Underwriting In A Merger and Acquisition Setting

It’s hard to believe that it’s the middle of 2024 already. We’re here to provide a mid-year outlook on merger and acquisition activity and to give tips about how to take advantage of opportunities.

Specifically, we’ll look at the underwriting process in financing and explain how to position your business to improve the likelihood of financing approval. To learn more about these topics, check out our webinar, “Beyond Underwriting: Strategy and Insights” and our podcast, “Deep Dive into the 5 C’s: Understanding Credit.”

→ Watch Now: Beyond Underwriting Webinar

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Mid-Year Market Conditions

Inflation remains sticky, although it’s slowly making its way toward the 2% annual rate the Fed has targeted. Hopes for four rate cuts in 2024 have mostly dissolved, but May’s improving inflation numbers suggest at least one rate cut by the Fed could happen this year, perhaps in September.

While the cost of borrowing is still higher than it has been for several years, business borrowers have mostly adjusted to the new normal, and M&A activity in the RIA and CPA industries is strong. Buyers and sellers are taking advantage of deal creativity finding new ways to finance deals and move opportunities forward.

Adam Farag, vice president of strategic market sales at Oak Street Funding, points out higher interest rates don’t make a good deal bad. In his words, “We've done stress tests on a lot of deals in our portfolio, and if you have a 6% rate or a 9% rate, I don't know that there's enough variance there where we'd say, ‘Hey, this was a good deal at 6% interest and now it's not.’” It’s the fundamentals of the deal that determine if it will work, not the interest rate.

The role of underwriting in M&A

Just as in the insurance world, underwriting in M&A is all about assessing risk. The role of the M&A underwriter is to determine if the potential borrower will be able to pay back the loan. In a traditional loan environment – say, a home mortgage – the collateral for the loan is the house itself, and the underwriter needs to assess whether the borrower’s income is sufficient to support the principal and interest payments. The lender’s risk is offset by the value of the house; should the borrower default, the lender can sell the house to recoup its loan.

→ Listen Now: Deep Dive into the 5C's of Credit

In commercial lending, especially in businesses with assets primarily made up of cash flow rather than physical items, such as buildings and equipment, the situation is somewhat different. The underwriter must ascertain whether the business will continue to have sufficient cash flow to remain profitable while maintaining the debt service. That means getting to know each potential borrower’s business model, specialty areas and client base while taking an intensive dive into financials.

What do underwriters look for?

At the heart of any lending decision underwriters use criteria based on the 5 C’s of credit: character, capacity, capital, collateral, and conditions.

• • Character represents the borrower’s history with debt. Do they pay their obligations on time? Have they been responsible borrowers in the past?
  • Capacity has more to do with the business itself. Will it have sufficient cash flow after the acquisition to maintain the debt service and still be able to grow?
  • Capital is the amount of equity the borrower can bring to the table, either as a down payment or as equity in the business. Lenders may be able to grant better terms or loan higher amounts if the borrower provides more capital.
  • Collateral is the predicted cash flow of the combined businesses.
  • Conditions refer to the overall state of the economy and the borrower’s industry. The better those conditions are, the less risk the lender is taking on, and the more likely a borrower is to be approved.

How to prepare for an acquisition

Start conversations with a lender early, even before an acquisition is identified. It takes time for a client and a lender to get to know each other, so it’s important to allow time for that step.

Communicate what you want to achieve with an acquisition. Are you looking to strengthen your specialty areas by purchasing a firm with similar business verticals? Are you consolidating with another general firm to increase capacity? Either option can be a good move, but it’s important to have a clear idea why you’re making the acquisition. You need to communicate your business goal not only to the lender, but also to staff and clients, if the deal goes through.

Underwriters will look at your firm’s history of organic growth and client retention. These factors are good indicators of the company’s health and its ability to maintain profitability after the acquisition. The collateral for the loan is the cash flow of the combined businesses, so the underwriter will be ascertaining whether that cash flow is strong enough to support the debt service.

Spend time to ensure the company books are in order. Three years of clean financials will be required, and all regulatory requirements will need to be up to date. Problems with any of these areas can cause a deal to be delayed or fall apart completely.

→ Read Now: How to Value an Acquisition

How Oak Street Funding’s underwriting process is different

With many lenders, the underwriting team works in the background, and the client may never meet them. Our underwriters are involved very early in the process, and they often make on-site visits to clients to get to know them and their businesses better.

By taking the time to really understand a client, our underwriters make better projections related to the client’s ability to repay a loan without unduly stressing the business. It’s in no one’s interest for a client to take on more debt than they can handle, so having underwriters take a deep dive into client financials and operations protects everyone involved.