In the third and final instalment of the Commonwealth Bank/Professional Planner series on succession planning, Tom Ilinkovski and Ian Anderson discuss intricacies of financing a transaction. Simon Hoyle reports
It’s the part of a succession plan that vendors and buyers often rush to first: how to raise the funds to finance a transaction. But in truth, funding, while very important, is only one piece of a much bigger puzzle.
All the other pieces have to be identified, and fit together, before lenders will consider getting involved, and before funding can be sourced at a competitive price.
Ian Anderson, head of Com- monwealth Bank Financial Planning Lending, says that by far the most common source of funding for a purchase is a bank, or other institu- tion. Sourcing funds from elsewhere – families, for example – can work, but generally only in limited circum- stances.
Anderson says it’s much better to keep business and family separate.
“[A bank] is the number one option we see for most people in the industry, either with a succession or an acquisition strategy, for sourcing debt,” Anderson says.
“In entirety, we probably see five common sources that they access to fund their acquisition or succession.
“Primarily, obviously, debt fund- ing is what we’re seeing the most of.
“Often they’re accessing their own capital, so cash reserves [is another].
“Private investors are often another way that they’ll source some investment funds, either through family friends, other associates or that side of things.
“Vendor finance, we don’t see a lot of it, and we tend to see most of it in the case where there’s an internal succession or an internal family succes- sion, because it does have its issues.
“And of late we’re seeing some of the dealer groups that we work with actually take [some equity], provide capital to assist with growth and taking [an] equity stake in some of those businesses that we’re working with to help complete on the transactions.”
Tom Ilinkovski, managing direc- tor of Insight Financial Services, which has offices in Sydney and Parramatta, says he likes to keep any transaction as coldly commercial as possible.
“When you have an equity stake- holder, whether it’s family, friends, an institution or dealer group…some- where down the track they want a say, they want to either sit on the board or a board of advice,” Ilinkovski says.
“And then you have the issues, if you’re not running the same strategy et cetera. So I find, having a com- mercial relationship with a bank…the bank generally leaves you alone to run your business according to your plan or strategy – as long as the numbers are stacking up.
“So in my experience, and our preferred path – and we’ve been ap- proached over the years a number of times from people taking equity positions, be it a dealer group or an institution – is always…to have a commercial arrangement with a bank.
“A bank is sometimes a good filter mechanism to ensure that you stay on track and [tell you] that it’s not a good deal if the numbers don’t stack up or the business numbers don’t stack up. And sometimes it’s not bad to have a bank say, well, you’re stray- ing off course, or your numbers aren’t adding up.”
When money is cheap – as it has been for many months now – fund- ing an acquisition entirely or partially with debt is a potentially attractive option. But as interest rates head north, issues of serviceability need to be addressed.
Says Anderson: “Gearing can be a concern if the servicing of a debt is tight; in a low-interest-rate environ- ment that’s often very attractive to borrow money.
“In an interest rate environment that’s heading north, you then have to consider the appropriate gearing level because you’re going to lose potential liquidity in that business. So you need to consider [that] the robustness of any debt servicing is probably key in determining the right level of debt/ equity mix. With higher gearing, obviously the greater risk you have if interest rates move north.
“In saying that, if you’re work- ing with experienced bankers that understand your industry, and also the debt funding side of things, there are strategies they can help you with to minimise interest rate risk. And that’s important too I guess, when you’re finding the right banker, that they have that knowledge.”
It’s best to “plan for the worst and hope for the best”, Ilinkovski says.
“And that way you stay out of trouble.”
He says that when his firm embarked on a growth strategy “several years ago”, it was difficult to find a source of funding or a lender.
“Even dealer groups wanting to take up equity was pretty new,” he says.
“And in our first acquisition we actually had to find a bank in Adelaide – some Sydney banks, you know, said: ‘Oh it’s too small!’ It was quite a small acquisition, so it was too small for some of the Syd- ney banks or lenders; they weren’t interested.
“It’s evolved. And one of the critical elements for us is to have a banking relationship where they understand our industry, for a couple of reasons.
“One, it’s very difficult to get your message across to someone that specialises in hotels or pubs; it’s just different.
“And the second aspect of that is they can’t share their experiences with you, compared to someone who has dealt in 200 transactions; and therefore, the knowledge they’ve gained from those transactions can help you in – it’s a two-way street.
“I guess it’s important that the bank gives you feedbackandtellsyou,‘Well this is our experience with other transactions, or how other practices have evolved’.
“So one of the critical elements is to have a funder that understands our industry.”
Finding the right lender means doing some homework. Just as super funds run“beauty pa- rades” for potential investment managers, financial planning firms should put a range of potential lend- ers through the wringer to find the best one.
“We know exactly what’s out there in the mar- ketplace,” Ilinkovski says.
“You have to [run it competitively]. Have to keep them honest.”
Of course, assessing potential lenders isn’t entirely like a beauty contest, because at the same time that a financial planning firm is assessing the lender, the lender is assessing the firm, to decide if it’s an acceptable lending risk. For that reason, the borrower needs to be prepared to divulge as much,
or more, information to the lender as the lender divulges to the borrower.
“You’ve got to look into the mindset that if I was going to lend me money or my business money, why would I lend my business money?” Ilinkovski says.
