Improving Your Risk Profile: Make an M&A Deal More Attractive to Lenders

It’s no secret that lenders have grown more conservative lately. Even though the credit crisis has abated, banks remain wary about uncertain markets. And more stringent “stress tests” have put them on their guard against excessive risk. As a result, otherwise qualified borrowers with second-lien loans, significant leverage, diminishing cash and other risky traits may have trouble finding M&A financing.

If your deal is threatened by financing uncertainty, take heart. In many cases, buyers can make changes that reduce their lending risk and help them qualify for a bank loan.

A changed world

Although 2016 looks far better than 2008, plenty of unknowns remain — and the banking industry is proceeding cautiously. The Federal Reserve’s annual stress tests, intended to ensure that banks have adequate capital to continue lending even after a severe market setback or long recession, has put them under enormous pressure. 

Stress tests apply to roughly 30 U.S. banks with more than $50 billion in assets. In December 2015, the Fed announced even more stringent criteria for banks that have over $250 billion in assets. Such screw-tightening is likely to force many banks to sell off a certain number of loans at the end of each year to pass stress tests. This could make them less willing to lend to borrowers with their eye on an acquisition.

Diminishing appetites

In related news, banks are finding it more difficult to sell their M&A-related debt to investors. For example, Morgan Stanley struggled in late 2015 to sell the $1.2 billion loan that funded Lannett’s purchase of Kremers Urban Pharmaceuticals after news broke that Kremers had lost a key customer.

During the same period, Goldman Sachs and J.P. Morgan Chase labored to sell loans backing Apax Partners’ leveraged buyout of clothing retailer FullBeauty Brands. The clothier’s loan package was split between first-lien loans (which are first in line for repayment should the borrower go bankrupt) and second-tier loans (which are repaid only after first-lien lenders get their money back). A substantial amount of second-tier debt apparently soured investors on the deal and the banks had to offer deep discounts to unload the loans.

Too hot to handle?

For prospective M&A dealmakers, the lesson is clear. If you have significant unsecured, second-lien or similar debt obligations on your balance sheet, lenders may consider your proposed deal too hot to handle.

To improve a deal’s risk profile, sellers might try to pay down or refinance their second-class debt. Shifting to longer maturities or swapping second-lien for first-lien loans (even if this requires making price concessions) can strengthen a buyer’s financing prospects — and the selling owner’s chance of closing a lucrative transaction.

For their part, buyers need to factor in the health of their market sector and decide whether now — or perhaps a year or two from now — is the best time to make an acquisition. Lenders are cautious about extending loans for acquisitions in stalled industries. The energy sector, for example, currently is unpopular due to low oil prices. These days, service sector applicants are more likely to find receptive lenders.

Lenders also look less favorably on slower-track deals. In the past, banks would “warehouse” M&A loans until they found a favorable market for them. Now, because of greater regulatory pressure, they’re often forced to sell such loans quickly to get them off their books — even when the market isn’t in the mood to pay top dollar. Therefore, loan applicants that can guarantee that a transaction will close quickly and by a certain date have an advantage. 

Making it work

Under current conditions, it’s clear why lenders have cold feet when it comes to funding acquisitions. Whether you’re an M&A buyer or seller, you’ll have better odds of closing a deal if you trim your risk profile.

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