What is Acquisition Debt?

Acquisition debt is money that is borrowed in order to purchase a company or asset. A leveraged buyout (LBO) is a method of acquiring a company with money that is nearly all borrowed.

How Does Acquisition Debt Work?

The basic idea behind acquisition debt 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 acquisition debt, the acquirer must therefore first make sure the target's assets are adequate collateral for the loan needed to purchase the target. The acquirer also must 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.

Once the acquirer has determined that the debt is financially feasible, it works on raising the debt. In some cases, the debt comes directly from one or more banks. In other cases, the acquirer issues bonds in the open market. Because the combined entity often has a high debt/equity ratio (near 90% debt, 10% equity), the bonds are usually not investment grade (that is, they are junk bonds).

Obtaining acquisition debt 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 transaction.

The pursuit of acquisition debt 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 also could 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.

Why Does Acquisition Debt Matter?

The purpose of taking on acquisition debt 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 that 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.