Financing future acquisition growth
The retail automotive dealership industry continues to experience significant consolidation. With blue sky values remaining strong, real estate costs continuing to rise, and OEM-mandated facility image upgrades becoming increasingly expensive, the capital required to acquire and grow a dealership group has never been greater.
From a lender's perspective, successful acquisitions begin long before a purchase agreement is signed. Buyers that understand their financing capacity, capital requirements, and covenant limitations are better positioned to move quickly when attractive opportunities arise.
This article outlines how dealership groups can prepare for future acquisitions and ensure they have sufficient capital and cash flow to support the debt often required to complete a transaction.
Capital sources and requirements
Before pursuing an acquisition, dealers should identify their available sources of capital, whether through commercial banks, captive finance companies, private equity firms, or other investors. Understanding each source's requirements early in the process can prevent surprises during negotiations.
Key financing considerations include:
- Advance rates on blue sky and real estate
- Loan tenure and amortization
- Working capital requirements
- Cash flow coverage expectations
- Financial covenant calculations
Dealers should also understand precisely how lenders calculate covenant compliance and how a proposed acquisition will affect those metrics. These calculations are generally outlined within loan documents and should be reviewed carefully before entering into a transaction.
Understanding typical loan covenants
Loan covenants can be thought of as the governor on an engine. They help ensure a dealership remains within acceptable financial operating parameters and provide lenders with ongoing insight into the financial health of the business.
Working Capital Covenant
Many lenders use a minimum current ratio requirement to measure liquidity:
Current Ratio = Current Assets ÷ Current Liabilities
Important considerations include:
- "Soft" assets such as owner or affiliated receivables are often excluded from current assets.
- Owner or affiliated debt may be excluded from current liabilities if it is formally subordinated to the lender.
A strong current ratio demonstrates the dealership's ability to meet short-term obligations and maintain adequate liquidity following an acquisition.
Debt Service Coverage Ratio (DSCR) or Fixed Charge Coverage Ratio (FCCR)
These ratios measure a company's ability to service debt obligations and are often calculated as:
(EBITDAR Less Taxes and Distributions) ÷ Debt Service
Where:
EBITDAR = Earnings Before Interest, Taxes, Depreciation, Amortization, and Rent
An important factor in evaluating cash flow capacity is the level of historical and projected owner distributions and the flexibility to reduce or eliminate those distributions, even temporarily.
The ability to reduce distributions can significantly increase the amount of acquisition debt a dealership group can support. If cash flow capacity is limited, lenders may require distributions to be restricted to tax payments only until financial performance improves.
Operating Leverage Covenant
Operating leverage is commonly measured as:
Total Term Debt ÷ EBITDA
Where:
EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization
Many lenders prefer operating leverage to remain within a range of 2.5x to 3.5x EBITDA.
Stated differently, a dealership group can often support term debt equal to approximately 2.5 to 3.5 times annual EBITDA, assuming all other covenant requirements are satisfied.
Determining acquisition capacity
Once dealers understand their lender's requirements, they can estimate the level of acquisition debt they may be able to support. When a target dealership is identified, its cash flow can be combined with the buyer's existing operations to determine total borrowing capacity.
Example
Assume the following:
- Blue sky purchase price: $10 million
- Real estate purchase price: $20 million
- Target dealership EBITDA: $2 million
- Existing dealership group EBITDA: $5 million
- Existing dealership group blue sky value: $30 million
The consolidated dealership group would generate approximately $7 million of EBITDA annually.
Applying a leverage range of 2.5x to 3.5x EBITDA results in estimated debt capacity of:
- $17.5 million at 2.5x leverage
- $24.5 million at 3.5x leverage
Assuming covenant compliance is maintained, the next step is determining how much of the purchase price can be financed and how much equity will be required.
Key questions include:
- Does the consolidated dealership group maintain acceptable DSCR or FCCR levels?
- What blue sky advance rate will the lender provide?
- How much equity will be required at closing?
Blue sky lending advance rates vary by institution but often range between 50% and 70%.
In some cases, lenders advance only against the blue sky value of the acquisition target. Other lenders may consider both the value of the to be acquired dealership and the value of the existing franchises owned by the borrowing group.
