When acquiring a company or business, one of the main issues for an acquirer is how to finance the acquisition. Except the acquirer is in a position to complete the deal using existing cash reserves, its main sources of funding for the transaction will usually be either (or a combination) of debt finance (by borrowing from banks and other financial institutions by way of loans or debt securities) or equity finance (through the issuance of new shares to existing shareholders and/or third party investors). So, essentially, acquisition finance refers to the different sources of capital for funding an acquisition. It is usually a complex process which requires thorough planning as acquisition finance structures come with a lot of variations and lending sources unlike most other transactions.1
In coming to a decision as to the method of financing an acquisition, several factors can influence an acquirer's choice in this regard namely the comparative cost of debt and equity. For cost of debt, the main factor to be considered is the interest rate at which the acquirer borrow. In other words, the rate a company pays on its debt, such as debt securities and loans2. On the other hand, the cost of equity is calculated by reference to anticipated shareholder returns such as dividends, capital appreciation and share buybacks.
In addition to the comparative costs as mentioned above, other considerations that can influence the acquirer's choice of financing include its existing capital structure which may enable the acquirer to finance the acquisition by an issue of shares. The acquirer's ability to borrow may also be restricted or limited by its articles of associations or by the terms of existing loan agreements or other debt instruments as they may have provisions which place restrictions on the amount of debt that the acquirer/borrower can incur without the lender's consent.
Other factors to be considered include the rating of the acquirer's shares in the market because if its shares are highly rated, it may be desirable for the acquirer to finance the acquisition with its own equity to take advantage of the high valuation) and the tax implications of the financing option.
Methods of Raising Acquisition Finance
The appropriate type of finance for the acquisition will depend on the size and creditworthiness of the acquirer, the availability and quality of security that can be given, the amount of money required and if applicable, the ability to structure the debt within the acquirer's group in a tax-efficient manner. As stated earlier, the typical financing options are debt and equity and we will attempt to explain them briefly in the following paragraphs.
Debt finance can be broadly divided into:
1. Loans: A loan is the simplest and the most common form of debt finance. A loan may come from a single lender, otherwise called a bilateral loan, or a group of lenders, otherwise referred to as a syndicated loan. A syndicated loan is a common source of finance for large acquisitions where each lender in the syndicate commits to make a loan to the borrower on common terms and conditions governed by the facility agreement.
2. Debt Securities: Debt securities are any form of financial instruments issued to create or acknowledge indebtedness. They can be by way of bonds, or by issuing short term notes in the debt capital market.
3. Leveraged Buyout: This is a unique mix of both equity and debt. In a leveraged buyout, the assets of both the acquiring company and target company are considered as secured collateral. The idea behind a leveraged buyout is to compel companies to yield steady free cash flow capable of financing the debt taken on to acquire them.
4. Debt packages: Debt from different sources may be used to finance a large acquisition, and lenders will be required to decide how their debt ranks on the borrower's liquidation. A debt package may include
- Senior debt. This is a loan from a single lender or a syndicate of lenders that ranks ahead of any unsecured and subordinated debt on the insolvent liquidation of the borrower by virtue of security and intercreditor arrangements (subject to legal restrictions and practical constraints).
- Mezzanine debt. This is a debt which ranks behind senior debt but ahead of unsecured and other subordinated debt by virtue of security and intercreditor arrangements and which includes both equity and debt features. It usually comes with a bullet repayment option and may have early prepayment fees. As with senior debt, mezzanine debt can be secured, although the security ranks behind the senior security. It usually comes with an option of being converted to equity.
On equity finance, the main methods by which companies can raise equity finance are as follows:
(i) Rights issues. This involves an offer of new shares to existing shareholders on a pre-emptive basis in proportion to their existing shareholdings.
(ii) Placings. This involves issuing shares for cash on a non pre-emptive basis to existing or new shareholders. In a placing, the recipients of shares are usually institutional shareholders who are likely to hold the shares as a long-term investment. This process is usually quicker than a preemptive offering because it is usually structured so that it is neither a public offer nor of sufficient size to trigger the requirement for a prospectus.3
Taking Security in Acquisition Finance
Generally, acquisition finance transactions are considered relatively risky by lenders due to the large amount of debt that will need to be raised. For this reason and for the purpose of taking priority, lenders will normally expect a comprehensive guarantee and security package from the borrower and any material subsidiaries. Indeed, the primary purpose of security is to reduce credit risk and obtain priority over other creditors in the event of debtor's bankruptcy or liquidation.4 A properly created and perfected security package will improve the position of the lenders in an insolvency, giving them priority over other creditors of the acquirer/borrower in respect of the charged assets.
When taking security over the acquirer/borrower's assets or accepting corporate guarantees, it is important that the lender considers certain legal issues such as:
The security may be in breach of covenants in existing security documents, such as a negative pledge:
(i) Company law restrictions on a group company giving guarantees and/or security over its assets in respect of facilities made available to another company in the same group.
