Taking the Debt With the Good

In June, Avnet announced it would acquire Marshall Industries in a deal valued at$830 million. The $6.3 billion distributor of electronics parts reported that the transaction, part cash and part stock, would also include the assumption of $160 million of Marshall Industries’ debt.

Now, the assumption of debt in an acquisition is nothing out of the ordinary. Among the many deals this year to include debt assumption were Cooper Tire & Rubber’s $584.4 million offer for Standard Products ($173 million of assumed debt), Trenwick Group’s $212 million purchase of Chartwell Re Corp. ($104 million of assumed debt) and Ogden Corp.’s $342 million deal for Volume Services America Inc. ($215 million of assumed debt).

But just because the assumption of debt is fairly commonplace doesn’t mean it shouldn’t be treated cautiously or that other options shouldn’t be considered.

Roy Vallee, chairman and CEO of Phoenix-based Avnet, says when his company looks at an acquisition there are a number of different ways to calibrate or measure the financial ramifications of a deal. “The one I favor is the return on invested capital and in that calculation I include debt as part of the overall investment capital. Therefore, the investment that I’m making is a combination of debt and equity and then I look at what the return should be.”

In Vallee’s calibrations, a debt-ridden company is obviously worth less than a debt-free company and “if you just keep increasing the level of debt you get to the point where the acquisition price has to be lower and lower. Sometimes, in fact, you just have to walk away.”

There is another concern, and that is the balance sheet of the company after the acquisition, especially if the rating agencies don’t like the look of all that new debt. A low rating on company debt creates two problems: it increases the amount of interest to be paid and reduces the access to capital as lenders are more interested in lending to A-rated companies rather than C-rated companies.

Companies have to go through a risk analysis to determine if it makes sense economically to pay the debt back, says David Reed, managing director and group head of PaineWebber’s M&A group in New York. “Often, the acquiring company has a better credit rating and therefore a lower cost of funds and it can actually enhance profitability by paying back the acquired company debt.”

In any acquisition, Reed notes, one either has to assume the acquiring company would have some sort of change of control provision, which means it has to come up with cash to pay the debt as part of the acquisition, or it has to come up with an alternative financing source without actually assuming the specific debt instrument.

Another concern is that the debt instrument of the acquired company might have a change of control provision where there are prepayment penalties. “While that adds to the cost of the acquisition, it’s not an impediment,” says Reed, “particularly as it is usually a big company buying a smaller one.”

In July, Equity Residential Properties Trust, a Chicago-based real estate investment trust, announced it would be acquiring Lexford Residential Trust in a $740 million transaction, including the assumption of about $530 million of debt. When completed, Equity Residential, the largest publicly traded apartment company in the U.S., will boast a market capitalization of $13 billion and 1,087 properties in 36 states.

The assumption of debt, says Douglas Crocker, Equity Residential’s president and CEO, is a large component of its deal analysis for four important reasons:

•   Its impact on rating agencies’ outlook for the combined company’s rating.
• The impact of the maturity schedule of the debt being assumed.
• The interest rate on the debt relative to current market conditions.
• The cost of assuming the debt (higher interest rate, shorter maturity, more collateral or covenants and assumption fees). Can the lender call the debt?

The debt of the company being acquired can be so high that the combined company’s interest and total coverage ratios could be negatively affected, says Crocker. “This would surely result in a rating downgrade, which would cost the new company each time it wanted to issue debt or preferred securities. To maintain ratings, the acquirer might be forced to issue equity at a disadvantaged price, thereby increasing the actual cost of the company being acquired.”

In the end, are there ways to avoid assuming the debt of the acquired company? The buyer could structure the deal so an affiliated entity pays back the debt, or the buyer could lend money to the target company in advance of the acquisition and the target company could use the money to pay back the original lender.

Steve Bergsman is a Mesa, AZ-based freelance business writer who has written about corporate finance for Reuters, Barron’s, Global Finance and Corporate Finance.