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How do lenders evaluate risk in acquisition lending?

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A quick primer on how senior lenders think about whether to move forward with a loan request in the simple case where an individual or group of individuals are using debt to finance an acquisition.

Banks will lend if they believe:

     a. They will earn a sufficient risk-adjusted return, and

      b. Their expected loss is low enough

We'll ignore (a) for now, but in simple terms, it implies that a riskier deal will entail higher costs for the borrower. Regarding (b), the lender does not actually expect to lose money, but they will calculate the following:

Expected Loss = Likelihood of Default x Loss if Default Occurs

It represents the % of the loan value that the lender statistically expects to lose on a deal over the course of the loan. This is the same as public bond ratings by companies like Moody's.

- Loss if Default Occurs will be determined by the quality of the collateral used to secure the loan, meaning companies with hard assets and guarantors with strong net worth will, all else equal, be more likely to secure a loan on favorable terms.

- Likelihood of Default is typically the primary driver of the yes/no lending decision. For most lenders, the rating is generated using historical financial data for the company adjusted for new debt, in combination with qualitative factors about the business.

The weighting of those data points can vary greatly between industries, but in general, the financial ratios drive a large majority of the overall rating (80-90%). Within the financial ratio section, cash flow and leverage are the most important factors, followed by liquidity.

Knowing what the implied cash flow, leverage and liquidity ratios will be following your proposed acquisition will help you get a sense of the likelihood that a lender will support.

Checking the following boxes will give you a much higher chance of securing a loan.

If the ratios are in line, and they believe in your plan to continue driving profitable growth within the company, you'll likely soon be moving to negotiating terms.

In this modern financial landscape, Acquirewell, by Village Wellth, stands as a valuable tool to navigate these challenges. By fostering competitive tension, expediting transactions, and securing favorable terms for buyers, Acquirewell accelerates and streamlines the acquisition lending process. It's the compass that guides you through the twists and turns of the acquisition journey, helping you reach your destination with confidence.

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April 30, 2024
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