(ii) Restrictions in a company's constitutional documents or/and any shareholder agreements.
(iii) The requirement to register security created by a company within a specified period of its creation, which is 90 days5 under Nigerian law, so that it will not be void against a liquidator, administrator, or any other creditor.
Forms of Security
In acquisition finance, the type of security typically created include charges, mortgages, and pledges.
(i). Mortgage: This is created by the transfer of ownership in an asset by way of security, subject to an express or implied condition which requires the mortgagee to transfer title back to the mortgagor when the obligation for which the security was created is discharged. Mortgages involve a security transfer of ownership and what distinguishes a mortgage from an outright sale with a right of repurchase is the intention that the transfer is to secure the performance of obligations, for example, the repayment of a debt. This transfer of title enhances the lender's ability to realise the security and prevents the mortgagor from disposing of the asset.
(ii). Pledges: A pledge involves the actual or constructive transfer of possession of an asset to a creditor and can only be used for assets whose title passes by delivery. Under a pledge and as distinguished from a mortgage, ownership of the asset remains with the pledgor but the creditor has a power of sale if the pledgor defaults on its payment obligations. A pledge is created by depositing the assets which may be a property, machinery or equipment, and in certain cases, the title documents to the aforementioned assets with the lender as security for the debt, on condition that the pledged assets will be returned to the upon the discharge of the debt by the borrower, or sold if the borrower defaults. It is important to note that only items of property capable of being delivered (including documents of title to property, such as bills of lading and bearer securities) can be pledged.
(iii). Liens: A lien can arise as a common law right from general usage or by agreement. It gives a creditor the right to retain possession of an asset until an obligation has been discharged. Although it does not confer a power of sale, a power of sale is sometimes granted by agreement between the parties or by custom6. Liens tend to be less important in finance transactions because they are generally security interests arising by operation of law rather than being granted by a borrower.
(iv). Charges: A charge does not involve any transfer of title to an asset and is therefore an equitable interest. It is an agreement between the chargor and the chargee which gives the chargee a right to sell the asset and to apply the proceeds in discharging the obligations of the chargor. Usually, lenders will not want to take possession of a debtor's assets and a debtor will not want to lose control of its assets, especially if they are used in the day-to-day running of its business. Accordingly, a lender will want to take security by obtaining rights over, but not necessarily possession of, specific assets of the debtor as security for the loan. A charge enables a lender to do this. A charge can be thought of as an encumbrance over an asset. It confers on the chargee an equitable proprietary interest in the charged property, giving the chargee the right to appropriate the charged property and have the proceeds of sale applied in satisfaction of the debt. It does not confer a right to possession.7 It is important to note that it is not a necessary characteristic of a charge that the chargee is either the creditor to whom the secured liabilities are owed, or a trustee or other fiduciary of that creditor. Charges can either be fixed or floating. While a fixed charge attaches immediately to the charged asset which is ascertained and definite, a floating charge hovers above a shifting pool of assets until it crystalizes. The key difference between a fixed and a floating charge is the lender's control over the charged asset, therefore if a charge is described as a floating charge and there are circumstances where there are severe restrictions on the owner's rights to deal with the property under the charge, the charge in reality may be a fixed charge8.
Unlike the forms of security interests highlighted above, a guarantee is simply a promise to ensure that a third party fulfils its obligations and/or a promise to fulfil those obligations if that third party fails to do so9. Put differently, it is an accessory contract (i.e. a suretyship arising out of contract), by which the guarantor undertakes to be answerable to the promise for the debt, default, or miscarriage of the principal.10 Indeed, the courts have repeatedly held that where a person guarantees the liability of another, a distinct, separate, and enforceable contract is created between the guarantor and the creditor.11 It is important to note that the guarantor's obligation is contingent on the primary obligation, and it will therefore not be greater than that of the obligor under the underlying agreement. Furthermore, if the primary obligations become unenforceable then the secondary obligation also becomes unenforceable, as, there is no enforceable obligation to guarantee. To address this, the guarantee should be worded as an indemnity, which would create a primary obligation on the part of the guarantor in favour of the lender. Finally, because the guarantor does not receive consideration for providing the guarantee, it should be executed as a deed by the guarantor to ensure the guarantor is bound by its terms.
Perfection of Security
When a creditor/lender takes security, it will be concerned with three issues: whether the security is binding on the borrower, that is whether the security has been validly created), whether the security is enforceable against third parties, and whether the security has the intended priority as against other creditors with competing security interests in the same assets.12 Perfection is therefore a means of providing notice to third parties about the existence of security interest in the asset in question. Perfecting security refers to the steps taken following creation of the security to ensure enforceability against third parties such as creditors, liquidators and administrators, and in the event of default by the borrower, a secured creditor will be able to follow the assets into the hands of the receiver or to claim the proceeds of the disposal.13
Once a valid grant of security has been made, in order to ensure that such security is enforceable against unsecured creditors and other third parties, such security interest needs to be perfected. Perfecting security can be done in any of the following ways:
(i)Possession: The secured party or a security trustee may need to take actual possession of the asset in question, for example physical share certificates and other negotiable instruments.
