Preparing for add-ons now not later are critical for returns.

Written by:  The PE Guru – Gerald Moran O’Dwyer, III – Blackmore Partners, Inc.

Private equity firms are facing challenges in financing their add-on acquisitions due to concerns about increasing debt and its impact on existing investments. In the past, when interest rates were low and lending standards were lenient, these firms could easily fund add-ons using debt or credit facilities. However, the current economic landscape, marked by rising interest rates, cautious lenders, and existing covenants, has limited their debt capacity.  

Add-on acquisitions have gained prominence, constituting 78% of total US buyouts in the first half of 2023, as investors seek alternatives to platform acquisitions that require substantial debt financing. Despite this trend, the number of add-ons remains relatively small compared to previous years. 

In response to the changing environment, private equity managers are adopting different financing methods. Rather than relying heavily on debt, they are using a mix of cash reserves, additional equity from the PE owners and co-investors, and a combination of debt and equity to fund add-ons. This approach helps to maintain a manageable capital structure for the platform companies, ensuring compliance with credit covenants and providing financial flexibility in uncertain economic times. 

The use of more equity in add-ons allows PE firms to create a stronger combined business with ample breathing room to navigate future economic uncertainties. In the past, add-ons were often funded with significant leverage, but now, the preference is to strike a balance between lower leverage and higher equity injections. 

One of the primary concerns for acquirers is the potential triggering of “most favored nation” provisions in existing credit facilities. These clauses grant lenders the right to adjust existing debt terms if new loans receive higher interest margins, leading to increased interest costs for the entire debt facility. This has prompted caution when considering additional debt for add-ons.