Acquisition finance: funding sources for acquisitions, Practical Law UK Practice Note...

Acquisition finance: funding sources for

acquisitions
by Practical Law Finance and Practical Law Corporate

Practice note: overview | Maintained | United Kingdom

Scope of this note

Debt versus equity
Methods of raising debt finance
Loans
Debt securities
Syndicated loan versus bond issue
Multiple layers of debt
Security and subordination
Structuring debt: tax
Methods of raising equity finance
Rights issues
Open offers
Placings and bought deals
Cash box placings
Vendor placings
Factors influencing fundraising structure
Equity issues: regulation and other guidelines
Calculating the cost of equity
Debt or equity: impact on earnings
Acquisition finance in the United States

An overview of the most common forms of debt and equity finance for funding a corporate acquisition, and the
key commercial factors that can influence the buyer's choice of finance.

This note also contains a link to an overview of acquisition financing by equity and/or debt in the United States.

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Acquisition finance: funding sources for acquisitions, Practical Law UK Practice Note...

Scope of this note

One of the main issues for a buyer when acquiring a target company or business is how to finance the
acquisition. Unless the buyer is in a position to complete the deal using existing cash reserves, its main
sources of funding for the transaction will usually be either (or a combination) of:

• Debt finance, which involves borrowing by way of loans or debt securities.

• Equity finance, which involves issuing new shares to existing shareholders and/or third party
investors.

This note considers the key commercial factors that can influence the buyer's choice of finance, and
provides an overview of the most common methods of raising debt and equity finance.

As funding an acquisition through equity finance tends to be a more readily available option where the
buyer is a quoted company (due to the greater marketability and liquidity of listed shares), this note
focuses on the different methods of issuing shares for companies with a premium listing of equity shares
on the London Stock Exchange (LSE).

For information on raising equity finance in transactions where the buyer is a private limited company
backed by venture capital or private equity investors, see Practice notes:

• Private equity buyouts: overview: Equity finance.

• Equity finance aspects of private equity transactions.

For general information on issuing shares, see Practice notes:

• Allotment and issue of shares.

• Pre-emption rights: allotment of shares.
• Share capital: overview: Alterations to share capital.

Debt versus equity

A buyer may be unable to fund an acquisition out of existing resources. If so, the two main funding
options are to borrow money, including by way of bank loans and/or by issuing debt securities (debt),
or to issue shares (equity) (or a mixture of the two).

While a variety of factors can influence the buyer's choice of finance for an acquisition, a key issue is
likely to be the comparative cost of debt and equity:

• Cost of debt. The cost of debt is relatively easy to establish, the main factor being the interest
rate at which the buyer can borrow. The tax system favours borrowing because generally interest
(unlike dividends) is tax deductible from profits, although certain restrictions may apply (for
further information, see Practice notes, Asset purchases: tax aspects of financing the acquisition:
Tax deduction for interest payments and Dividends: tax rules for corporates: Non-deductibility).
In assessing the cost of borrowing, account will be taken of these tax savings.

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• Cost of equity. The cost of equity is calculated by reference to anticipated shareholder returns
(including dividends, capital appreciation and share buybacks). The return on equity is a cost to
existing shareholders because their share of the future dividends and capital growth is diluted.
The calculation is relatively complex but broadly involves adding the yield on gilts to the equity
risk premium (the extra return that shareholders receive for investing in shares rather than risk-
free alternatives) adjusted by a company's risk weighting (its "beta") (see box, Calculating the cost
of equity).