(ii)Registration: The security interest may need to be registered in a registry, for example for landed assets, at the lands' registry or for ships and marine vessels, at the Ships Registry.
(iii)Title transfer: An actual transfer of the title to the asset in question to the secured party may be required, and this is often the case with legal mortgages.
Depending on the asset, perfection of security in Nigeria generally requires stamping the relevant security documents and registration. In addition, the creation of security over certain types of assets may require the consent of certain regulatory bodies, for example the Federal Inland Revenue Service (the "FIRS"). Additionally, section 22 of the Stamp Duties Act 2004 (SDA) requires instruments or documents creating security over assets situated in Nigeria to be stamped and this will guarantee their admissibility in evidence in civil proceedings before Nigerian courts.
Furthermore, all Nigerian companies are required, in accordance with the CAMA14 to register charges created by them over their assets within 90 days of the date of its creation with the Corporate Affairs Commission (CAC), and failure to undertake the registration will result in the charge being void against a liquidator and any competing secured creditor of the company(in respect of such asset. In addition, under the Secured Transactions in Movable Assets Act15, security interests in movable assets can also be registered at the National Collateral Registry in Nigeria. As previously mentioned, the consent of a regulatory body may be required to create security on a particular class of assets. For instance, under Nigerian law, the creation of a legal mortgage over real property will require the consent of the Governor of the State where the land is situated or, in cases of lands situated in the Federal Capital Territory, Abuja, the consent of the Minister of the Federal Capital Territory.
Under Nigerian law, security documents are required to be stamped within 30 days of execution and where the documents are executed outside Nigeria, they are required to be stamped within 30 days after the date on which the instrument or a copy could, in due course of post, and if dispatched with due diligence, have been received in Nigeria. There are some documentary taxes and stamp duties payable on the grant of a loan, guarantee or security interest in Nigeria. They include:
(i). Stamp duties: Pursuant to the SDA, all instruments executed in Nigeria or relating wheresoever executed to any property situate or any matter or thing done or to be done in Nigeria, will not, except in criminal proceedings, be given in evidence or be available for any purpose whatever, unless it is duly stamped. Thus, where loan or security documents fit this bill, they will require stamping. Stamp duty is also typically paid on loan agreements and security documents on an ad valorem basis.
(ii). Asset registry fees: Where the property to be used as security consists of a property with its own registry, security over such asset must be registered at the relevant registry and registration and other administrative fees may be payable.
(iii). CAC fees: For the registration of security at the Corporate Affairs Commission, fees are charged ad valorem on the value of the loan.
(iv). Value added tax: Value added tax is chargeable on fees and other vatable supplies in respect of the loan documentation and perfection of security.
In addition, other fees may be payable on the enforcement of security, and such fees may vary depending on where the security is situated. It is important to note that security interest can be created over all the assets of an entity. In this case, one security document will suffice, and this is typically called an `all asset debenture' in Nigeria.
For the purpose of acquisition finance, in addition to requiring a corporate guarantee, the lender or financier may take security over any of the following class of assets namely shares and intellectual property. With respect to shares, security can be taken over the shares of a company by way of a mortgage or a charge. It is however important to note that in Nigeria, shares in companies are issued in registered form and therefore, a pledge of shares by mere delivery of the share certificates to the secured party would not be an effective means of creating security as a share certificate is merely evidence of title and not an instrument conferring title. Consequently, the most common forms of security that can be granted over financial instruments in Nigeria are legal or equitable mortgages or charges. On the creation of security over intellectual property, the forms of security that can be taken are mortgages, charges, or security assignments.
For guarantees, and all forms of security interests, the common enforcement triggers include default in financial or other obligations under the facility agreement, failure of the borrower to pay any instalment of principal sum and interest, or the whole or part of the principal or any interest, owing under the facility documents amongst others. In Nigeria, the common procedures for enforcement in the event the loan is accelerated, are the appointment of a receiver or a receiver and manager in respect of the security, and this may be made by the court on application of the creditor once the debt is due or out of court, taking possession of the security asset, enforcement of claims vested in the company, exercising the power of sale to dispose of the security assets, subject to the leave of court, bringing a foreclosure action; and winding up the company.16 However, lenders must comply with the CAMA and the terms and conditions of the security document for valid enforcement.
As stated above, companies seeking to acquire other companies can raise money by a plethora of methods such as taking loans from a bank or other financial institutions or by issuing debt or equity securities. However, for lenders to have a safety net against risk of default by the acquirer/borrower, it is advisable to request that the borrower provide some form of security as collateral for the loan. In the alternative, the lender can request that the borrower procures a corporate guarantee for the loan and ensure that the guarantee is worded as an indemnity so that the guarantor becomes primarily liable to the lender for the loan.