Wednesday, June 26, 2024
Wednesday, June 26, 2024

Considerations when raising debt finance to support a search fund buyout

In this article I share some of my observations and experiences of the search fund market with the hope of offering some useful insights for prospective searchers.

By Adam Agius, Partner, Altenburg Advisory

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Introduction and Purpose

In this article I share some of my observations and experiences of the search fund market with the hope of offering some useful insights for prospective searchers, investors and other stakeholders in the industry. In summary the topics I cover are:

  • Search fund activity in the UK
  • How funders typically view and approach search fund lending opportunities
  • Selected focus areas that may influence the perceived credit risk of a search fund transaction
  • The importance of preparation as you only get one chance to make a first impression
  • Trends and wider considerations.

Observations of search fund activity in the UK

Having spent most of my career in the lower mid-market (EV: c.£10-75m) both as a funder and advisor I have observed with interest the rise of search fund buyouts in UK as well as Europe.

The increase in both deal volumes and seemingly average deal size has been driven in my view by a combination of factors including:

  • strong supply side dynamics supported by succession challenges facing many founder owned UK SMEs
  • an increasing appreciation for search funds amongst investors (particularly in Europe) as a distinct asset class; offering attractive risk-adjusted returns through acquiring proven, cash generative businesses often sourced off-market, combined with the ability to diversify exposure through backing multiple search funds
  • a less crowded institutional private equity market in the core searcher acquisition hunting ground of £1-5m EBITDA
  • greater funder appetite to support such transactions and at gearing and leverage levels that can facilitate IRR and MoM levels above target return thresholds for a wider cohort of investors.

I anticipate this trend continuing in the coming years. As the wider private equity community contend with how to drive value creation post the era of ultra-low interest rates, and less compelling multiple arbitrage plays, the ability for search investors to take longer term views on hold periods and the inherently hands-on approach taken as part of the search model provide a differentiated way to meet this challenge.

We at Altenburg Advisory (“Altenburg”) are particularly passionate about supporting the search industry having observed first-hand the sacrifice and dedication required to successfully navigate the search process from beginning to end. We’ve had the privilege of working directly on some of the larger UK search fund transactions including raising debt facilities for the buyouts of Water Direct Ltd in 2022 (plus a follow-on acquisition in 2023) and Saepio Solutions Ltd in 2024.

The ability to identify a suitable target, structure and negotiate an appropriate purchase price and transaction structure, undertake due diligence, raise debt financing and in parallel manage information flow and communication with investors and the vendor to ensure that all parties remain engaged is no mean feat. This can all be very daunting especially if the searcher is encountering many aspects of the process for the first time.

Search fund transactions from a debt funders perspective

Focusing on the debt financing aspect of the transaction, having worked on both sides of the table as funder and advisor on search fund deals, we believe that we have a good appreciation for how funders assess opportunities and how execution risk can be minimised during such a process.

Specific characteristics of a search transaction that influence the credit risk assessment from a funder’s perspective include:

  1. Corporate or Sponsor Transaction
  2. Funders will often categorise lending opportunities between owner managed businesses (“corporate”) and private equity backed (“sponsor”) transactions with distinct approaches and defined credit appetite for each
  3. Search fund transactions can often sit somewhere between the two depending on the funder’s view
  4. The presence of an equity cheque from professional investors who will also provide a level of governance can be viewed positively. However, without one or more significant equity investors, debt funders will invariably want to explore the equity bases in more detail to gain comfort on track record and the ability to provide follow-on capital if required
  5. A search fund won’t meet the criteria for a typical corporate deal given the change of control dynamics 
  6. Despite “sitting in the middle” we are seeing an increasingly wide range of funders with appetite to support appropriate search fund transactions
  7. As search funded deals remain an emerging asset class in the UK each funder typically adopts their own distinct and varied credit and diligence processes to address the requirements of their own internal gatekeepers and stakeholders.
  1. Management Buy-In
  2. Search fund transactions are also distinguished from a more traditional private equity buyout in that the searcher(s) themselves typically takes on a CEO / MD role in the target post-transaction as opposed to a private equity house backing an existing management team
  3. Depending on the circumstances, and without appropriate mitigation, funders can perceive this type of transaction as having an associated management buy-in risk premium attached to it, which can limit appetite.

As a function of these distinct characteristics, potentially varied credit processes and ultimately in funding appetite, it is i) critical to cover all bases when preparing to approach funders and ii) to ensure you speak with the ‘right’ funders in the right way to maximise the chance of obtaining strong appetite and ultimately appropriate debt funding.

With a view to covering all bases, the vast majority of funders will expect to be provided with external financial due diligence (and commercial due diligence in larger transactions). Although the diligence will initially be for the benefit of the searcher and investors it is key to have a good awareness of the funders that are likely to be approached as part of a debt raise prior to instructing an appropriate firm. This is to ensure the selected due diligence firm are acceptable to all funders and the scope is sufficient to meet all of their likely requirements.