In addition to the comparative costs of the two types of finance, other legal and commercial
considerations that can influence the buyer's funding choice include:

• The buyer's existing capital structure. If its gearing is already high, the buyer may only be
able to finance the acquisition by an issue of shares. Acceptable levels of gearing vary according
to the buyer's identity, the business sector in which it operates and regulatory guidance to which
certain lenders are subject. For example, a ratio of 100% may be acceptable for a company with
strong cashflow and asset backing, such as a utility. A much lower ratio would be appropriate for
a new company with few tangible assets. Gearing of between 30% and 50% has traditionally been
regarded as average in the UK. However, lenders increasingly look to interest cover (the ratio of a
company's earnings before interest and tax to its total interest costs) as a measure of security; at
least five times often being regarded as comfortable. (UK companies have traditionally had lower
gearing than companies in other European countries.)
• Restrictions on borrowing. The buyer's ability to borrow may be limited by restrictions in its
articles of association or by the terms of existing loan agreements or other debt instruments. Most
loan agreements are likely to contain restrictions on the amount of debt that the borrower can
incur without the lender's consent.
• The availability and cost of debt finance. Are lenders prepared to lend to the buyer and, if
so, at what rate of interest?
• How the buyer's shares are rated. What is the likely reaction of the buyer's shareholders to
an issue of equity? If its shares are highly rated by the markets, it may be attractive for the buyer
(and possibly the seller) to finance the acquisition with its own equity to take advantage of the
high valuation.
• Impact on post-acquisition earnings. This will depend mainly on the cost of borrowing and
the market value of the buyer's shares. A low interest rate will favour debt finance. But if the buyer's
shares are very highly rated, an equity issue may be more likely to enhance earnings. (Broadly, if
the buyer's price/earnings ratio is higher than the ratio of interest costs to borrowings, an equity
issue will have a better effect on earnings per share) (see box, Debt or equity: impact on earnings).
• Tax implications. Which financing option minimises the post-tax cost of funding the
acquisition? For further information on this issue, see Practice note, Asset purchases: tax aspects
of financing the acquisition: Debt and Equity.

Irrespective of the impact on earnings per share of an acquisition, buyers are increasingly looking at
the prospects for the after-tax return on the investment exceeding the weighted average cost of capital
(WACC), which is the blended cost of the enlarged company's equity and debt. An acquisition funded
by debt may improve earnings at a time of low interest rates, yet be value-destructive, because the after-
tax returns have little prospect of exceeding the WACC. In other words, a buyer should not be tempted
by low interest rates without analysing all the implications.

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Methods of raising debt finance

The appropriate type of debt finance for the transaction will depend on the size and creditworthiness
of the buyer, the availability and quality of security that can be given, the amount of money required
and the ability to structure the debt within the buyer's group in a tax-efficient manner. Debt finance can
broadly be divided into two main types:

• Loans.
• Debt securities.

For more detailed information on debt finance used to fund acquisitions, see below and Practice note,
Acquisition finance: debt for buyouts.

Loans
This is the simplest form of debt finance. A loan may come from a single lender (a bilateral loan) or a
group of lenders (a syndicated loan).

In a syndicated loan (see Syndicated loan versus bond issue), each of the syndicate lenders commits
to make a loan on a several basis on common terms and conditions governed by a common document
(the facility agreement). Usually, one of the lenders will take on the role of facility agent (also known
as the agent or agent bank). The facility agent administers the loan, collects and distributes interest,
receives information from the borrower and distributes it to syndicate lenders and, following a default,
takes instructions from the lenders on whether to accelerate the loan or take other enforcement action.
This is a common source of finance for large acquisitions.

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A loan may be secured on the assets of the buyer and/or the target, subject to compliance with the
rules against the giving of financial assistance. The Companies Act 2006 (CA 2006) changed the law
on financial assistance, including abolishing the prohibition on the giving of financial assistance by
a private company for the purchase of shares in itself from 1 October 2008. The financial assistance
prohibition still remains (as re-enacted by sections 677 to 683 of the CA 2006) for public companies
giving financial assistance and subsidiaries of a public company giving financial assistance for the
purpose of the acquisition of shares in a public holding company.

For further information about financial assistance, see Practice note, Financial assistance.

Debt securities
This term is commonly used to describe virtually any form of financial instrument issued to create or
acknowledge indebtedness. Debt securities can be divided into a number of categories:

• Those issued domestically in the form of "stock". For example, an acquisition may be funded in
whole or in part by the issue of loan stock by the buyer to the seller.
• Those issued internationally in the form of eurobonds. These are bonds (usually in bearer form)
typically marketed in the international capital market to investors in countries outside the issuer's
domestic market and/or denominated in a currency other than the domestic currency of the issuer.

