Mergers & Acquisitions and the “Net Debt Adjustment” !

Mergers & Acquisitions and the “Net Debt Adjustment” !

Author: J.J.P. (Joris) Kersten, MSc RAB

Kersten Corporate Finance @ Uden/ The Netherlands

Sunday February 14th 2021

Source used - book: Crushing it as a corporate buyer in the middle market (2020). Kevin Tomossonie. Rock Center Financial Partners, New York.

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Introduction Kersten CF

Kersten Corporate Finance is an independent M&A consulting firm in The Netherlands.

Deal segment: Middle sized and SME companies. So companies with an Enterprise Value (EV) of in between 2 million euro and 50 million euro @ The Netherlands and Benelux.

Activities:

1.    Selling companies;

2.    Buying companies;

3.    Business Valuation & Financial Modelling;

4.    Financing of acquisitions with bank loans and/ or private equity firms;

5.    Buy & Build strategies for strategic buyers and private equity;

6.    Searching & selecting acquisition targets;

7.    Finding multiples for precedent M&A transactions in a certain field.

Website M&A consulting: www.kerstencf.nl

Website M&A training: www.joriskersten.nl

M&A training:

·      Business Valuation & Deal Structuring – 6 day training – 7 until 13 April 2021 – Location: Hotel van der Valk Uden/ The Netherlands – Also online available on live stream. 29 PE points for Registered Valuators (RV) from NIRV;

·      Business Valuation & Deal Structuring – 6 day training – 29 September until 5 October 2021 – Location: Crown Plaza Hotel Amsterdam South – Also online available on live stream. 29 PE points for Registered Valuators (RV) from NIRV.

In addition, Joris provides valuation training all over the globe on (bulge bracket) investment banks and universities in: New York, London, Hong Kong, Singapore, Dubai, Saudi Arabia, Kuwait, Mongolia, Surinam and Peru.

130 references on M&A training: https://www.joriskersten.nl/nl/reviews

Net debt adjustment

Yesterday I started a blog with an introduction to “cash & debt free” in M&A.

And today I will continue on this topic with sub-topic “adjusted net debt”.

When you are interested, the article from yesterday can be found on the link below:

https://www.dhirubhai.net/pulse/mergers-acquisitions-done-cash-debt-free-basis-kersten-msc-bsc-rab/?trackingId=RioJPbzb7Z5mhbYoS38l3g%3D%3D

Net debt adjustments are commonly used and accepted in M&As in The Netherlands (where I am from) and all over the globe.

But things get a little complicated on how a buyer and seller choose to define what should be included in “debt”.

This since there is a “grey area” on what “debt” and “debt like items” are.

And anything that the buyer sees as debt will be subtracted from the “headline price” (enterprise value).

But this also reduces what the seller gets in the end.

So here you see the potential problem!

(Kevin Tomossonie, 2020)

Defining debt

When it comes to defining debt in an M&A transaction, some line items from the balance sheet are (almost) always included.

Think of:

·      Interest bearing loans;

·      Bonds;

·      Notes payable;

·      Other long-term debt like obligations.

Unpaid dividends are also treated as debt in M&A.

Just so that a seller does not declare a lot of dividends that need to be paid by the buyer after the transaction is closed.

So most M&A lawyers have a standard list of debt items in M&A transactions.

And here it is very important for you as a Corporate Finance advisor to cooperate with the lawyers, this in order to give the financial economic input in the agreements !!

But sometimes there are special items that can also be treated as debt in an M&A deal.

These type of debt items generally fall within three buckets:

1.    There could be obligations that were created but what really were finance decisions by the seller;

2.    There could be “legacy liabilities” from things that happened a long time ago but still haven’t been paid;

3.    There could be things that a buyer is just not willing to pay.

Examples of these debt items are:

·      Accrued interest;

·      Financial lease obligations (also operating lease obligations, still there under Dutch GAAP, as I am from The Netherlands);

·      Liabilities related to hedging activities/ financial instruments;

·      Unfunded pension obligations;

·      Unpaid employee severance;

·      Restructuring liabilities;

·      Past due payables to suppliers (stretched beyond normal terms);

·      Payables to related parties;

·      Income tax liabilities.

And at the end, these debt items are finally addressed in the due diligence.

(Kevin Tomossonie, 2020)

Debt versus operating liabilities

Debt items should not be confused with normal operating items.

Examples of normal operating items are:

·      Payables to suppliers (that aren’t yet due);

·      Accrued payroll;

·      Accrued rent;

·      And all other operating expense type items that are normally incurred in businesses (and aren’t due yet).

Concerning these working capital items, these are separately covered in the share purchase agreement (SPA).

I will talk about how to deal with working capital adjustments in M&A in the next blog.

(Kevin Tomossonie, 2020)

Negotiating debt and debt-like items

Now we have concluded that it is not always clear what debt and debt like items are in M&A.

That’s why I advise you as a buyer to be very clear about debt items.

For example, when you place a bid on a certain target company, then for example place the bid on:

1.    A certain times (cleaned) EBITDA;

2.    Cash & debt free;

3.    AND define what you mean with debt !!

By defining “debt” in the bidding phase already, and later in even more detail in the letter of intent (LOI), there will be less confusion when determining “adjusted net debt” when closing the deal.

When you do not address the definition of debt early in the deal, then you might get the feeling of re-negotiating the deal over and over again in the M&A process.

(Kevin Tomossonie, 2020)

Source used - book: Crushing it as a corporate buyer in the middle market (2020). Kevin Tomossonie. Rock Center Financial Partners, New York.

In the following blogs on this topic I will talk about:

·      Working capital adjustment;

·      Working capital targets;

·      Locked box mechanism.

Please leave your email address in the comments below when you want to receive my monthly valuation/ M&A articles in your email box in PDF (100% free and also free of any subscription).