M&A Insights

Debt, Equity or Both: Financing Add-on Acquisitions

Debt, Equity or Both: Financing Add-on Acquisitions

In the roll up example below, the acquirer would be seeking $11.2mm of capital to finance two acquisitions, which grows EBITDA from $2mm to $5.25mm. Based on the below scenario, we explore different financing options, to enable the most value creation.

  • Debt (Mezzanine) – also known as 2nd lien, sub-debt, uni-tranche, mezz, is the debt that is raised when you can’t raise cheaper senior debt, which is usually limited with asset-light cash flow-based businesses. The cost, or the interest rate of 12% seems steep, yet when equity value is likely to grow quite dramatically over time, the 12% becomes a drop in the bucket compared to equity dilution. The other benefit is debt is a lot more systematic, as the lenders are seeking their principal and interest to realize their return profile, so as long as they’re comfortable with the cash flow coverage, such as a modest Debt/EBITDA ratio, they will be comfortable to lend (usually lenders want to be <3x this ratio). Further, while the cash pay interest is pricey, mezz lenders usually defer principal payments to support cash flow of high growth companies. Its quite common to see an interest-only loan, with a bullet amortization payment as the end of a 5 year term.
  • Growth Equity – or equity financing is a different animal as you’re bringing on a partner to support the execution of the growth plans. This investor joins the board (or creates one if one doesn’t exist), and is active from a strategic perspective, relating to finance, accounting, M&A, and in some cases supporting operational improvements. This is the costliest capital by far, as firms are seeking to generate 3x their money in 3-5 years. While on the surface this appears much less appealing than debt, equity firms do offer positive attributes and are more suitable to certain profiles of companies. This includes breakeven or money-losing companies who may be in hyper-growth mode, as growth equity does not have cash-pay interest. Also, a growth equity partner can institutionalize the company, with proper governance, controls, reporting, a board of directors, financial audits, guidance and support on acquisitions, and ultimately helping maximize value in an exit, 3-5 years later. Lenders offer some of this but much less. Also, given how much capital is in the market today, and for those growing fast while being very profitable, growth equity firms can offer shareholder liquidity as part of the investment, in addition to the growth capital.
  • Hybrid – in a scenario where the amount of capital required is above and beyond what a debt provider can provide, the company can explore raising both, debt and equity. This is a common dynamic in today’s financing environment, and a strong preference for many mezz lenders, as it gives them significant comfort knowing there’s a private equity partner for the company and borrower, so if things go sideways, the equity firm can bail the company out. There are however a subset of mezz lenders who do not require an equity sponsor.

In conclusion, when seeking to finance add-on acquisitions, using debt and limiting equity dilution can create the most value long term. However an equity partner can add intangible value despite its cost. Often companies will require and be able to raise both types of financing to execute on highly synergistic acquisitions.

 

Please note, the strategy, as depicted above only applies to stand-alone acquirers with ~$2mm+ in EBITDA for service companies, or $5mm+ in ARR for SaaS companies, with >10% growth. If you have an interest in an add-on acquisition or roll-up strategy, have a target or two in mind, and would like to discuss the particulars, please contact us to set up a time to discuss.

 

Harbor Ridge Capital has deep add-on acquisition and financing experience over the last 15 years, across direct private equity investing, investment banking and C-level management. Notable add-on acquisition transactions include a technology service business that grew from $25mm to $250mm in revenue by way of 7 acquisitions and organic growth, and an ad-tech business that was $3mm in EBITDA which acquired its much larger competitor doing $20mm in EBITDA.

Understanding Value Arbitrage from Tuck-In Acquisitions

Understanding Value Arbitrage from Tuck-In Acquisitions

While private equity and strategic acquirers are fully aware of the immediate value creation and arbitrage from add-on acquisitions, which Harbor Ridge Capital frequently sells companies to such parties, I repeatedly have discussions with founders that are interested in being the acquirer, where they can capture such value arbitrage themselves, yet seek support across the board to execute on such an initiative, especially with first-time acquirers.

Where the discussion gets especially intriguing from my perspective, is an M&A opportunity born out of a CEO having a relationship with a peer CEO in an overlapping or complementary business, who perhaps they have known and respected for years, and understand their business to a certain degree given the overlap. This existing relationship, the deep understanding of the space, offering and operations, coupled with strong financial performance, significantly de-risks the opportunity. To put it in perspective, private equity firms acquire businesses every day, which in most cases they did not even know the company’s name or industry three months prior to the acquisition. They expect to make between 2-4x their money on every deal, and 80-90% of the time this is the case.

This is why we call such acquirers “strategic”, as there’s inherent synergies across the board in addition to the financial aspect of the deal. Harbor Ridge Capital advises companies pursuing add-on acquisitions, where the entrepreneur can capture the vast majority of the upside, while often maintaining control. The buy-side advisory services include deal structuring, financing, and post-deal integration. Further, we seek to participate with our clients in the equity, to align interests and being bullish on the future upside potential. Below is a buy-side acquisition template we use for clients pursuing add-on acquisitions, to map out long term objectives and to assess feasibility.

As you can see, if executed properly, this can yield significant value creation for the equity, within a much shorter time frame. There’s quite a bit of variability with the inputs in this model, except what’s generally consistent across different business types, whether its software or service, is the multiple arbitrage that comes with size, which you can see from the Stand-Alone Acquirer Multiple to the Pro-Forma Combined. Once integrated, and if you apply some modest growth over a three-year period, the multiple is likely to increase even further.