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Eurobonds are generally only issued by companies with a good credit rating wishing to raise a
large amount of money (usually over £100 million).
• High yield bonds. These are bonds that are rated as sub-investment grade by credit rating
agencies. They are generally issued by young companies in growth industries such as telecoms.
The interest rate is high to reflect the lending risk. For more information on high yield bonds, see
Practice note, High yield bonds.

Syndicated loan versus bond issue

Key differences between syndicated loans and bond issues are that:

• Syndicated loans are more flexible, as the borrower can borrow as and when needed. With a
bond issue, the issuer receives the full subscription price on the issue date. This is an important
difference in the context of an acquisition. A syndicated loan can be agreed before signing and
drawn down on closing (or not at all if the acquisition does not proceed). Bond issues are rarely
conditional and, therefore, inappropriate if there is any doubt about an acquisition proceeding. For
this reason (and the publicity on a bond issue (see below)), bonds are more often used to refinance
other acquisition funding rather than to finance the acquisition initially.
• Syndicated loans usually have a floating interest rate; bonds have either a fixed or floating interest
rate.
• Syndicated loans may be made on a revolving basis, so that the borrower can repay and redraw
money as required, and may provide for repayment in instalments. Bond issues usually provide
for a bullet repayment on maturity.
• Syndicated loans are "private transactions" between the borrower and the syndicate of lenders.
Bond issues are public transactions, which require a prospectus (or offering circular) and public
disclosures.
• Traditionally, syndicated loans are subject to more stringent covenants than bonds, although the
terms of many larger loans have converged to some extent with high yield bond terms. However, if
there is, nonetheless, a covenant breach or potential covenant breach it is easier to negotiate with
lenders in a syndicated loan structure as opposed to bondholders in a bond structure.

For more information on the differences between syndicated loans and bond issues and the impact this
can have, see Article, Private equity transactions: selecting funding sources, PLC Magazine, 2011.

Multiple layers of debt

Debt from different sources may be used to finance a large acquisition. A key question for lenders will
be how their debt ranks on the borrower's liquidation.

A debt package may, for example, include:

• Senior debt. A loan (from a single lender or a syndicate of lenders) that ranks ahead of unsecured
and subordinated debt on the insolvent liquidation of the borrower by virtue of security and
intercreditor arrangements (subject to legal restrictions and practical constraints). Interest is

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usually charged at a margin over LIBOR. The documents may incorporate a margin ratchet
under which the margin is reduced as the financial performance of the borrower group improves.
Tax advice should be taken to ensure that this does not result in the interest payments being
recategorised as a distribution (see Structuring debt: tax). An arrangement fee on the total
amount of the facility is charged. Large loans may be divided into different tranches with different
maturities. These tranches are commonly called alphabet notes (because each tranche is identified
by a letter of the alphabet: A, B, C and so on). For more detailed information on senior debt in
the context of acquisition finance, see Practice note, Acquisition finance: debt for buyouts: Senior
debt.
• Mezzanine debt. Debt which ranks behind senior debt but ahead of unsecured and other
subordinated debt by virtue of security and intercreditor arrangements. It sometimes benefits
from share warrants (giving the warrant holder a right to subscribe for shares in the borrower's
holding company at some date in the future). Mezzanine debt will have a higher rate of interest
than senior debt, reflecting the greater risk. Typically, mezzanine debt will also have a longer
maturity than senior debt (up to nine or ten years). There is usually a bullet repayment and there
may be early prepayment premiums. As with senior debt, mezzanine debt can be secured, although
the security ranks behind the senior security. For more detailed information on mezzanine debt
in the context of acquisition finance, see Practice notes, Acquisition finance: debt for buyouts:
Mezzanine debt and Mezzanine finance in leveraged transactions.
• Other unsecured and subordinated debt ranking behind senior and mezzanine debt. This
may include, for example, debt securities such as high yield bonds, which are often used to
refinance loans after an acquisition has taken place. For more detailed information on high yield
debt in the context of acquisition finance, see Practice note, Acquisition finance: debt for buyouts:
High yield debt.

