instead be able to draw on their own resources and fund acquisitions from their own cash reserves or retained earnings.

While it may seem far-fetched to expect companies to be able to finance acquisitions from their existing cash reserves during such a prolonged period of economic uncertainty, during which many firms have experienced a decline in trading, there are actually numerous reasons why existing cash reserves could prove to be a key source of financing in the current climate.

For one, other financing options are currently less readily available. Debt financing has been severely constrained amid soaring inflation and interest rates and, while equity financing is still a viable option, it too has been impacted by the economic picture and competition for funds will be fierce.

For companies with strong cash reserves, therefore, it might be advisable for them to utilise these to make acquisitions, rather than spend time and resources attempting to attract outside investment and potentially failing.

Businesses could undertake strategic plans to raise further capital for acquisitions, such as through growing their customer base, upselling or cross-selling to existing customers, streamlining certain processes or offsetting assets or parts of the business that are non-core to their operations.

Remember to factor in any cash reserves sitting in the target’s bank accounts. This is missed as often as it is used as a slice of the ‘funding pie’. Ensure that enough reserve is kept to deal with day-to-day cash flow and post-acquisition contingencies.

Another factor that could make acquisitions funded through cash reserves a more viable option in the current M&A landscape is the growing popularity of alternative deal structures such as earnouts. With valuations falling, but seller expectations remaining high, earnouts are increasingly being used to help bridge valuation gaps and facilitate deals. If buyers are able to negotiate deals with lower upfront considerations, then they may be able to use existing reserves to finance the initial cost.

Finally, the fall in valuations, as well as high insolvency levels, means that there is scope for opportunistic buyers to make acquisitions or distressed takeovers with limited cash reserves.

Seller financing - Deals funded through seller financing will typically involve the buyer putting down a certain proportion of the agreed-upon valuation as an initial consideration (thus making it a potential solution for buyers with some cash reserves), with the remainder being funded by the outgoing owner and repaid by the buyer over a pre-agreed period. This is similar to an earnout deal structure, but the repayments are not contingent upon performance.

The payment for the business is spread out over time, based on its performance. If the business hits certain revenue or profit targets, then the seller gets additional payments. This method aligns the seller with the company's continued success post-acquisition and reduces the upfront purchase price

For that reason, seller financing would typically be a more viable option for a seller eager to make an exit. As a result, it could have a significant role to play as a financing option over the coming months, with valuation and expectation gaps meaning that sellers are struggling to attract the kind of prices they’d expect for their businesses.

If a sale process is stalling due to a lack of buyers willing to meet a seller’s valuation, then deals could be facilitated or expedited by adopting a deal structure that limits the up-front cost for buyers while enabling sellers to secure a final price that comes closer to meeting their own valuation.

This trend has been demonstrated by the increasing popularity of earnouts and Employee Ownership Trusts (EOTs) and seller financing could offer similar benefits. Another potential stipend for owners is that they could make an exit now and potentially attain an even higher valuation by tying the repayment/remainder of the consideration into the business’ future profits. This could prove lucrative should the business’ performance improve considerably as and when the economy returns to growth.

The alternatives:

Joint ventures, equity partnerships and investment syndicates - In some instances, it may be possible for businesses to pool their cash reserves with other buyers in the same sector and pursue acquisitions through a joint venture or equity partnership. As well as enabling two buyers to combine their finances, such collective investment arrangements can also allow the businesses to benefit from each other’s expertise and resources and dedicate more time and staff to identifying and pursuing acquisition opportunities.

In addition to greater resources and improved efficiency in finding and executing acquisitions, a joint venture or syndicate of this kind also means that risks can be mitigated. For example, if there are post-integration challenges then the combined businesses may be better equipped to resolve these, while other financial or market-related uncertainties can be spread between the buyers, rather than simply landing on one acquirer.

An M&A strategy built around a joint venture or syndicate can often improve a buyer’s chances of attracting funding. With combined expertise and resources, the buyers may be able to present a more strategic and financially compelling case to possible investors, increasing the likelihood that they could secure financing from a bank, private equity or venture capital lender.

Another kind of partnership can be considered if outright acquisition isn’t feasible - forming a joint venture with the target. There is no set formula to achieve this, but often it can lead to the company being acquired down the track, and in the meantime achieve some level of control or influence over the company’s operations.

If the terms of an eventual acquisition are agreed at the outset, then this is termed an Option to Buy. Having influence over the company’s operations can lead to a situation where the target company’s cashflow can contribute to acquisition funding.

Deferred compensation - This is where part of the acquisition deal can involve keeping key management in place and deferring their compensation tied to future company performance, allowing the company to utilise the additional cashflow to borrow a higher amount.

