Acquisition Pro Formas for Bank Loans
Acquisition Pro Formas for Bank Loans
This article aims to help advisors understand acquisition pro formas from a lender's perspective, but I want to emphasize upfront that pro forma templates are readily available in our industry. You can obtain one from your relationship contact at your broker-dealer or custodian, as well as from various vendors in the M&A ecosystem. We provide templates as well. Please do not feel that you need to build a pro forma spreadsheet from scratch. However, it’s important to understand them, because regardless of whether you're securing a bank loan or not, pro forma financial models are a fundamental tool for evaluating the acquisition as an investment in the first place. Let's dive in.
Historical & Projected: To qualify for an acquisition loan, the two basic factors that a bank examines are the past and the future, in that order and weighting. The past will involve the two years of combined EBITDA of both the buyer and seller compared to the debt service. The Debt Service Coverage Ratio (DSCR) must meet historical minimums for the future DSCR to be relevant from a bank loan approval perspective. When considering the future of the combined entity, banks rely on a pro forma. They expect the buyer to prepare and provide this document; the bank analyst reviews this they typically don't create for you.
The Purpose of the Pro Forma: A pro forma is a projected financial statement that provides a forecast of a company's future performance. Simply put, a pro forma is a financial forecast model. It takes your current financial data and blends it with your projections for the acquired business, painting a picture of the merged entity's future performance. It's essentially a hypothetical snapshot of how a company might look financially under different scenarios.
The pro forma is structured like a combined forward-looking P&L. A pro forma will show Revenues, COGS, Income, Expenses, Net Operating Income, and/or EBITDA. Most pro forma templates calculate how many years and months the acquisition loan pays for itself.
Adjusted EBITDA Adjusted earnings provides a clearer picture of a practice's operating performance by excluding certain non-cash expenses, and add-backs are adjustments made to EBITDA to account for non-recurring or non-operating expenses. This can include items such as: depreciation and amortization, which are non-cash expenses that allocate the cost of assets over their useful life; any one-time costs, like expenses that are unlikely to recur, such as restructuring charges, legal fees, or consulting fees; equity-based compensation; and any gains or losses from the sale of assets. These applicable items should be accounted for in the pro forma so a more accurate projection picture can be seen. A basic pro forma may only include unadjusted EBITDA, which includes depreciation and amortization. For advisor acquisitions, you want to use a more detailed pro forma and account for adjusted EBITDA and add-backs.
Key Add-backs and Assumptions: A pro forma is based on assumptions about future events. Key assumptions might include the expected level of cost savings or revenue growth from the merger, assumptions about overall financial markets and industry trends, and estimates of one-time costs associated with integrating the practices.
Realistic Assumptions: Make your projections neither overly optimistic nor conservative, as banks will often perceive them as optimistic regardless. Aim to identify what is certain and most probable, using the most realistic assumptions you can while keeping a balanced perspective. The optimism and pessimism of your projections can be adjusted by considering the CAGR and evaluating scenarios where revenues drop by 10% or 20%.
Don't be Too Optimistic, but Especially Don't be Too Conservative: While striving for realism, avoid being overly optimistic. For instance, don’t use a 10% CAGR as an assumption if your growth has been between 5% and 6% CAGR over the last three years. However, if you’re acquiring a practice twice your size, a 10% CAGR may be justifiable. Similarly, if you're close to a 10% growth rate but face significant attrition due to an aging book, yet are acquiring a book with younger demographics that don't experience the same attrition rates, then a higher CAGR would be warranted. This leads us to the next topic: providing explanations in the pro forma.
Explaining Variances from Historical Data: Pro formas involve projecting figures that differ from historical data. Bankers want to understand the rationale behind these variances, add-backs, and assumptions. Each assumption should be briefly explained, with a paragraph usually being sufficient. For add-backs, a sentence explanation is typically adequate. This provides the underwriter with the proper context for the item.
Give Context With Explanations: Sometimes (often), advisors are a bit too brief with their explanations. Please refrain from one or two-word answers. For example, if the P&L shows the seller is paying $3,000 in rent, and the pro forma does not include an amount for seller-side rent, don’t simply write "no rent" or even "no rent per LOI" as your explanation. You want the analyst to spend less time, not more, underwriting your loan. Help them be efficient. In this example, consider an explanation like, "Seller rent is excluded because we are not taking on the location, which only has one assistant who is moving to our office. See LOI for more details." This is much more helpful to the analyst and only takes seconds to write. The analysts see deals all day, every day, so more thoughtful explanations really aid in underwriting efficiency.
Monthly Pro Forma: Banks want to see the pro forma detailed by month, not just the total sum by year. While your personal ROI forecast may cover a longer period, banks typically only want to see the first one to two years.
While a pro forma isn't a crystal ball they are pretty revealing in the short term (year one) when you have one established practice buying another.