Corporate finance advisors are enabling businesses to seal strategic deals by providing bespoke ‘hybrid’ funding solutions that plug a critical funding gap and offer more flexibility than conventional transaction structures.
Hybrid finance is being used more widely in deals as higher interest rates and challenging debt markets have led to banks and private equity houses reducing mergers and acquisitions (M&A) funding.
Hybrids such as mezzanine finance and vendor loans were once considered exotic forms of financial engineering fraught with complexity and risk. The situation today is very different.
A striking feature of Moore’s M&A Compass 2023 report on European cross-border mid-market transactions was the significant increase in diversity of deal funding sources. It was an important factor in maintaining a buoyant market in the face of post-Covid uncertainty, with more than 4,200 cross-border deals completed last year worth a total of €200 billion.
A typical deal pre-Covid would have seen the buyer funding the transaction with 70% debt and 30% equity: today that is more likely to be 60% debt, 20% equity and the final 20% comprised of “hybrid” financing.
Hybrid finance packages include characteristics of both debt and equity, offering investors the potential benefits of each form of funding. They usually cost more at the outset but corporate finance advisers are skilled in developing the optimum mix for individuals that are cost-effective in the developing the optimum mix for individuals that are cost-effective in the long term.
“The M&A process has become more complex over the past 20 years,” says Philippe Craninx, chairman of Moore Global Corporate Finance (GCF). “There is a gap in debt funding in certain situations but thousands of transactions are still being funded: it is just that we put them together differently.
“One of the benefits of this new approach is that funding of deals is more diversified, vendors and sellers have more flexibility and we can find bespoke solutions that were not available to them before.
“We always explain to clients that how they structure deals is a strategic choice. As well as making sure you have the money to pay the sellers to close the deal, you need to be thinking about a growth strategy for the next five or 10 years that earns a proper return on investment.”
Craninx, who is also head of corporate finance at Moore Belgium, says there are key decisions in any deal, regardless of structure and the funding requirement, that come down to personal choice.
Finance packages usually require legal guarantees and often confer rights on those putting up the money that may appear onerous. These might involve the degree of pre-deal due diligence to be conducted and the amount of influence a funder will have on strategy.
Committed investors can offer tremendous support to management teams keen to develop their skills and grow revenues, however some entrepreneurs may struggle with loss of autonomy.
Each hybrid instrument has a different impact on cash flow. That could be a concern as many mid-market companies rely on working capital to fund expansion. The tax treatment of different solutions can also be a deciding factor, especially when it involves the inter-generational dynamics of family-owned companies.
Europe is the crucible of this more flexible kind of deal-making and Moore GCF comprises a team of dedicated corporate finance professionals with decades of experience in the main M&A markets.
John Cowie is a corporate finance partner at Moore Kingston Smith in London and urges vendors and buyers to be open to creative funding solutions.
While it may be necessary to use a hybrid financial structure to get a transaction over the line, they are not cheap. For example, some forms of debt can cost 8% above the prevailing base interest rate.
Minimising the impact of those higher rates by finding efficiencies elsewhere and careful tax planning is a vital part of the deal process. In the UK, Employee Ownership Trusts (EOTs) are popular with management buy-out teams as they provide an exit for owners that can exempt them from capital gains tax.
Cowie says this is particularly attractive to a generation of 50- and 60-something business owners who are keen to sell up and begin a new phase of life. For them, price is only one of many factors: a more flexible work-life balance may take precedence.
“I had a situation recently where an owner was offered £20 million but we all knew that the business was worth more,” Cowie recalls. “There were so many issues we could push back on and get closer to our valuation but our client had expended a lot of emotional energy getting to the point of being prepared to sell.
“He knew the offer was low but entertaining higher offers would have involved accepting some hybrid funding to bridge the gap. By choosing the lower offer, he could reduce his risk exposure and he was still walking away with a life-changing amount of money.”
