Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Acquisition Loan

What it is:

An acquisition loan is money borrowed specifically to purchase a company or asset.

How it works (Example):

The basic idea behind acquisition loans is that the acquirer purchases the target with a loan collateralized by the target’s own assets. In hostile takeover situations, the use of the target’s assets to secure credit for the acquirer is one reason that the tactic has a predatory reputation.

To obtain an acquisition loan, the acquirer must therefore first make sure the target’s assets are adequate collateral for the loan needed to purchase the target. The acquirer must also create and study financial forecasts of the combined entities to make sure they generate enough cash to make the principal and interest payments. In some cases, maintaining optimal cash flow could be a real challenge if the target’s management team leaves after the acquisition.

In some cases, an acquisition loan can come directly from one or more banks. (Sometimes acquirers issue bonds in the open market.) Obtaining acquisition loans is often expensive and complicated, and when a particular deal is especially large, there is often more than one acquirer, which allows for sharing of the risks and expenses (and rewards). An investment bank, a law firm and third-party accountants are often necessary to correctly structure the loan and the transaction.

Why it Matters:

The purpose an acquisition loan is to make a large acquisition without having to commit a lot of capital, but the even greater purpose is to maximize shareholder value. If the acquisition creates a stronger, more efficient, more profitable entity, then most shareholders agree the debt is worth the trouble. But if debt levels are too large or the synergy just isn’t there, the company may not be able to service its debt and could go bankrupt.

This high level of risk is why share prices usually fall when a company announces news of an acquisition involving a lot of debt. This, however, can be a buying opportunity if investors think the company will be able to pay down the debt, which increases the value of the shares.

The pursuit of acquisition loans usually increases when interest rates are low (this reduces the cost of borrowing and encourages investors to seek high-return opportunities) and/or when the economy or a particular industry is underperforming (and thus company values are falling). However, an increase could also signal more competition for deals, which tends to bid up the price for targets, further increasing the debt needed for acquisitions and increasing the chances a combined entity won’t be able to support its debt obligations.

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