Security and subordination

Ranking of debt will normally be achieved by security arrangements, guarantees and subordination.

As acquisition finance is often risky (for example, because of the lower credit rating of the borrower
or because of the size of the facility it requires) lenders will generally require a comprehensive security
and guarantee package from the borrower, the target and any material subsidiaries. A properly created
and perfected security package will improve the position of the lenders on an insolvency, giving priority
over other creditors of the relevant security provider in respect of the charged assets.

A guarantee given by a subsidiary relating to the borrowings of its parent (an upstream guarantee)
will give the lenders direct access to the cashflows of the subsidiary, rather than relying on cash in the
subsidiary being paid up to the parent by way of distributions. A guarantee given by a parent of the
borrowings of its subsidiary (a parent or downstream guarantee) will be beneficial to the lenders, as it
will give indirect access to other cashflows in the parent's group. A guarantor may be required to give
security for its obligations under the guarantee.

Legal issues to consider when taking security and guarantees include:

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• The prohibition against a public company giving financial assistance or the subsidiaries of a public
company giving financial assistance for the purpose of the acquisition of shares in a public holding
company other than in prescribed circumstances (see Practice note, Financial assistance).
• The new security may be in breach of covenants in existing security documents, such as a negative
pledge.
• Company law restrictions on a group company giving guarantees and/or security over its assets in
respect of facilities made available to another company in the same group. In principle, a company
can do this but the security or guarantee must be in the best interests of the company giving it
(otherwise directors would be in breach of their general duties, including their duty to promote
the success of the company (section 172(1), CA 2006). For further information on directors' duties,
see Practice note, Directors' general duties under the Companies Act 2006. Best interests may be
particularly difficult to establish in the case of an upstream guarantee. It is therefore common for
the guarantee or security to be approved by shareholders (by ordinary resolution).
• Restrictions in a company's constitutional documents. Before 1 October 2009, lenders commonly
required that a company's memorandum of association should expressly grant the company power
to give guarantees and security in respect of the obligations incurred by other group companies.
Since 1 October 2009, a company formed under the CA 2006 has no restrictions on its objects,
unless any restrictions are specified in its articles of association (section 31(1), CA 2006). In respect
of a company incorporated under the Companies Act 1985 (or earlier companies legislation),
the objects stated in its memorandum continue to act as restrictions on the company's capacity
(although it is open to such a company to amend or revoke its objects by special resolution, subject
always to the requirement to notify Companies House of any change (section 31(2), CA 2006)) and
so will continue to be relevant to any lender's decision. Accordingly, if a company has restricted
objects then a lender may require that it has an express power to give guarantees and security in
respect of the obligations incurred by other group companies. For more information, see Practice
note, Memorandum of association: content.
• The requirement to register security created by a company or limited liability partnership (LLP)
registered in England or Wales within 21 days of its creation so that it will not be void against a
liquidator, administrator or other creditor (see Practice note, Registration of charges created by
companies and limited liability partnerships on or after 6 April 2013).

Even if security is available, senior lenders will not want to compete with other providers of finance
to the borrower in the event of the insolvent liquidation of the borrower. This is normally achieved by
subordinating the claims of other lenders.

The purpose of subordination is the same as security: to give one category of lender priority over another
(subordinated lender) on the insolvent liquidation of the borrower.

There are two main types of subordination: structural (common in the UK and mainland Europe) and
contractual (common in the US).

Broadly, structural subordination is achieved by inserting an intermediate holding company (or

companies) in the acquisition structure (see below).

