We expect that the market will move slowly when it comes to larger mergers and acquisitions – at least in the first half of 2023, but possibly beyond. Ongoing concerns about Brexit, a potential (global) recession, the UK’s cost-of-living crisis, the energy crisis, the ongoing war in Ukraine, and supply chain challenges arising from China only recently opening up for business post-COVID have meant that businesses and investors have adopted something of a ‘wait and see’ mentality.
However, the UK has a thriving small and medium enterprise sector. As leading players emerge, they look to expand through merger and acquisition activities. While economic contractions can slow mergers and acquisition (M&A) volume, they also present opportunities – sometimes a competing business will be struggling and can be taken over at great value, or it will make sense to take over or merge with a business when competitors are effectively waiting out the market.
Private equity can be one route to expanding market share and accessing capital for mergers and acquisitions. However, this isn’t always a viable route for SMEs who need to raise less capital to buy out another company, and not every business wants to dilute ownership. Therefore, raising finance is usually a better path for funding M&A activities.
But even for the most successful SMEs, raising finance for M&A remains challenging. Plenty of lenders – especially high street banks, advertise corporate finance. However, many have exceptionally strict or inflexible lending criteria, won’t extend credit for M&A activities, or simply don’t offer smaller loans. So how can SMEs raise the finance they need for M&A?
Financing Mergers And Acquisitions In The Middle Market
The SME lending market is fragmented and can be hard for even seasoned executives to navigate. Plenty of lenders, especially high street banks, advertise M&A finance facilities, but the reality is they will only target specific types of deals – usually for businesses that want to raise millions of pounds in debt.
M&A financing is complex and convoluted for borrowers and lenders alike, but while many SMEs are hungry for finance, larger lenders baulk at the amount of time smaller, sub-£5 million market financing, takes to arrange. For SME’s however, there is a huge demand for finance in the £50,000 – £5 million range to back high-ROI M&A opportunities, and there is therefore a disconnect between borrower demand and availability of finance.
Boutique and alternative lenders have identified SME demand for sub-£500,000 finance and have stepped into the space with aplomb, but arranging finance is still difficult. The competitiveness of what a business is offered will depend on far more than just their loan application: the quality and detail of due diligence, ability to demonstrate scalability, financial and credit history, post-M&A capabilities/market share and financial forecasting all have a critical role.
Borrowers also need to lay out the efficiencies between the two businesses carefully as part of the application, as well as showing lenders how they will circumnavigate the usual risks that come with M&A deals (operational inefficiencies or excess headcount, potential culture clashes, increased costs). Borrowers increasingly need to ensure lenders understand their logic for a merger or acquisition, especially in deals where the borrower or business that’s being acquired operates in an emerging sector with emerging tech or healthcare, for example, where a lender may need detailed explanations about products or services, what they are, demand and evolution.
Lender Approach to SME M&A in 2023
However, for many UK SMEs, it makes sense to consider mergers and acquisitions now. Some companies may have revalued or may be struggling in the context of a contracting economy, which means there are ‘bargains’ available in terms of consolidating businesses or competitors. While lenders are assessing corporate finance carefully, there is still plenty of capacity to offer loans. However, in the context of the current economy, as well as the strength of the deal, the following elements will be important:
Stability in both firms
Stability here is an all-encompassing term. Lenders want to see stability in both the business buying and being acquired or merged, a history of stable/growing valuation, steady demand and market share and sound, cash-backed projections about future profitability. It’s a tall ask in the current market, but importantly, some companies deliver on all these fronts – and financing is available.
Price
Lenders have undoubtedly become pickier about the deals they will finance, even if lending criteria haven’t officially changed. The business being bought or acquired needs to be priced ‘right’ now more than ever. While this is central to lenders in the current market in the context of risk, buyers also need to consider this carefully, given the increased cost of borrowing. Money is no longer cheap, and an acquisition or merger with another business must present an outstanding opportunity.
Liquidity
Cash flow and liquidity is critical to lenders in the current market and they will play a key part in if you are offered a loan and the competitiveness of the deal.
As well as having good security to put forward, companies engaging in M&A deals must be able to show they are liquid and can adequately forecast how this will continue. Lenders will look carefully at cash-flow projections, and these must be reasonable and attainable, and they may even adjust them more conservatively to reduce risk and increase the margin of comfort if you can’t meet the numbers. Lenders will want to understand how you have forecasted cash flow and will want to understand the logic behind your projections.
Getting The Best Financing Deal
Because M&A finance is so complex, the loan needs to be arranged carefully and structured as much as possible from the borrower’s side to ensure the business is getting the best deal available on the market. Price is one part of the puzzle, but security also needs to be considered as does the flexibility of the facility or facilities. Leveraged buyouts are common even in smaller deals, and the assets involved, and the overall structure need to be carefully laid out ahead of time. In many cases, cash flow will form at least part of the security, and borrowers need to ensure they have a deal that doesn’t squeeze their actual income more than it needs to – there is usually room for negotiation, even if lenders don’t say so.
Although uncommon in smaller financing deals, SMEs looking for larger loans to fund M&A activities sometimes offer equity in return for finance on top of senior debt and mezzanine finance. In these cases, equity needs to be carefully considered through the lens of control and percentage.
This guide is for information and illustrative purposes only and nothing contain within should be construed as advice or a recommendation.
Financing options available to you will depend on your requirements and circumstances at the time. Any changes in your circumstances, any known likely changes, or omissions in the information you provide can affect the suitability of the options available to you. These should be communicated to us as early as possible.
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Islay Robinson, a founder of Enness, is widely regarded as one of the UK's leading mortgage brokers. He has been instrumental in delivering some of the most complex and high value mortgages in the UK.
