B. Riley Insights

Growth Capital: to Seek Funding for Opportunistic Acquisitions or Market a Clear Use of Proceeds?

By Garret Orbach,
B. Riley FBR, Inc.

To grow a company organically is slow and difficult, with many small and middle market companies turning to acquisitions in order to quickly diversify their geographies, end markets, and achieve scale. However, companies that do not have capital on hand face a problem: without a specific target in mind, the buyer will have trouble raising meaningful capital; without committed capital, a valuable target may not enter exclusivity with the buyer. Each path – to seek funding first or to identify a target first – has clear advantages and disadvantages, and one will be better suited to your particular company. 

Opportunistic Acquisitions: Seek Funding First, Identify Target Second
Whether a company seeks capital via equity or debt, the use of proceeds in a standalone raise is usually advertised as “opportunistic acquisitions, working capital, and general corporate purposes.” This process is appropriate for companies with strong historical growth, an experienced management team, and a compelling roadmap to future success. In meetings with institutional investors, management teams will focus on telling their own story, rather than potential synergies with a target. This method is intended to generate confidence in a standalone company rather than focus on the success of a particular transaction. 

Raising money in this structure provides several benefits. First, the capital will be on hand and readily available to effect a transaction, which provides confidence to a target that the transaction will close. Second, there is no immediate need to deploy the funds. This allows the management team to keep it as “dry powder” on the balance sheet until the best target is identified. Finally, the company and its investment banker will have spent weeks perfecting its message and setting up valuable meetings with institutional investors. This is essential groundwork to “tell the story” and put the company on the radar of institutional investors. 

However, there are drawbacks to raising capital prior to identifying a target. If the capital is in the form of a term loan, bonds, preferred equity with cash interest payments, or any other non-PIK interest structure, the company must be able to support the larger interest and principal repayment without the added cash flow from the acquisition. Shareholder value will be eroded if the company pays interest on idle funds. If the capital is in the form of common equity, the company must be able to bear significant dilution to EPS in the short term (and corresponding effect on stock price) without an acquisition to bolster Net Income. 

Clear Use of Proceeds: Identify Target First, Seek Funding Second
Identifying a target first and marketing the transaction as the use of funds will be most compelling for a company that is struggling to stand on its own and requires a transformational acquisition to achieve its goals. Whether the buyer wishes to expand to new geographies, add products to its portfolio, or perhaps purchase a competitor with a stronger brand, the acquisition should be large and transformative rather than small and opportunistic. With the specific rationales in hand, a buyer will have a greater chance of financing the acquisition because investors can analyze the tangible benefits of the combined company such as larger revenue, cash flows, and feasibility of consolidating operations. 

The largest benefit of this process is that management can present investors with a clear use of proceeds, and investors will focus more on the combined company than the standalone outlook of the buyer. In addition, since the deployment of funds is concurrent with the close of a transaction, the buyer will not incur interest on idle funds. If the capital raised is in the form of debt, the interest expense is immediately supported by the larger operations. If the capital raised is in the form of equity, the larger Net Income offsets the increased share count, which then offsets EPS dilution and minimizes the negative effect on the stock price. 

A large drawback of identifying the target first, and therefore tying the funding to the transaction, is that if the transaction fails to close, the funding will be lost as well.The company will not retain the funds and lender diligence will have to be restarted if another target is identified. Additionally, the buyer strains its internal resources by running two complicated processes simultaneously: management responding to diligence requests from lenders while analyzing diligence provided by the target.

Conclusion
Growth by acquisition requires many important decisions along the way – first of which is how to fund it.  Although both of the processes above have their strengths, applying the wrong strategy will have a significant impact on the success of a transaction, and more broadly, the fate of your company. To learn more about this topic, or a myriad of other important considerations in developing your company’s acquisition strategy, please contact B. Riley & Co.  

 

This report is provided for information purposes only. The information provided herein shall not constitute a recommendation to buy or sell any securities. B. Riley & Co. does not make a market nor does it provide research coverage nor has it provided investment banking services within the last three years to any of the securities mentioned in this report.