Cross-Border Acquisition Financing: Understand the Source of the EBITDA or Be Lost in the Translation

This article was originally published in the program materials for the 13th Annual Texas ACG Capital Connection Event in Houston, Texas on March 9-10, 2016.

Private equity sponsors and secured lenders looking to finance acquisitions outside of the United States can quickly find themselves in unfamiliar territory, particularly when it comes to understanding, diligencing and underwriting the arcane and seemingly endless investment, legal, political and other considerations associated with putting capital at risk in foreign operations and foreign countries.  In this brief article, we thought it best to highlight one particular area where we believe sponsors and lenders can materially improve the likelihood of successful cross-border acquisition financings:  understanding and accurately identifying the assets, properties and interests that are the real source of the cross-border target company's domestic and foreign EBITDA. 

By doing this, sponsors will be better able, on a legal, tax and cost efficient basis, to value, underwrite and diligence their opportunities, as well as prepare for prospective add-on acquisitions and the repatriation of their capital upon exit.  These sponsors also will be better prepared to anticipate and effectively address lender concerns, especially in situations where substantial portions of the cross-border target company’s operations are in countries that may be perceived as unfriendly to the interests of U.S. lenders. 

Getting this right from the outset can materially shorten decision cycles, improve overall deal timeline, and save considerable executive time and transaction costs, especially when compared to trying to do it "the other way."  

Understanding Where the EBITDA Is Generated

A simple review of the consolidated financial statements of a multinational company frequently does not provide a clear and reliable roadmap to its EBITDA-generating assets.  For example, the books of a business with operations in Mexico, Latin America, Western Europe, Southeast Asia and the Caribbean Basin may show that:  

• its revenues and expenses are booked disproportionately among subsidiaries located in low tax rate countries (and that the inverse exists as to expenses and higher tax rate countries), and
• its fixed assets are owned by its subsidiaries in the countries where those assets reside.

Based on this limited information, drawing any meaningful conclusions regarding the true location of the cross-border target company’s EBITDA-generating assets is difficult. However, consider how a much different picture emerges with the following additional information about the company and its business: 

• it derives significant revenues from contracts with foreign governments and commodity trading companies throughout the world,
• it has a principal distribution and service hub at a third-party location in Dubai,
• it communicates with its customers primarily through a third-party call center located in Uruguay,
• significant portions of its business are heavily dependent on proprietary and licensed intellectual property owned by a related foreign-domiciled special purpose entity, and
• it believes that the recent developments between the U.S. and Cuba create enormous opportunities for it with the Cuban government, and a material part of its growth strategy includes investment in this direction. 

It is essential in these situations to drill down into the underlying business and operations to determine which specific assets (or clusters of assets) generate the EBITDA – whether tangible, intangible or purely legal – and identify the legal regimes in which those assets reside.  This is especially important in regards to "choke points" in the company's supply or service chain.  This will enable you to better determine the methods and vehicles through which you will acquire those assets, understand the extent and quality of your rights in those assets, and improve your prospects of arranging financing for the acquisition.

Financeability of the EBITDA

Not surprisingly, lenders in cross-border acquisitions also have a keen interest getting this right, in large part because the local laws of the foreign countries in which the EBITDA-generating assets reside often will determine how (and if) the lender will be able to obtain the type of security package, equity co-investment and related rights that it desires, and whether the cost of doing these things in every potentially relevant foreign jurisdiction is reasonable under the circumstances.  These concerns go beyond the familiar tax and other liability exposure with which most sponsors are familiar in cross-border acquisitions, such as the U.S. tax laws relating to controlled foreign corporations and passive foreign investment companies, and foreign local laws that limit the effectiveness of minority investor protections, the expected liability limitations of foreign "limited liability" entities or capital repatriation.  In some situations, foreign borrowers or foreign collateral may raise additional difficulties or impediments for some lenders, including foreign licensing or qualification requirements, foreign jurisdiction withholding taxes, currency restrictions, multicurrency acquisition and funding concerns, and the possible need for agent banks, fronting institutions, collateral allocation mechanisms and other risk participation techniques.  An additional concern is that many developing countries (or countries that are renewing their economic ties with the U.S., such as Cuba), have legal systems that at present are poorly suited to reliably support U.S.-style leveraged acquisitions and related financings. 

The Good News!

Fortunately for sponsors and lenders, there have been considerable improvements in recent years in international commercial practices, the cross-border legal landscape, and the quality and general availability of experienced cross-border legal counsel in the U.S. and abroad.  As a result, there is material deal activity and related financing available for cross-border acquisitions, particularly in the upper middle market and above.  The diligence, underwriting and legal complexities are by no means simple, but they are in just about all cases manageable, particularly when the real source of the target company’s EBITDA-generating assets is not "lost in the translation".