Consider equity partners early-on
For dealership groups utilizing private equity or non-operating investors, confirming available equity commitments should be part of the acquisition planning process.
In addition to understanding how much capital is available, dealers should have clear expectations regarding:
- Required investor returns
- Distribution requirements
- Timing of capital contributions
- Restrictions imposed by senior lenders
For example, if investors require an annual return of 8%, management should confirm that future distributions are permitted under existing floor plan, term loan, and mortgage agreements.
Addressing these matters before entering into negotiations can prevent delays and conflicts later in the process.
Prepare financial projections
Lenders and OEMs typically expect to see detailed financial projections covering the first one to three years following an acquisition.
These projections should clearly outline assumptions related to:
- New vehicle unit sales
- Used vehicle unit sales
- Front-end gross profit per vehicle
- F&I income
- Service and parts performance
- Operating expense assumptions
Financial projections should also incorporate verifiable add-backs and non-recurring expenses associated with the target dealership. Common examples include prior ownership or management fees, above-market rent expense, personnel changes, and cost savings resulting from operational synergies.
Cash flow and sensitivity analysis
Financial projections should include DSCR and FCCR calculations to demonstrate ongoing covenant compliance. These projections should also contain a sensitivity analysis to understand the impact on cash flow from changes in unit volumes, front-end grosses and interest rates.
If relatively modest fluctuations create covenant pressure or materially reduce debt service capacity, additional equity may be required to provide greater flexibility and financial cushion.
Providing a range of outcomes demonstrates management's understanding of both the opportunities and risks associated with the acquisition.
Prepare a day-one balance sheet
As the majority of buy-sell transactions are structured as asset purchases, buyers should prepare a projected Day-One balance sheet that includes both sources and uses of funds.
Sources of Funds
- Acquisition term debt
- Mortgage financing
- Investor equity
- Dealer equity
Uses of Funds
- Blue sky (goodwill)
- Real estate
- Parts inventory
- New vehicle inventory
- Used vehicle inventory
- Working capital
The Day-One balance sheet should then be consolidated with the buyer's existing balance sheet to evaluate the post-closing current ratio and overall working capital position.
This analysis helps determine whether liquidity levels will satisfy lender requirements after the acquisition is completed.
Maintain strong financial reporting
Given the largely unsecured nature of acquisition financing, lenders commonly require CPA-reviewed financial statements at a minimum.
Dealers planning to grow through acquisitions should consider engaging a CPA firm with substantial automotive dealership experience before acquisition opportunities emerge.
Strong financial controls, accurate reporting, and consistent financial performance provide lenders with greater confidence and can significantly shorten approval timelines.
Conversely, dealerships with recurring floor plan audit exceptions, weak controls, or significant year-end accounting adjustments may face additional scrutiny when seeking acquisition financing.
Quality of earnings reports
For larger acquisitions, lenders and buyers frequently require a Quality of Earnings (QoE) Report, particularly when the seller does not have CPA-reviewed or audited financial statements.
A QoE report validates reported earnings and cash flow by identifying non-recurring items, normalization adjustments, and potential financial risks.
From a lender's perspective, the report provides additional confidence that the projected EBITDA supporting the acquisition debt is sustainable and accurately presented.
Conclusion
Successful acquisitions are rarely the result of preparation that begins after an opportunity is identified. Rather, they are typically executed by dealer groups that have already evaluated their borrowing capacity, covenant limitations, capital structure, and cash flow requirements.
By understanding lender expectations, maintaining strong financial reporting, conducting sensitivity analyses, and preparing detailed post-closing projections, dealers can move quickly and confidently when acquisition opportunities arise.
A well-prepared buyer not only improves the likelihood of securing financing but also enhances credibility with lenders, OEMs, brokers, and sellers. In a highly competitive acquisition environment, that preparation can become a meaningful competitive advantage.
Joe Connolly and Ryan Schoen are both Managing Directors in BMO’s Dealer Finance Group. For over four decades, BMO Dealer Finance has been dedicated to serving the automotive retail industry. With over $30 billion in commercial loan commitments to franchised auto dealers throughout North America, BMO Dealer Finance has remained a stable, reliable, and committed financing resource for dealerships.