The reason for which acquisitions are often made with a loan is the so-called leverage. This is also where the term ‘leveraged buyout’ comes from: the buying out of an incumbent shareholder with (partly) borrowed money. Leveraged financing is easy to explain:

You buy a company with a value of 100, putting in 25 of your own funds and borrowing 75 from the bank. The bank loan is repayable over a period of five years from the free cash flows of the acquired company. If, after five years, that company has also increased in value by 50%, then you have earned almost 125 over five years on an investment of 25 (150 (value of the company) minus 25 (equity). The interest costs still have to be deducted from the yield so it gets a little less, but without leverage you would have earned 50 after five years, namely 150 minus 100 (own capital). By leveraging borrowed money, the return on equity is significantly increased.

When concluding an acquisition financing agreement, the following points must always be considered.

Interest on acquisition financing

The interest and handling fee constitute the cost of the financing. The interest rate may be fixed or variable. The uncertainty of variable interest rates can be hedged by means of an interest rate derivative. An interest rate derivative is usually the surrender of the risk of an interest rate increase. The question of whether this really helps a company is, of course, the question in view of the interest rate swap issue. Interest rate derivatives are available in many types and have nice names such as the zero cost knock-in collar. Obtaining expert financial advice is essential. An important point to remember is that the bank does not have the same interests as the person wanting to borrow money. The bank wants to make money through the interest rate and non-transparent products such as interest rate derivatives. The entrepreneur wants to hedge their interest rate risk for a minimum cost.

Another factor to be aware of is the well-known trick that banks play in charging 360 interest days instead of 365. However the bank sees it, there are 365 days in a year. As the financial institution understands this very well, it charges an additional five interest days in one year, taking it from 360 to 365. The bank uses this trick to effectively raise the interest rate by approximately 0.1%. That does not seem much, but for longer-term loans amounting to millions, this saves tens of thousands to hundreds of thousands of euros in terms of maturity.

Repayment of acquisition financing

The interest and repayment dictate how much money needs to be raised from the purchased company (the target) during the term of the loan. The cash flow must be able to pay for the interest and repayment. In the case of acquisition financing, the repayment is a much greater burden on the cash flow than the interest, because the bank usually wants to have the acquisition loan repaid within three to five years. To keep the periodic repayment low, it is possible to agree on a so-called lump sum or balloon payment at the end of the term, meaning that a lump sum payment is then required. In the case of mergers and acquisitions, a lump sum payment is less common because the large payment at the end of the term is too uncertain: it has to come from existing resources or refinancing. A vendor loan may be a solution.

A professional financier almost always wants security for the payment of the interest and especially for the loan repayment in the event of problems. A so-called unsecured loan, a loan for which no security is required, does not occur in acquisition transactions. In the case of acquisition financing, we generally encounter the following securities: a pledge on the shares of the company or companies purchased, a pledge on debtors, stocks and inventory of the company or companies purchased, a mortgage right on property, a corporate guarantee and a suretyship from the director and major shareholder.

A pledge on shares means that shares are pledged as security in the event of default on the loan: if the loan cannot be repaid, the bank can sell the shares. A right of pledge on shares is established by a instrument executed by a civil-law notary. Shares with a right of pledge cannot simply be sold and, in principle, pledging for a second time is not possible without the consent of the first pledgee (the bank). If this happens without the consent or knowledge of the parties involved, this may, in principle, result in directors’ and officers’ liability.

Execution of a pledge on shares is difficult in practice because there is no public market for shares of private limited companies. The same issues arise here as in the case of attachment in execution of shares. However, it is legally possible to sell the pledged shares.

A pledge on debtors is almost always a so-called undisclosed pledge. In the case of an undisclosed pledge on receivables, the debtor is not informed in advance of the pledge established by the person to whom they must pay in favour of the bank. This only happens if the person who borrowed the money defaults on the loan. After disclosure of the pledge, the debtor can only pay the pledgee (the bank) in full discharge of their obligations. If they do inadvertently pay their creditor, they have to pay the bank again. A pledge on debtors is created by means of a notarial instrument or private instrument. A private instrument is a written document signed by both parties. A private instrument of an undisclosed pledge only becomes fully legally valid once it has been registered with the tax authorities. The tax authorities do not process the registration of a pledge further; they serve only as an independent body providing the pledge with a registered date.