Structural subordination

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• The top company (TopCo) may, for example, issue high yield debt, the proceeds of which it then
lends to the intermediate holding company (the acquisition vehicle or HoldCo).
• HoldCo borrows senior debt that is secured on the assets of the target (subject to compliance with
financial assistance rules). TopCo may also give the senior lenders a guarantee and/or charge over
the shares it owns in HoldCo to secure the senior debt.
• The inter-company loan of the high yield debt proceeds from TopCo to HoldCo will also be
contractually subordinated to the senior debt.
• The holders of the high yield debt issued by TopCo are structurally subordinated to the senior
lenders to HoldCo. TopCo will only be able to repay the high yield debt from the distributions
made to it by HoldCo or if HoldCo repays the inter-company loan. Usually, the intercreditor
arrangements will only permit a distribution to TopCo or repayment of the inter-company loan by
HoldCo after the senior debt has been repaid in full.

With contractual subordination, loans are made to the same borrower but lenders agree priority of
payment by contract (see below). This can be achieved in a variety of ways, including:

• Trust subordination. The junior lenders agree to hold any payments they receive from the
borrower on its liquidation on trust for the senior lenders to the extent that the senior lenders'
debt remains unpaid.

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• Contingent debt subordination. The junior lenders agree that their debt only becomes due
and payable to the extent that the borrower has sufficient assets left after payment of the senior
lenders in full.

In the UK, contractual subordination is relevant between different categories of secured lenders to the
same borrower (for example, the mezzanine debt is often lent to the same company as the senior debt).

Contractual subordination

Structuring debt: tax

The main UK tax issues relating to debt finance are:

• Whether interest payments are tax deductible. Generally interest payments (unlike dividends)
are tax deductible, although certain restrictions may apply (see Practice notes, Asset purchases:
tax aspects of financing the acquisition: Tax deduction for interest payments and Dividends:
tax rules for corporates: Non-deductibility). The tax treatment generally follows the accounting
treatment (accruals basis). However, interest can sometimes be categorised as a distribution:
• if a loan carries interest at a rate that represents more than a reasonable commercial return,
the excess is regarded as a distribution; and
• if the return on a loan is dependent upon the results of the borrower or the value of its assets.

• The buyer may wish to offset interest expenses incurred by the acquisition vehicle against profits
of the target for tax purposes. This will generally be possible on a purely domestic transaction
under group relief rules. These allow UK companies within the same group to surrender losses
to each other for tax purposes (a 75% group relationship is required). Tax consolidation may also
be possible in the context of a cross-border acquisition, as companies that are tax resident in
different countries can sometimes surrender losses to each other for tax purposes. It will generally
be necessary for the interest to be incurred by a local acquisition vehicle. For further information
about group relief rules, see Practice note, Groups of companies: tax.

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• Whether there are any withholding obligations on interest payments. A withholding obligation
applies to interest paid by a corporate borrower on loans that could last for more than a year.
Important exceptions apply in respect of:
• interest payable on an advance from a UK bank where the person beneficially entitled to the
interest is within the charge to UK corporation tax;
• interest payable to a non-resident lender that has the benefit of a double tax treaty (the treaty
may provide for the reduction or elimination of the withholding obligation); and
• interest payable by a UK company if it has a reasonable belief that the person beneficially
entitled to the interest is either a company resident in the UK for tax purposes or a company
not so resident that carries on a trade in the UK through a permanent establishment and that
is subject to UK corporation tax on the interest.

For more information, see Practice note, Lending activities: tax: Commercial loans: withholding
tax.

Methods of raising equity finance

The main methods by which UK listed companies can raise equity finance are:

• Rights issues.
• Open offers.
• Placings.
• Cash box placings.
• Vendor placings.

For a high-level comparison of the key features of each of these fundraising methods, see Practice note,
Comparative table of secondary issues.

Rights issues
A rights issue involves an offer of new shares (or possibly other securities) made to existing shareholders
on a pre-emptive basis pro rata (in proportion) to their existing holdings. A key element of a rights issue
is that the right to subscribe for the new shares, which is set out in a provisional allotment letter (PAL),
has a value itself and so a shareholder can realise value by selling their rights in the market nil paid.
In addition, even if a shareholder does nothing (known as a lazy shareholder), they retain the right to
receive any value over and above the subscription price if the shares that they could have taken up are
sold in the market at a premium to the subscription price.

For more information on rights issues, see Practice note, Rights issues: overview.

