From the blog
What is Acquisition Financing?
Acquisition financing is commonly used in the energy, metals and mining sector by potential acquirors to purchase target assets or shares. Aside from reducing the equity required of the borrower, it also lowers the overall cost of capital of the transaction so long as the cost of debt is lower than the borrower’s cost of equity.
Vendors often require potential acquirors to reveal their sources of acquisition financing as a pre-condition to submitting a compliant bid so that serious acquirors can be filtered out from other acquirors who may just be in the process to “kick tyres”.
Who provides acquisition financing?
Bank project/specialised finance departments arrange secured term loans, relying on the target cash flows as the primary means of debt service, and the intrinsic value of the target using DCF and other market valuation metrics. One category of such financing in the commodities space is reserve-based loans (also known as borrowing base loans) used by acquirors in the purchase of upstream E&P assets.
Leveraged finance (or LevFin) desks of banks typically arrange high yield bonds for reputable and well-known issuers, leaning primarily on the issuer’s credit rating, and track record of borrowing from international debt capital markets and are therefore covenant-light compared to secured term loans. Comparatively, private credit funds and other alternative financiers such as commodity trading firms can offer more bespoke transaction structures and participate across capital stack to reduce the borrower’s equity requirements, and typically provide greater speed, both of which entail higher fees and interests. These often also comes with features to extract more duration from the target assets, including make-whole interest/penalties on prepaid loans (up to at least 50% of initial loan duration), or provide deeply in-the-money warrants if the borrower is a listed company. As acquisition financing provided by private credit funds are generally more expensive, they are used more as transitionary/bridging capital, and so visibility of a take-out prior to maturity is essential to credit approval.
Energy and mining commodity assets can be well suited for acquisition finance if they have predictable cash flows available for debt service, including a steady production outlook, competitive cash costs, stable fiscal regime with defined license expiry and finished products that are either sold on a fixed price, or trade with reference to an index which is liquid and hedge-able.
Assets are also financeable if they are strategically located close to key markets, have infrastructure already in-place, have significant reserves certified by internationally reputable reserves consultants. Of particular interest are assets that are a matter of national importance and/or were previously owned by large majors or multi-national corporations that have maintained the assets well, and are ideally selling them as they have become non-core. Unattractive asset candidates tend to be too mature (e.g. oil fields that produce increasing amounts of water vs. oil), are too close to paying abandonment/site rehabilitation liabilities, or rely on undeveloped reserves for cash flow generation.
Acquisition financing does not solely depend on the assets being underwritten, but also the borrower’s track record of operating similar assets, and level of portfolio diversification post acquisition. In M&A auctions where there are multiple bidders, lenders also conduct channel checks to assess if the borrower has the political connectivity to secure regulatory approval for the bid.
As preparation for the acquisition financing can be a long-drawn process, deal selection is key for lenders to prevent time wastage for both parties. Critically, losing the deal for backing the wrong bidder risks damaging the credibility of the deal team members with their credit committee. Given the uncertainty of being outmaneuvered by new borrowers, it is unsurprising that lenders manifest familiarity bias towards sponsors/families with whom they have established transactional track records with.
Timeline to execute the acquisition financing is also an important factor in determining the type of facility which would be suitable for the acquisition. Generally for bank-financed deals, not only does the time to financial close take longer, but there is also a higher standard of care on due diligence and conditions which can be onerous on the borrower (e.g. calling for required reserve amounts to be equity funded upfront, requiring lower LTV ratios, etc.). On the other end of the spectrum, our experience with fund-financed deals is that they tend to be quicker due to their flatter credit committee structures and less requirements to syndicate the funding and risk. Not all lenders are cut from the same cloth – lenders have varying preferences for loan duration, return hurdles, fossil fuel lending policies, etc. and varying degrees of success in financing such transactions.
Due diligence is typically done in phases but will revolve around whether the lender model has considered the findings of external due diligence (reserves certification, financial and tax, legal disputes, etc.) and also obtaining external data points from industry experts to verify findings. At times, confidential investigative due diligence on key directors and management of the borrower is also commissioned by lenders to ensure they are not getting outmaneuvered. Should there be a requirement for a signed, credit committee-approved term sheet as part of bid submission, the standard of diligence and duty of care to investors increases.
Commonly Seen Loan Features
Regardless of asset and facility type, lenders will apply a variety of sensitivities to stress test CFADS in different market price environments and cash costs, which may necessitate:
- Additional security outside the target assets
- Minimum hedging (typically rolling hedges for 2 to 3 years) especially as most lenders do not have a mandate to bear market risk, which may require the borrower to budget for as part of the uses of proceeds (if puts are required)
- Minimum liquidity buffers (typically between 3 to 6 months of cash calls)
- Cash flow waterfall governed by a CAMA, administered by an escrow agent
- Intercreditor agreements with co-financiers for security sharing between different hierarchies of lenders
- Escalating interest margins, to incentivise the borrower to refinance as soon as possible
- Unpaid interest to be capitalised or paid-in-kind (PIK)
- Make-whole interest/prepayment penalties (e.g. minimum 50% of initial loan duration)
- Mandatory cash sweep of post-debt service available cash flows towards servicing principal in addition to scheduled repayments
- Restrictions on distributions/dividends to equity holders
- Leverage cover ratios e.g. LLCR, PLCR and reserve tails
- Commitment fees to start accruing from the start of availability period, even if no drawdown yet. Once FA is signed, legally bound to reserve capital. They do not wait for CPs to be satisfied
Target Returns for Lenders
For bank-led acquisition financing, the cost of capital tends to gravitate around the high single digits. Banks arranging the acquisition financing are mostly there to earn commitment fees, and expect to be refinanced before maturity. This can take many forms, including a refinancing by a longer-tenor borrowing base loan (as above), or an anticipated IPO/trade sale/partial sell-down, which lenders will need verification of.
For private credit funds, most lenders aim to generate low to mid-teens IRR and 1.5x to 2.0x money-on-money multiples. Deals are structured with a favourable risk to reward, where there is upside sharing in a bull case (e.g. deeply in-the-money warrants or royalties) and downside protection to the lender in a bear case, in the form of the ability to take senior security or ensuring sufficient cash flow cover (e.g. 1.5x cash flow cover over the loan duration, 70-75% LTV on project unlevered NPV, etc.).
Tips for Borrowers to consider
We generally recommend borrowers partner lenders that have the DNA for the target assets and the risks associated with the transaction type. If a lender is uncomfortable with the assets/trade being financed, the lender will apply discounts to the NPV and gravitate towards the no further action (NFA) case signed off by the reserves consultant unless they can obtain external validation on any proposed upside case. To align interest, the borrower may, in an upside case (e.g. commodity price rally), request the lender to allow for some distributions to equity holders to be shared between borrower and lender e.g. if Debt/EBITDA ratio falls below 3.0x. Ultimately, the overall deal returns need to work for all parts of the capital stack, and as such the borrower should be prepared to lower bid consideration if pricing escalates to preserve the deal risk-to-return profile.
Caravel Capital specialises in matching borrowers’ deal specifications with lenders’ preferences to assist in bringing the transaction to a close, and to prevent time slippage for both parties. Please contact us to discuss your acquisition financing requirements.