Buy-and-build boom sees add-on debt surge

Issuers are tapping institutional loan markets for add-on debt at a rapid pace as private equity firms turn to buy-and-build strategies to lower entry multiples and accelerate deployment

Debt issuance to fund add-on acquisitions soared in the past 12 months, as private equity (PE) firms turned to buy-and-build investment strategies to deploy capital at reasonable valuations in a highly competitive market.

According to McKinsey, buy-and-build strategies — where PE firms buy a platform business and build out scale with a series of smaller add-on acquisitions — historically accounted for 40% of PE deal volume, but grew to a 70% share in 2021.

Rising add-on activity tracked the record levels of financial sponsor investment. Global buyout and secondary buyout deal value totaled US$1.5 trillion in 2021, almost double the previous record of US$846.8 billion posted in 2007. This in turn produced a record-breaking year for leveraged finance issuance intended for buyouts — for example, in North America and Western and Southern Europe, funds for this purpose reached US$328.1 billion by the end of last year.

The popularity of the buy-and-build approach only increased as overall PE deal flow accelerated. Financial sponsors recognize that smaller add-on deals carry lower execution risk than large, full-blown acquisitions and they are simpler to finance and manage from a regulatory standpoint. When done well, buy-and-build deals can also improve profitability by unlocking synergies, introducing new products and services and allowing the company to expand into adjacent geographies.

With PE firms sitting on record levels of dry powder (more than US$3 trillion according to Bain & Company), add-on deals also helped financial sponsors deploy capital across a wider pool of targets and secure lower entry valuations as smaller assets typically price at lower multiples.

Add-on abundance

The rise in add-on activity was buoyed by a willingness in leveraged finance and direct lending communities to provide financing packages for PE buy-and-build acquisitions.

According to Debtwire Par, issuers in North America tapped institutional loan markets for record monthly add-on issuance of US$13.6 billion in October 2021 and US$7.6 billion in November 2021, pushing the year’s total to US$68.3 billion — its highest level since 2017.

In Europe, meanwhile, figures from Deloitte for the nine-month period ended in Q3 2021 show that one-fifth of direct lending deals at the time were for add-on acquisitions.

For example, UK software company Iris secured an upsized £125 million add-on loan to repay revolving credit facility drawdowns used to partially-fund recent acquisitions. Platinum Equity’s France-based Biscuit International raised an add-on €205 million term loan B to fund its purchase of Continental Bakeries. Ardian-backed diagnostics business Inovie, which announced six add-on deals worth around €600 million in 2021, according to Fitch, launched a €775 million term loan B add-on at the end of 2021.

Exploring the options

It has been extremely helpful for sponsors in competitive deal situations to provide evidence of committed financing to demonstrate deliverability of their offer to sellers.

In terms of loan markets, sponsors have mainly funded add-on acquisitions through fungible (debt treated as part of the same tranche of an original loan) or non-fungible incremental term loan facilities. Sponsors can also raise financing outside of existing credit agreements, arranging what is known as incremental equivalent debt in side-by-side credit facilities. Fungible tranches, however, have been the preferred option. The financings for Biscuit International and Inovie, for example, were both fungible deals.

Direct lenders, meanwhile, have structured many of their products so that buy-and-build platform credits have access to a committed acquisition finance line. This usually takes the form of a delayed draw term loan facility that offers upfront commitments to provide debt to finance acquisitions over a set period, usually between 12 and 36 months after the closing of a debt package. These delayed draw term loan facilities will typically include a leverage governor (set at closing date levels) as a condition to draw down.

Borrowers have enjoyed further flexibility when it comes to meeting leverage thresholds and tests put in place when a debt package is agreed. Most deals will include a “free-and-clear” or “freebie basket,” which allows sponsors to incur additional debt capacity in the form of incremental loans or incremental equivalent debt without having to meet any leverage test. In such a case, borrowers can increase leverage above closing date levels. Also, typically to utilize the “incurrence-based” prong of the incremental loan facilities, borrowers would have to be in pro forma compliance with the applicable closing date leverage level (without taking into account, however, any concurrent use of the “free-and-clear” prong, which again permits borrowers to increase leverage above the applicable closing date level). Further, in many cases, sponsors have been able to negotiate “no worse than” tests, which enable businesses to make acquisitions using incremental debt capacity as long as the applicable leverage ratio is no worse than such leverage ratio immediately before the acquisition on a pro forma basis.

Liquid debt markets have made it possible for PE firms to negotiate this flexibility into debt packages for platform businesses. Sponsors also are making the most of current tailwinds to broaden their lender bases and maximize the number of lenders they can turn to when raising extra financing for add-on acquisitions.

Sponsors prefer to approach incumbent lenders as a first port of call for additional debt to fund acquisitions, which also now includes a larger group of private debt providers for added flexibility when planning add-on deals. Having access to a larger group of incumbent lenders who know a credit reduces the execution risk and costs involved in raising financing for add-on acquisitions.

McKinsey expects buy-and-build strategies to continue gaining traction in 2022, which in turn should support a sustained pipeline of add-on deals.

All financing options are set to remain open to PE firms, on borrower-friendly terms, as they continue to pursue add-on targets for their portfolio companies.

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