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Open offers
An open offer is also an offer of new shares which is made to existing shareholders on a pre-emptive
basis. But there are important differences between an open offer and a rights issue. Notably:

• Application forms are used (instead of PALs) which cannot be traded nil paid.
• No arrangements are made for the sale of any shares not taken up by shareholders. Therefore, lazy
shareholders will not receive any money in respect of the shares to which they are entitled but
do not apply for (unless the offer is structured as a compensatory open offer; see Practice note,
Alternative structures for secondary issues: overview: Compensatory open offers).
• Shares are offered at a lower discount than on a rights issue. Open offers cannot be made
at a discount of more than 10% to the mid-market price of those shares at the time of the
announcement of the offer unless the company's shareholders have specifically approved the
discount (LR 9.5.10R(3)).
• If a general meeting is required (for example, to grant authority to allot the shares under section
551 of the CA 2006 or disapply pre-emption rights under section 561), application forms can be
posted with the notice of the general meeting. On a rights issue, PALs can only be posted after the
general meeting because the UK Listing Authority (UKLA) does not allow shares which can be
traded to be allotted provisionally on a conditional basis. Because the notice of the general meeting
and offer period can run concurrently on an open offer, it allows subscription monies to be received
in the company's account up to two weeks earlier than on a rights issue, with a corresponding
saving of underwriting commissions.

Open offers tend be quicker and involve lower transaction costs than a rights issue, but they are less
flexible for shareholders. For this reason, the Association of British Insurers (ABI) has indicated a
preference for rights issues rather than an open offer if the increase of share capital is more than 15%
to 18%, or the discount is greater than 7.5% (page 33, Encouraging Equity Investment: Facilitation
of Efficient Equity Capital Raising in the UK Market (July 2013); for background, see Legal update,
Equity capital markets: ABI report on encouraging equity investment).

For further information on open offers, see Practice note, Placings and open offers.

Placings and bought deals

Placings and bought deals involve issuing shares for cash on a non pre-emptive basis to existing or new
shareholders. In a placing, the recipients of shares are usually institutional shareholders who are likely
to hold the shares as a long-term investment. In a bought deal, one investor, usually a large securities
house, takes a block of shares with a view to trading out of its position at a profit.

The placing process is usually quicker than a pre-emptive offering, because placings are usually
structured so that they are neither a public offer nor of sufficient size to trigger the requirement for a
prospectus.

A company's ability to do a placing is limited both by the statutory pre-emption provisions in the CA
2006 and by the requirements of Investor Protection Committees (IPCs).

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The Pre-emption Group has published guidelines to companies and investors for cash issues other
than on a pro rata, rights issue basis. These guidelines are intended to be benchmarks which enable
companies and their advisers to know that, if they act within them, there will be no need for prior
discussions through the IPCs.

The current guidelines state that a routine disapplication of the statutory pre-emption rights in
accordance with section 570 of the CA 2006 should, generally, be limited to:

• 5% of existing issued ordinary share capital in any one year (which can be used for any purpose).
• An additional 5% of existing issued ordinary share capital in any one year (which must be used for
an acquisition or specified capital investment).

Companies are also expected to observe cumulative limits on the extent to which they use their section
570 disapplication in any rolling three-year period (7.5% of issued ordinary share capital ). Additionally,
any "discount" to the current share price should be restricted to a maximum of 5%, including expenses,
although where the placing includes a substantial clawback offer to existing shareholders, provided that
the firm element is priced at no greater discount than the element subject to the clawback, the firm
element need not comply with the 5% discount limit. This is stricter than the Listing Rules provision
that the discount may be up to 10% or, in some circumstances, greater than 10% (LR 9.5.10R).

For further information on placings, see Practice note, Placings and open offers.

Cash box placings

A cash box structure is a method of raising cash from the issue of equity securities which is characterised,
for the purposes of the CA 2006, as a share-for-share exchange. As the shares are issued in exchange
for shares rather than cash, this allows the company to issue the new shares free of the statutory pre-
emption requirements of section 561 of the CA 2006 by relying on the exception set out in section 565
(for further information see Practice note, Pre-emption rights: allotment of shares: Exceptions to the
statutory pre-emption right). Note, however, that although the statutory pre-emption requirements do
not apply, the Pre-Emption Group considers cash box transactions to be issues of equity securities for
cash for the purposes of its principles and, therefore, subject to the same limits as other issues for cash
(see Placings and bought deals).

