Trends in financing M&A deals

In this challenging environment, M&A transaction volumes and values continue to be more modest compared to recent years as buyers remain more cautious. But although lenders strengthened their lending criteria in the wake of higher interest rates, the tide may be turning as downward-trending core inflation has enabled central banks in several CEE economies to focus on potentially trimming interest rates in the year ahead. Against this background, acquisition finance has been evolving rapidly to adjust to the new paradigm.

According to Paul Stallebrass, partner at CMS in Prague, banks are not necessarily averse to M&A financing. “Indeed, we’ve seen deals refinancing existing transactions, which have been very successful,” he says. “From the banks’ perspective, they do not feel that they can’t finance M&A deals; they seem very happy to. The difficulty has been the relative absence of deals.”

The key problem, he notes, is that financing is available, but very difficult to price, making it harder to rely on rising EBITDA multiples. “And if it’s difficult to price the financing, it’s difficult to price a deal because if you don’t know how much your financing is going to cost in interest terms, then you don’t know what price you should be paying for the asset,” he explains. “Certainty has been lacking with interest rates. But over recent months, they have steadied and are now at a level that people can predict are unlikely to increase significantly.”

Jakub Wieczorek, partner at CMS in Warsaw, develops the point. “Although interest rates are still high, many investors now believe they will decrease in the months and years ahead,” he says. “They have also adjusted to higher rates. At first, it was really difficult for them to invest in such an environment, but they have just got used to it.”

Higher rates have, nevertheless, brought changes in traditional M&A financing, notes Jelena Nushol Fijačko, partner at CMS Croatia. “In 2023, there seemed to be an increased use of alternative financing instead of traditional bank loans,” she says. “Traditional bank loans may have also become more stringent and less accessible.”

Fijačko notes that, “alternative structures are filling financing gaps where traditional lenders may not be willing to make a significant contribution to bridging the gap in M&A transactions, especially where they are unable to meet the requirements of these deals. Alternative structures, such as mezzanine financing, venture debt or private equity, can offer more flexible terms than traditional bank loans.” Alternative lenders, she adds, “may have a higher risk appetite and be able to provide more flexible financing solutions to meet the needs of M&A deals.”

Wieczorek offers a different perspective in Poland. “The vast majority of M&A transactions are still financed by traditional Polish banks. We have all seen alternative structures and sources of lending growing, but expectations about this have been around for the last ten years, and the level of growth is really very slow. That’s due to the competition because domestic Polish lenders are able to offer a lot of flexibility and quite competitive pricing.”

On structures, he adds: “Lenders would rather try to strip the terms and increase the margin for buyers. We don’t see any parent company guarantees, and the security package has not changed significantly, at least in Poland, because the Polish lending market is pretty specific. Borrowers feel that they are able to negotiate much more than previously. So, structures are becoming more and more aggressive.”

There have been a very small number of deals done with debt funds or with bonds, according to Stallebrass. “The high yield bond market in CEE for acquisitions is very limited: a blue-chip sponsor and a very large transaction,” he says. “The local markets are much more local bank driven. Even in a big transaction with a prime sponsor, most of the funding will come from local banks: they have a high level of liquidity for these kinds of transactions, which partly explains the absence of debt funds.”

Alternative structures often allow for quicker approvals and disbursements, adding speed and efficiency which are important elements in the M&A environment. Another very important element that alternative structures can deliver is bridge financing. Access to interim funding until a longer-term financing solution is secured can be critical in M&A transactions. In structuring some deals, where valuation or funding gaps exist, bridging them can be achieved through bespoke pricing structures.

David Kohl, partner at CMS Austria, says: ‘One way to bridge valuation and funding gaps is to make the total consideration received by sellers more contingent on the post-closing performance of the target company via elaborate earn-out mechanisms. We’ve already seen an increasing trend of earn-outs being used in deals throughout most sectors. The current economic climate and rising uncertainty has widened the valuation gap between sellers and buyers, due to diverging performance expectations.”

Earn-outs can enable the gap to be bridged by shifting some of the future performance risk to the seller and reducing the liquidity burden for the buyer at closing, by pushing payments into the future.

“We also see more step-wise acquisitions, where buyers in a first step buy less than 100% of the target, or even a minority stakes,” says Kohl. “Again, this allows buyers to share future performance risks with the seller, bridging potential valuation gaps, and lowering short-term funding needs. Particularly in greenfield investments, we also see an increased use of JVs to achieve similar effects.”

For private equity, market conditions have also been challenging: PE and higher interest rates rarely align well together because it is harder to finance acquisitions primarily through debt. Increased global uncertainty has inevitably led some local PE players in CEE markets to accelerate their exits, while banks have also become increasingly unwilling to provide the leveraged financing on which many PE houses rely.

But driven by the necessity to invest, PE activity has begun to increase across the CEE region. “There’s a huge amount of liquidity in the PE market that has to find a home, and find it soon,” says Stallebrass. “The situation has to change, and it will over the next six months because of the enormous amount of dry powder. If you are a PE fund and you end up returning money to your LPs (Limited Partners), you’re history: you will never raise another fund.”

Kohl believes that PE will become increasingly competitive in finding new CEE deals. “This is due to the large amounts of dry powder that prevail and the increased demand in yields by investors,” he says. “Given the current macro-economic challenges in the CEE region paired with industry-specific challenges, we expect a rise in opportunities to invest in distressed assets and companies at relatively low valuations.”