Focus areas specific to search fund transactions

When attempting to mitigate perceived risks prior to approaching funders we believe that the following should be considered:

  • Structural: including an element of deferred consideration is a common component of transaction structures, but incentivisation of the vendor by way of an element of equity rollover combined with a performance linked earn-out can be an effective way of i) providing comfort to the funder that there is downside protection on cash outflows in the event of underperformance ii) increasing leverage capacity if structured appropriately and iii) demonstrating the vendor has belief in the future potential of the business by providing a continuing vested interest in the business.
  • Searcher: inevitably a key focus for funders will be the searcher or search team themselves with a specific focus on:
    • Granularity of knowledge: funders will be cognisant of the fact that searchers possess a variety of skillsets and experiences that require individual assessment. However, given the rigorous nature of the search process funders would expect a deep, almost forensic analysis of the target, sector (particularly as funders are generally sector agnostic) and value creation opportunities which should translate into a supportable forecast plan
    • Personality: as important will be assessing the personality of the searcher to provide the confidence that they have the requisite confidence, communication skills and authority to lead the business post deal
    • Skin in the game: whilst there is appreciation for the fact that embarking on a search typically involves giving up a well-paid job and not insignificant career risk, funders will also be keen to see a proportionate level of personal equity invested by the searcher(s) to further demonstrate their commitment and “skin in the game.”
  • 2nd tier management: having the benefit of a loyal, credible 2nd tier management team (often running day-to-day operations on behalf of the seller) can significantly reduce the perceived MBI risk. Assuming the 2nd tier management are to be appropriately incentivised (by way of EMI schemes, sweet equity etc.) the role of the incoming searcher can be viewed as supplementing a functioning team rather than filling a gap in leadership from day 1. A full assessment of the team may be a staggered process as vendors typically only provide meaningful access to management (including for the funder) once they have a strong level of confidence that the transaction will proceed so as not to cause undue alarm or disruption.
  • Quality of the security: ultimately funders providing debt facilities are limited in their level of upside return (with their return being by way of fees and margin rather than equity) and are correspondingly focused on ensuring they are taking and pricing for commensurate risk. As such they will have a keen eye on their equity cushion. The more confidence a funder has over the valuation agreed at entry and the M&A activity/demand levels in the sector (with a view to exit routes) the more likely they are to accommodate for specific credit risks associated with the transaction and underlying business.

Trends and wider considerations

In our experience many search transactions in the UK and Europe gravitate towards £1-2m EBITDA at 4-6x multiples with a defined plan around professionalisation and accelerating organic growth.

At Altenburg we have seen other strategies being employed including the acquisition of larger businesses in growth and buy and build sectors. This does necessitate the need to explore a wider range of funding options to ensure i) appropriate leverage levels can support the equity returns required if acquiring at higher EV multiples and ii) the growth and acquisition plans are fully funded from day 1 via a combination of committed and (un)committed acquisition debt facilities.

Where we have supported searchers, the primary focus has been to determine, structure and arrange optimal debt facilities whilst minimising execution risk. Additionally, whilst securing the facilities to facilitate the transaction is paramount, ensuring that structural terms and covenants are negotiated appropriately (including collaborating with the searcher to prepare a conservative funding forecast case to accompany the investor base case) is critical to maximising headroom for and protecting the searchers position and their investors against bumps in the road.

From a broader standpoint as a firm Altenburg invariably provides wider corporate finance guidance to our clients and this is also true of search transactions where a buy-side M&A advisor is seldom present. Our role can include a full financial model build, walking through locked-box completion mechanisms, running equity returns analysis under different scenarios or simply a second opinion on the terms of the SPA.

Conclusion

Ultimately, whether advised or not, whilst identifying a target and raising equity can be regarded as the critical milestones to overcome, the preparation for approaching the debt markets should be undertaken early in the search process. This will reduce execution risk, ensure target timelines are set appropriately and to ensure agreed acquisition and equity terms are deliverable.

In summary, the search fund buyout market is a fascinating one, and one that we expect to continue to grow as private equity houses and their LPs seek alternative routes to sourcing high quality assets that deliver target returns.

With debt financing used in the vast majority of deals, determining structuring and implementing the most appropriate debt solution is key to ensuring the deal works from both an upside perspective (delivering/exceeding target returns) and downside, providing headroom and flexibility to deal with unforeseen events.

About the Author

Adam Agius is a Partner at Altenburg Advisory, a specialist debt advisory firm that works with established businesses seeking debt financing to help them achieve their strategic objectives. Altenburg advises on structuring and arranging bespoke financing solutions, with a focus on leverage finance, speciality finance, asset based lending and real estate funding.

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