The natural follow-up question to the above model, is how to best get this strategy financed, with the cheapest, most flexible type of capital. Please stay tuned for Part 2 of this series, which I will share the specifics of various acquisition financing options, cost of capital, and the different attributes of each.

If you have an interest in an add-on acquisition or roll-up strategy, have a target or two in mind, and would like to discuss the particulars, please email cmaghami@harborridgecap.com to set up a time to discuss. Please note, the strategy, as depicted above only applies to stand-alone acquirers with ~$2mm+ in EBITDA for service companies, or $5mm+ in ARR for SaaS companies.

Harbor Ridge Capital has deep add-on acquisition and financing experience over the last 15 years, across direct private equity investing, investment banking and C-level management. Notable add-on acquisition transactions include a technology service business that grew from $25mm to $250mm in revenue by way of 7 acquisitions and organic growth, and an ad-tech business that was $3mm in EBITDA which acquired its much larger competitor doing $20mm in EBITDA.

Profiles of our Most Active Buyer and Investors with Deep Domain Expertise

Profiles of our Most Active Buyer and Investors with Deep Domain Expertise

Harbor Ridge Capital has been covering the technology services and vertical software industries within the lower middle market ($5-50mm in revenue) for over 15 years, and while we primarily represent CEOs in a sale or capital raise, we’ve augmented this practice by securing buy-side agreements with a select number of highly strategic acquirers and investors that focus on these same verticals. This allows us to facilitate connections between our network of CEOs and these investors or buyers, as we see fit, in lieu of, or instead of, running a full process. For entrepreneurs interested in a transaction, this can serve as a great way to get quick tangible feedback from high quality sources, who may not be on your radar, regardless of whether a company is down the line with one party, or is even working with a banker. What makes the groups below so strategic, is the significant experience within technology services and software, usually from several past successful investments. This translates to a seamless understanding of company value, an ability to contribute beyond capital, and often pay a higher price as a result. Below are profiles of our most active buyers and investors where buy-side agreements are in place, and what they are most interested in:

  • Boston-based PE firm managing $1.7 billion; invests $15-50mm of equity in variety of transactions including majority/minority recapitalizations, full buyouts, and growth capital
    • Seeking companies with >$3mm in EBITDA
    • Deep expertise in technology services, internet infrastructure, managed IT services, IT services, and vertical software; active in healthcare IT as well
    • Portfolio companies seeking smaller add-on acquisitions ($1-5mm in EBITDA):
      • Regional managed IT services (regional and or vertical focused)
      • Managed cyber security services (MSSP/MDR/Consulting)
      • Software/Services for government agencies – state/local primarily
      • MSFT focused cloud/managed services
    • Positioning:
      • 70-80% of activity is in business/tech services (deep understanding and focus)
      • Just raised fund of $700mm thus seeking to put $ to work
      • Can do minority deals, growth and or liquidity as well as buyouts

 

  • Southeast-based PE firm, just raised a $1.4 billion fund, investing $25-125mm per investment
    • Target companies with revenues of $10-150mm, focused on verticals including: business/technology services, communications, and healthcare
    • Deep expertise in all areas of technology, cloud, and managed services, including managed cyber security services
    • Portfolio companies seeking add-ons acquisitions for platforms ($1-5mm in EBITDA):
      • MSFT Azure cloud partners
      • CRM cloud partners
    • Positioning:
      • One of most active and successful investors/acquirers in technology services
      • With fund size seeking larger companies for new platform deals
      • Given experience and success, understand quality assets in technology services, and thus willing to pay appropriately

 

  • Bay Area-based PE firm focused on acquisitions of software companies
    • $1 billion fund raised last year has a lot of dry powder
    • Seeking software companies with >$1mm in EBITDA with high repeat/recurring revenue and ~90% customer retention
    • Seeking smaller add-on acquisitions in following software domains:
      • Marketing, Government, Medical, Legal, and Logistics
    • Positioning:
      • One of top tier firms for software buy-outs
      • Unique in that they require software companies to be profitable (for platform acquisitions)
      • Entrepreneur in residence led format
      • More growth centric vs. value from a valuation perspective

 

  • Bay Area-based PE firm focused on technology services and vertical software
    • ~$500mm fund raised last year, focused on buyouts
    • Deep expertise in technology/cloud/IT services; companies that are $2mm+ in EBITDA
    • Portfolio Companies seeking add-ons in managed IT services, cyber security services, managed/vertical hosting, MSFT azure cloud, and CRM cloud services,
    • Positioning:
      • One of most experienced cloud/technology services investors and acquirers
      • Can write a check as small as $15mm for new deals, smaller for add-ons

 

  • Southwest-Based Alternative Debt Fund
    • Excellent avenue for those seeking debt to minimize dilution
    • Debt investment size of $10-40mm, up to 4x leverage of pro-forma EBITDA, with companies >$2mm in EBITDA stand-alone trailing
    • Traditional mezzanine debt type pricing

 

  • Former Entrepreneurs Who Sold Their Prior Businesses, Seeking Acquisition Opportunities
    • Entrepreneur sold his business for >$100mm, seeking managed security VARs, Consulting and or MSSP/MDRs
    • Entrepreneur who sold his cloud services business is seeking to acquire a legacy internet infrastructure business that can be modernized with the cloud
    • Entrepreneur who sold his cloud services business is seeking to invest in or acquire a cloud business in a high growth segment

 

Should any of the above profiles resonate with your financing and or M&A objectives, and or if you would like to receive broader feedback on your strategic plans, please do not hesitate to reach out to discuss.

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