Bootstrapped buyouts - Leveraging various aspects of the target company's financials to fund the acquisition. For example, using the company's accounts receivables as collateral to secure a loan for the buyout, otherwise known as invoice factoring. Or putting the firm’s assets up as collateral (asset-based financing).

Revenue-based financing - Early stage companies and those without assets for collateral will find it very difficult to obtain bank financing. In particular, E-commerce companies, with their unique characteristics, don't exhibit the profile of a perfect candidate loved by bank lenders.

An alternative financing solution has emerged called revenue-based financing, tailored for companies seeking capital to fuel their growth. It's not a loan per se - it's a financing solution where the capital plus a flat fee is paid as a portion of the company's monthly revenue.

There is no interest payable, the platforms don't take equity and payments are directly proportional to the company's monthly revenue. The providers generally pitch their offerings to online businesses, partly because it’s easy to link into their Amazon or Recurly accounts to see the live cash inflows, but we are aware of at least a couple of operators about to extend into other sectors.

Peer-to-peer lending - Economic uncertainty has made many traditional lenders more stringent in how they deploy acquisition financing and also meant that many are more reluctant – or won’t even consider – lending to smaller or medium-sized firms.

This has led to the growing popularity of peer-to-peer lending as a method for funding M&A deals and other transactions, such as management buyouts, in which the buyer may not be a well-capitalised firm with a strong track record of successful acquisitions.

Providing a buyer has a strong growth plan, peer-to-peer lenders may be willing to invest in their M&A strategy. This is often facilitated through peer-to-peer lending platforms, which enable would-be buyers to create a proposal outlining their M&A plans which can then be reviewed by potential lenders, who may then agree to provide loans to finance the company’s acquisitions.

As with other acquisition financing methods, peer-to-peer lending will see the acquiring company repay the loan(s) following the completion of their deal over the course of an agreed-upon period, with repayments including both the principal and a set interest rate.

However, unlike traditional acquisition financing peer-to-peer loans will typically be less stringent in reviewing potential applicants and can often offer more flexible payment terms, as well as offering buyers a more diverse range of funding sources.

This can make them a more viable source of funding for smaller, less experienced buyers, provide a broader pool of options and offer financing quicker then it could be secured by applying for a bank loan or attracting private equity investment.

Discussing the rise of peer-to-peer lending since the COVID-19 pandemic, HNW Lending Chief Executive Ben Shaw said his firm were “quicker and more nimble than banks.” He added: “We don’t say ‘no’ just because someone has a county court judgement or other chequered credit history in their past. We try to look past this to whether the funding requirement stacks up on its own merits and whether there are assets available that can support repayment of the loan if the borrower was to default.”

However, as peer-to-peer lending is less stringent than traditional financing, buyers should be rigorous in ensuring regulatory compliance and that lenders are credible and reliable, as well as being wary that – due to the greater risk on the lender’s side, interest terms may be significantly less favourable than other forms of M&A financing.

Mezzanine Debt - This is a hybrid of debt and equity. A lender will provide the needed funds for the acquisition in exchange for interest payments and the option to convert the debt into equity if it's not repaid by a certain date.

Supplier or Vendor Financing - Convincing suppliers or vendors to provide extended terms or even upfront capital in return for long-term purchase agreements or favourable terms post-acquisition.

Crowdfunding - Finally, a more obscure option, but one that could prove to be useful for buyers looking to supplement an additional source of financing, is crowdfunding for acquisitions. Crowdfunding has often been used to help finance new startups or business projects, but is relatively untested as a means of acquisition financing.

Crowdfunding platforms specialising in connecting entrepreneurs and business owners with investors are common and it is feasible that this could be used to help businesses raise the financing they need to kickstart an acquisition process, particularly if this was utilised in conjunction with another form of financing, such as peer-to-peer lending or to add to existing cash reserves.

Again, this may offer buyers more flexibility and a far wider pool of lenders than traditional financing methods. However, they will also need to ensure regulatory compliance and, should the fundraising be successful, have a clear strategy with regards to ownership structure and remuneration for investors.


Financing conditions may be considerably tougher for buyers at the moment, particularly inexperienced buyers or smaller businesses, but there is also a far wider range of funding options available to acquisitive businesses than they may previously have been able to access.

With sellers potentially more open to exploring alternative deal structures in such an uncertain economic environment, and with the rise of options such as peer-to-peer lending, would-be buyers with strong M&A proposals should be able to generate the finances they need to execute acquisitions.

Share this article

Latest Businesses for Sale

---

---

---

View more businesses for sale