Christoph Schlotthauer, president of Coffra group in Paris, says there is still a big appetite for the “right” deal – these include strategic mergers and funding the growth of companies that are either market leaders or likely to become so by applying disruptive technology.
He estimates that company valuations in the areas in which his firm operates have dropped, on average, from 12x to 9x EBITDA (earnings before interest, taxes, depreciation and amortisation).
“There is still great competition for the best deals and those transactions tend to maintain prices at the higher level,” he says. “However, we expect longer discussions and more information to be shared to give greater comfort to the financing parties.”
While banks are more reluctant to commit to funding, Schlotthauer and his GCF colleagues have been successful in finding new ways of structuring the financial components of transactions.
“We have seen a lot of new mechanisms and tools coming to the market which have helped replace some of the traditional funding,” he says. “In the past we would perhaps use one of them, now we might combine several.
“Unitranche financing has become popular, where several of the 50 debt funds in France come together under one umbrella and we only have one negotiation. However, I think we will see other mechanisms emerging that offer lower rates, lower risk, higher levels of financing and the ability to increase leverage.”
A pragmatic approach to valuation also informs discussions with clients of Attolini Spaggiari Zuliani & Associati in Italy, says founding partner Giancarlo Attolini. He says sometimes there can be great strategic value in disregarding current market conditions.
He recently took a call from a client who wanted to progress with a merger between his company and a rival based on figures from the middle of 2022 that produced a considerably higher valuation than would be expected today.
“I objected at first, then I realised if we had to update the valuations based on full-year 2022 numbers, or mid-2023, we would very probably never reach agreement,” says Attolini.
“The more important point for the two parties is that what they will have at the end of the merger process will be incomparably more valuable than what they have now in two separate companies. My client basically said: ‘What’s a few million today, if you can make an extra €10 million in five years?’”
Another of Attolini’s clients has come up with a novel approach where a purchase price is agreed based on “normal” market conditions and he then makes regular payments over an agreed number of years.
“This is an interesting structure which I can see being very attractive to owners of small businesses,” says Attolini. “The first person who agreed to this was so happy to receive his money regularly. He moved to Spain, bought a house by the sea and can live very well without having to worry about the business. It was the perfect deal for both sides.
“As long as you trust the person who is paying and as long as there is proper due diligence and the legal paperwork is in order, then why not? Otherwise, that business owner might be stuck in a situation where he has a valuation expectation based on the good years but cannot find a buyer to match it. This way, he gets cash now and the full value of the business eventually – he just has to wait three or four years.”
As well as working on deals in their own countries, the firms in Moore Global Corporate Finance co-operate on cross-border transactions where local knowledge of market conditions, legal and tax frameworks and personal relationships with potential funders make negotiations run smoothly.
The Moore firms can pool their expertise and work as a single integrated team. Marco Du Pré, partner at Moore DRV in Rotterdam, recalls a recent transaction with two companies in different countries that were keen to merge but struggled to find acceptable funding options.
Both companies, one in the Netherlands the other in Belgium, had track records of strong profits and cashflow and were an excellent strategic fit. Unfortunately, they operated in a sector that banks are under shareholder pressure to pull back from.
“We were stuck at a barrier with a really good deal that was, unfortunately, in the ‘wrong’ sector,” says Du Pré. “So, we had to think laterally and worked closely with our Moore colleagues in Belgium to find another path.”
Both Moore firms were able to use networks in their respective countries to put together pieces of the jigsaw. They each knew specialists within local banks that would be able to sanction lending if certain criteria were met.
“Today it is less clear what banks are willing to back,” says Du Pré. “That is why you need to have a black box of tools at your fingertips you can use either to persuade banks or that helps you switch to alternative sources of financing.
“This deal and other cross-border transactions we have worked on together shows the strength of the Moore GCF network,” says Du Pré. “Each firm plays to its individual strengths but our clients only see one team working across many areas to bring their deals to a close. It works really well in the mid-size market where personal relationships are very important.”