M&A deal success can often hinge on the choice of funding strategy

There are obvious pros and cons with the various sources of finance to fund mergers and acquisitions (M&As) but the decision will often come down to what sources are available and appropriate to each individual scenario, says Donal Cantillon, managing director of Focus Capital.

“The aim in any funding mechanism is to achieve the optimal funding structure which aligns with the goals and nature of the transaction,” says Cantillon. “Therefore, it is vital to engineer the appropriate acquisition financing structure to fit the circumstances that each individual transaction will present.”

The financing structure must also be flexible enough to adapt to fit different scenarios; the strength of the business’s cash-flow-generating capacity, the strength of its asset base and the proposed cost of capital etc, will dictate what the optimum funding structure will ultimately look like. And even though debt is inexpensive relative to equity, Cantillon points out that the capital and interest payments required to service it can inhibit the flexibility of an organisation.

“Higher debt quantums are more appropriate for companies that are mature, with steady cash-flow generation, and that do not require large amounts of capital expenditure,” he says.

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Businesses that operate in more unpredictable sectors, that want to grow fast and also need higher amounts of capital to grow are most likely to need equity financing, in his estimation.

According to Brian Fennelly, partner in Deloitte’s Debt and Capital Advisory team, the choice of funding strategy, be it the use of internal cash reserves, the raising of new debt financing or equity investment, can depend on a wide range of financial and non-financial factors.

When determining the optimal funding strategy, the size of a proposed M&A transaction, the financial strength of the acquirer and a weighing up of the costs of the various sources of capital – for example, interest rates on a loan versus dilution of ownership through equity investment – are key factors to be considered by a prospective acquirer, he says. Yet other factors can come into play that can strongly influence this decision.

“Very often the strategic importance of a transaction and tight deal time frames, particularly in competitive auction processes, can also influence an acquirer’s financing decision making when it comes to engaging in M&A activity,” Fennelly warns.

Ultimately, he says, an acquirer seeks to use a financing structure that is the most cost-effective and achieves the balance between maximising deal flexibility and minimising financial risks to the acquirer.

“The lowest-cost financing source is not always the most appropriate funding option and very often the optimal financing structure for an acquirer can be a mix of a few different sources/types of capital.”

Fennelly also notes it is important to ensure that the level of borrowing taken on to support an acquisition does not strain the acquiring company’s financial position or jeopardise its ability to meet existing obligations.

“In an M&A context the risk appetite of the acquirer will also have a bearing on what level of financing an investor deems appropriate,” he says. “Some acquirers may be more conservative and prefer to minimise borrowing in order to maintain a lower level of risk, while others may be more aggressive and willing to take on higher levels of debt to finance strategic acquisitions.”

For many businesses engaging in M&A, raising new equity investment can be appropriate, says Fennelly. He points out that it is important to remember that a new equity investor can bring more value to a business than the cash investment alone.

“In addition to bringing investment, institutional private equity investors, for example, can bring a wealth of strategic, financial and operational expertise and insights, which can help further drive business growth and enhance shareholder value,” he adds.

Irish SME business owners are still somewhat sceptical of private equity (PE), however. Yet Cantillon says those who embrace PE investment can fast-track their growth story, which may also allow for business owners to personally de-risk, diversify and build their own personal balance sheet as part of any potential PE investment.

“Sometimes PE is seen as a necessary evil in unlocking that growth potential in businesses where own resources are not available, debt is not appropriate or where shareholders wish to grow without the inherent risk of a highly leveraged capital structure,” he says.

Importantly, he adds, PE investment also signals ambition and intent in the market, will help attract and retain talent, improve access to capital and also enhance M&A deal capability.