A cash box structure typically involves the issuer's bank subscribing for preference shares in the issuer's
newly incorporated subsidiary, which is likely to be a Jersey company (see Practice note, Secondary
issues and acquisitions: cash box and vendor placings: Jersey companies). The subscription price for
the preference shares is expressed to be a sum equal to the proceeds of the issuer's placing, and the
issuer's bank undertakes to pay the subscription price conditional on the admission of the placing shares
to the relevant market. The bank then carries out the placing and identifies those persons who wish to
take up the placing shares (the placees), following which the placing shares are issued to those placees
nominated by the bank. The bank then receives the proceeds of the placing and uses those proceeds to
discharge its undertaking to pay the subscription price for the preference shares. Finally, the preference
shares subscribed by the bank are transferred to the issuer in consideration of the issue of the placing
shares to the placees.

For further details, see Practice note, Secondary issues and acquisitions: cash box and vendor placings.

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Vendor placings
For companies looking to raise equity capital to finance an acquisition, vendor placings have
traditionally been a popular alternative to a rights issue. Historically, a vendor placing involved shares
being allotted by the buyer to the seller in exchange for shares in the target company. The seller would
agree with the buyer's investment bank that it would place the shares in the market for a cash sum, or,
failing that, subscribe for the shares itself. Through this arrangement the seller received cash while the
buyer financed the acquisition by issuing shares. In practice, this method involved a stamp duty reserve
tax charge so these days, the usual practice is to allot the shares to persons proposed by the investment
bank in consideration for the acquisition of the target.

A key advantage of a vendor placing is that the statutory pre-emption rights in section 561 of the CA 2006
do not apply. This is because a vendor placing is not a cash issue, as the shares are issued in exchange for
shares in the target (section 565, CA 2006). However, the Pre-emption Group's Statement of Principles
and ABI guidelines do place limits on the extent to which a vendor placing can be used. Under these
guidelines, shareholder consent should be obtained where a vendor placing will involve either:

• The issue of new shares representing more than 10% of the company's issued share capital.
• A discount greater than 5% on the company's share price unless a clawback is offered to
shareholders. On a clawback, shares are placed with placees, subject to a right of clawback to meet
applications from shareholders. Shareholders are normally offered the shares in proportion to
their existing shareholdings. The clawback usually takes the form of an open offer.

For more information on vendor placings, see Practice notes:

• Alternative structures for secondary issues: overview: Vendor placings.

• Secondary issues and acquisitions: cash box and vendor placings: Vendor placings.

Factors influencing fundraising structure

A number of factors can influence which method a company uses to raise equity finance including:

• The amount to be raised.

• The likely reaction of the market.
• The importance of certainty of funding.
• The timetable for raising funds (which is often driven by the factors above).

The first two considerations are likely to have an impact on whether the fund-raising is done on a fully
pre-emptive basis (for example, by a rights issue or placing with claw-back) or a non pre-emptive basis
(for example, by an institutional or vendor placing).

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Acquisition finance: funding sources for acquisitions, Practical Law UK Practice Note...

Generally, a smaller acquisition is likely to be funded by a non pre-emptive placing, as this is often the
quickest and most straightforward way for an issuer to raise funds. If the issuer limits the size of the
offering and has customary shareholder authorities in place from its last annual general meeting, it can
structure the offering to avoid the need to obtain shareholder approval for the capital raising and the
requirement to prepare and publish a prospectus. This makes it an ideal method of financing a bolt-on,
rather than transformational, acquisition.

