In mergers and acquisitions (M&A), debt financing is the payment for a target in cash using borrowed funds. This financing method is the opposite of equity financing which involves issuing stock to raise capital. Debt financing can be achieved by the sale of fixed income products, such as bonds, bills, or notes.
There are a number of reason why acquirers may choose to borrow funds as opposed to use existing cash or their own stock. As equity represents an ownership stake in the company, the issuance of new stock will cause dilution and generally upset existing shareholders.
However, the funds raised do not need to be paid back. With debt financing, the company issues debt but this must be paid back to investors. However, control is maintained by existing shareholders and in addition there are certain tax benefits. If leverage is controlled, and a sustainable debt-to-equity ratio is maintained, the acquirer should be able to service the debt as necessary assuming normal business conditions are maintained.
Financing for Mergers and Acquisitions
Whilst dividend payments to shareholders signify the cost of equity, the cost of debt is the interest payment to bondholders. These are known as coupon payments. The total cost of debt to a firm is calculated by the weighting and cost of the firm’s debt and equity. Failure to cover the cost of capital means the company is unable to earn a return on its capital sufficient to satisfy finance sources.
Over time, a company may issue new stock via employee plans or to raise new financing for capital projects. At the same time bonds may fall due and be repaid. As the capital structure evolves the firm must be aware how this effects profitability and what actions needs to be taken in order to maintain continuity. Therefore when evaluating investments, the firm looks to where the capital structure will be. If leverage permits, and the balance sheet ratios suggest it is possible a firm may increase its debt load to pursue and acquisition strategy.
The formula for the cost of debt financing is
Cost of Debt = Interest Expense x (1 – Tax Rate)
Interest on the debt is tax-deductible. Making this adjustment makes figure more comparable to the cost of equity because earnings on stocks are taxed. This tax deduction is part of the attraction for private equity firms when initiating a leveraged buyout. Traders must be aware of the source and level of financing used as any complication may be the cause of the widening of the merger arbitrage spread.
Debt Financing Example
The following text is taken from the Form PRER14A Preliminary proxy statement relating to merger or acquisition filing with the SEC made by Cincinnati Bell (CBB) on May 1, 2020 in relation to the proposed merger with RF Merger Sub Inc.
In connection with the merger, Parent has obtained a commitment letter, dated February 28, 2020 (as amended, the “Parent debt commitment letter”), from Goldman Sachs Bank USA, Regions Bank, Regions Capital Markets, a Division of Regions Bank, and Société Générale (collectively, the “Parent debt commitment parties”) to provide, severally but not jointly, upon the terms and subject to the conditions set forth in the Parent debt commitment letter, acquisition debt financing in an aggregate amount of $1.6 billion, consisting of a $250 million senior secured revolving credit facility and $1.35 billion in aggregate principal amount of senior secured term loans (such financing, the “Parent debt financing”) and (ii) Parent and one of its affiliates have obtained an amended and restated commitment letter, dated March 5, 2020 (the “bridge commitment letter” and, together with the Parent debt commitment letter, the “debt commitment letters”), from Goldman Sachs Bank USA (the “bridge commitment party” and, together with the Parent debt commitment parties, the “debt commitment parties”) to provide, upon the terms and subject to the conditions set forth in the bridge commitment letter, acquisition debt financing consisting of $493 million in aggregate principal amount of senior bridge loans (such financing, the “bridge financing” and, together with the Parent debt financing, the “debt financing”).
In this document, the sources and uses of the debt financing are clearly stated and it is shown where shareholders can obtain more information such as the debt commitment letter. The constitution of the financing is also stated such as “bridge loans” and the banks which have provided the financing.
he document goes on to list a number of conditions that must be complied with in order to obtain the required funds
The obligations of the respective debt commitment parties to provide the debt financing under the applicable debt commitment letters are subject to a number of conditions, including:
- the substantially simultaneous completion of the merger in accordance with the merger agreement without giving effect to certain material amendments or waivers absent the consent of the applicable debt commitment parties,
- the consummation of the equity financing prior to, or substantially concurrently with, the initial borrowings under the debt facilities set forth in the debt commitment letters, and the consummation of the refinancing of Cincinnati Bell’s existing U.S. credit facility and existing securitization facility prior to, or substantially concurrently with, the initial borrowings under the debt facilities set forth in the debt commitment letters,
- that no event or development shall have occurred that would constitute a “company material adverse effect” (as defined in the merger agreement),
- payment of all applicable invoiced fees and expenses,
- the delivery of certain audited, unaudited and pro forma financial statements,
- the delivery of certain customary closing deliverables (including, but not limited to, a solvency certificate in agreed form),
- with regards to the Parent debt financing only, the completion of the required marketing period,
- the receipt of documentation and other information about the borrowers and guarantors required under applicable “know your customer” and anti-money laundering rules and regulations (including the PATRIOT Act and the Beneficial Ownership Regulation),
- the execution of certain definitive debt documentation consistent with the applicable debt commitment letters, including definitive documentation to perfect the administrative agent’s security interest in the collateral as provided in the applicable debt commitment letters, and
- that the specified representations and certain representations and warranties in the merger agreement material to the interests of the lenders will be true and correct to the extent required by the applicable debt commitment letters.
Despite the length and detail, this is standard boiler plate language for this type of arrangement. However, the further significance of debt financing in mergers and acquisitions is highlighted by the 155 occurrences in this document alone.
