Funds use range of techniques to fill funding gaps and navigate M&A valuation mismatches

Issue

Uncertainty caused by the Ukraine war, stubborn inflation, high interest rates, volatile listed equity markets and supply chain concerns are making assets hard to value. 

At the same time, these headwinds have meant that the bank syndicated loan and high yield markets have had little appetite for underwriting new debt at acceptable pricing. Funding has been available, in particular from private credit funds that have been stepping in to bridge the funding gap via a range of financing solutions, but this is not the only liquidity-raising option sponsors have been exploring.

Solutions

Alongside simply committing more equity or pursuing bilateral deals, there are a range of creative options to fill the funding void and address mismatches in asset valuations.

• Vendor loans, whereby the seller agrees to defer a portion of the purchase price, lending to the sponsor on terms better than those offered by other finance providers. The terms of these loans are often heavily negotiated, including around consent rights, acceleration events, information rights and in some cases second-ranking security. We typically see them as sitting somewhere between a shareholder loan and a third party financing, with a bespoke negotiation influenced by the commercial dynamics and any equity rollover of the seller.
• Buyers committing a higher than usual equity funding amount (even fully equity underwriting deals) and then leveraging the asset post completion. This is sometimes achieved by leveraging a portfolio of assets post-completion using a NAV (net asset value) facility, allowing funds to be returned to LPs, reducing the equity funding component and thereby boosting IRR. 

Aggressive bolt-on strategies and JVs with corporates grow in popularity

• Sponsors pursuing aggressive bolt-on strategies to leverage potential synergies, exploring opportunities driven by industry or market dynamics (e.g. pharma divestments as a result of patent cliffs, acquisitions in the ESG space, disruptive digital businesses), and even exploring JVs with corporates keen to spin off brands in search of higher equity returns. Bolt-ons often give rise to greater regulatory issues than a standalone buyout given the existing operations of the portfolio company (a topic we explore in more detail here ). An early analysis of likely antitrust concerns and possible remedies is important when modelling potential revenue and cost synergies.
• The use of creative investment structures and financing instruments to manage risk, bridge financing gaps and improve asset performance. These include preferred and hybrid equity, holdco PIK financings and convertible instruments. We have seen a significant rise in the use of preferred and hybrid equity instruments as companies seek equity financing to provide a capped (preferential) return while mitigating the impact on their balance sheet and credit rating. Market practice is relatively nascent for preferred equity in particular, resulting in these investments being highly structure- and transaction-specific. A variety of strategies can be employed to emulate the fixed-term nature of debt investments while preserving the characteristics of equity.
• An increasing interest in co-investments, partial sales (both primary and secondary) and deals where the seller gets the option to re-invest post-disposal. Minority sales allow sponsors to both raise new equity (especially for acquisitive portfolio companies) and de-risk an existing position. Minimum return protections are common if the sell down occurs part-way through an investment. Conversely, minority rollovers allow sponsors to continue their exposure to well-performing assets, although moving to a minority position means that exit rights become critical, particularly for closed-ended funds.