“It’s important that the lender understands your business, understands what you’re trying to achieve. And understands the prospective acquisi- tion is in-line with your strategy or your objectives.
“And that you have to obviously also demon- strate a track record of success in the past in these sorts of ventures. If I was lending our practice money, or if I was lending to myself, what would I need to know to lend myself money? Why would I lend?”
“Your first primary concern is the individuals themselves,” he says.
“Who are they? What experience do they have to undertake the strategy or the growth strategy to acquisition? Do they understand what they’re really getting into? Track record is also important – a history of being able to show that they have the ability and the desire to make the payments to the bank. That’s the primary concern – it would be the character of the individual.”
A lender will also want to know about clients.
“When we’re talking about an accounting or financial planning business, and we’re talking about a cashflow lend, a lot of due diligence goes into the client base itself,” Anderson says. “What makes up the cash flows? It’s all very good to say you’ve got X dollars in recurring revenue, but what you really want to know is their concentration in that client base.
“If you have an existing firm, you want to understand what makes up those cash flows, as we’re lending against those cash flows. If we’re lend- ing against the combined entity, then you want to understand what the mix and nature of that client base is in its entirety.”
Anderson says lenders should put in a consider- able amount of their own time and effort checking budgets and verifying financial statements.
“This is where a lot of work goes in from the banks,aroundmodellingforecasts,understanding line-by-line the numbers that are in those forecasts, taking a worst-case scenario from time to time, and just sensitising figures to see how robust they are around future ability to make repayments,” he says.
“The thing about the financial planning world, at the moment, is renewable income. That’s quite easy to verify as a line item in a budget. So we’d probably break it into two sections: the income part of the cashflow; and verifying the assumptions of what’s going to happen around new business.
“In the current market, that’s obviously a little bit tougher to do. But certainly, looking back at history on those particular books to see what the trend has been in regards to growth.
“On the expense line items, again, it’s not the most complex industry out there; the overheads, a lot of them, are fixed. So the key ones and the highest percentage of overall expenses usually are around the wages and rental expenses for the premises.
“But from the banking perspective, we quite often have clients come to us with a lack of preparation of budgets. And that’s a real concern for us in that they obviously haven’t done their due diligence on the viability of the opportunity that they’re assessing.
“Basically, with budgets, you really need to be able to justify them based on historical data.”
Anderson says that ideally, historical data should go back three years. Banks generally won’t worry too much about data older than that.
“Certainly, the last two years are important, trend-wise,” he says.
“When we’re talking about acqui- sitions of books of fees, businesses can financially change dramatically just by bolting on a new client base and taking advantage of synergies. So really, the budgets are where a lot of the decisions are made around the financial modelling and the financial affordability of the debt that they’re requesting.”
Ilinkovski says it’s better to err on the side of caution than to assume a best-case scenario will inevitably pan out.
“From my point of view [it’s about] choosing a partner that’s more conservative, rather than looking at a funder who will lend to you based on the best case scenario,” he says.
“Some of the clients we advise, they’ve dealt with banks or funders that are very aggressive, and you give them a set of figures and they will even project them even higher, and lend even more. That’s all great in an increasing market, but when you experience what we’re experiencing now, it just all crumbles.”
Anderson says lenders think of themselves as “taking an investment in a business, when we’re lending the money”.
“We need to understand the transaction in its entirety,” he says. “There’s certain aspects of the
legal documentation, [such as] the contract of sale, that we also need to understand quite thoroughly. Because that can pose risk to the lender, par- ticularly when the primary security for the loan will be with business and the client book.
“We generally see transactions structured with an 80 per cent or 70 per cent payment upfront, and some retention clause around retaining the current…number of clients or cur- rent level of recurring revenue, those sorts of things. So we need to under- stand that deferred consideration.
“With a financial planning firm or a lot of professional service firms, the real value is in the relationship between the advisers, or the business owner, and the individual client. So we need to understand the strategy, or why that person is exiting the business, over what timeframe they’re going to exit, are they going to come and work for our client for a period of time to transition that client base over.
“It can have real risks from a lender’s perspective if clients are going to leave that business. That can be a trigger point for people to consider, well, you know, maybe it’s time to find a new adviser.
“So the retention clause helps us mitigate some of that risk with clients leaving and the reduction in recurring revenue.”
When it comes to putting up security for a loan, Anderson says there’s a fairly narrow range of op- tions.
“When it comes to security, and when we refer to a cashflow, we’re primarily looking at the assets of the business,” Anderson says.
“And behind that, there will be personal guarantees and access to the cashflow from platforms, and those sorts of things. So that’s primarily a cashflow lend.
“Other options are obviously bricks and mortar assets, so residential property, commercial assets, those sorts of things. We tend to not like to see third-party assets being used. So other family members’ assets and those sorts of things, [where] you don’t have a direct involvement in the business.
“The individual who is going to pledge an asset really needs to go and get independent advice and show that they really understand what risk they’re taking with an asset that they are pledging against someone else’s debt,” he says.
“Primarily, in our space, security would be the business and its cash flows only. But where we can’t provide the finance to that next level, then certainly residential property is something that is often pledged to support it. The way we look at it, though, our primary exiting source is the cash flows of the business. And secondary then, in the worst-case scenario, we would be looking to [other] assets.”