A larger, more transformational, acquisition will need broader shareholder investment and support,
and is likely to be funded by a rights issue. The issuer has to balance two competing issues: the potential
need for certainty of funding of the proposed acquisition (see Article, Equity financing of acquisitions:
impact on offering structures: Certainty of funding, PLC Magazine, 2011) and the desire to preserve
the flexibility to cancel the capital raising or to return the proceeds to shareholders if the acquisition does
not happen (see Article, Equity financing of acquisitions: impact on offering structures: Returning
proceeds, PLC Magazine, 2011).

With a smaller placing, the risks of the placing going ahead, the funds being raised and the acquisition
not proceeding are unlikely to be of major concern to the issuer. If the acquisition does not proceed,
the issuer may choose to retain the proceeds of the capital raising and use them for general corporate
purposes or for another acquisition.

Equity issues: regulation and other guidelines

For an overview of the main regulations and other guidelines governing the issue of shares by a listed
company, see Practice note, Alternative structures for secondary issues: overview: Regulations and
other guidelines.

For general information on issuing shares, see Practice notes:

• Allotment and issue of shares.

• Pre-emption rights: allotment of shares.
• Share capital: overview: Alterations to share capital.

Calculating the cost of equity

A company's cost of equity is calculated by reference to:

• The rate of return required from risk-free assets ("Rf" or "the risk-free rate"). The risk-
free rate can be derived from the gross redemption yield of long-term government
securities (such as gilts).
• The equity market risk premium (EMRP), that is, the difference between the expected
return on the market portfolio and the risk-free rate ("Rm-Rf").
• The company's beta (effectively, its risk weighting).

In arithmetic terms, the cost of equity can be calculated as follows:

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Acquisition finance: funding sources for acquisitions, Practical Law UK Practice Note...

Re (cost of equity) = Rf + (beta x EMRP).

For example, if the risk-free rate is, say, 5% and the EMRP, say, 4%, a company with a beta
of 1.5 has a cost of equity of:

5% + 1.5 x 4% = 11%.

Calculation of the equity market risk premium. The EMRP is usually estimated
by calculating the difference between the required returns on equities and government
securities. This can be done either by:

• Examining the comparative historical returns of equities and government securities

over various time periods.
• Estimating future likely economic trends and the market risk premium consistent with
them.

These two approaches can produce different results. Historically, returns on equities have
been significantly greater than returns on government bonds.

Calculation of beta. Betas for publicly quoted companies can be obtained from a variety
of sources such as Thomson Datastream and the London Business School.

Debt or equity: impact on earnings

• Suppose Company A has 1,000 shares in issue, each worth £1, and makes profits before
tax (PBT) of £100. Its PBT per share are therefore 10p (100 ÷ 1,000). This analysis is
substantially the same as for earnings per share.
• Suppose that it then acquires Company B at a total cost of £100, and that B makes
operating profits of £10.
• If A issues shares to acquire B, the assumption would be that its profits become £110,
and its issued shares become 1,100. Therefore, its PBT per share are still 10p.
• Suppose instead that B is bought for cash at an interest rate of 5% per annum. Profits
will be £105 (£100 + £10 - £5), shares in issue will still be 1,000 and PBT per share
will be 10.5p.
• If the example is worked with an acquisition of B for cash at an interest rate of 20%,
the resultant profits are £90 (£100 + £10 - £20) and its shares in issue are again 1,000.
PBT per share are 9p.

Notes:

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Acquisition finance: funding sources for acquisitions, Practical Law UK Practice Note...

• The UK tax regime favours debt finance because interest (unlike dividends) is tax
deductible.
• Rather than simply looking at earnings per share, investors consider the overall return
on their investment (dividends, share buybacks and capital growth). Although debt
financing may increase earnings per share, it may have an adverse impact on the
company's share price (and overall investor returns). If, for example, investors believe
that the company is too highly geared (and therefore exposed in the event of a downturn
in trading conditions), they may sell shares which will result in the share price falling
(and a drop in the overall investment return).

The acquiring company should also have regard to its optimal mix of debt and equity in its
capital structure to minimise its weighted average cost of capital.

Acquisition finance in the United States

For an overview of acquisition financing by equity and/or debt in the United States, see
Practical Law US Finance, Practice note, Acquisition Finance: Overview.

END OF DOCUMENT

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