Posted on: June 14th, 2018
Mezzanine Financing has grown in popularity over the years, but is still widely misunderstood by business owners. The actual name does little to help those unfamiliar with it as it describes its position in a capital structure from the perspective of the deal architect. Most entrepreneurs are less interested in capital structure nuances than they are in getting their hands on capital to close their deal. The most accessible way to understand mezzanine financing is as a loan against future cash flow growth.
Mezzanine financing providers are not collateral oriented but cash flow growth oriented. If the business has strong cash flow and there is a growth catalyst at hand to increase future cash flow, then your deal will fit the criteria for mezzanine financing.
They use future cash flow to calculate a current business cash flow value. They then make a loan against the business cash flow value, which is most often measured as a multiple of current EBITDA. Because mezzanine financing providers are comfortable with future cash flow, they do not need collateral for their loans, as they expect to be repaid through the future cash flow. This is the large dividing line between bank loans and mezzanine loans.
Mezzanine loans are usually in second position to bank loans, are generally unsecured. Bank loans are largely always secured and fully collateralized. Mezzanine loans are not, giving them less in common with bank loans and more akin to an equity investment, which is inherently not secured and is a claim on future value. Due to their cash flow underpinnings, mezzanine financing providers focus on lending to stable companies, with strong historical profits, high gross margins and clear growth runways. As businesses grow, they can often go through a hyper growth stage, brought upon by industry dynamics or strong market demand.
A high growth rate is usually accompanied by a need for a greater levels of funding during the transitional growth period. Here are the three most popular use cases for mezzanine financing.
- Industry Roll-up – when a company acquires multiple smaller companies to add geographical diversity and an existing customer base, mezzanine financing is a great funding mechanism. In a roll-up, the acquirer leverages its strengths at the acquired company to drive more efficiency and revenue gains. The acquisition synergies often help drive down the purchase multiple, helping to free up more financing for the next acquisition. Roll-ups are long term, and operationally intensive processes that benefit from having a smart, long term thinking capital provider.
- Strategic Acquisition – Purchasing another business that will double or triple the size of your business is a high risk strategy and requires a smart lender. These types of deals need a patient lender that can give you time and space to integrate and implement the growth plan. Mezzanine lenders are the best funding options for these types of deals.
- Strategic Investment – Companies often reinvent themselves with new products and new markets. Capital investment is needed to add new growth dimensions to a company so it can scale up in rapid fashion. Mezzanine financing is a great tool to accomplish this as principal repayment is back ended and there are no personal guarantees. This enables aggressive investment without the restrictions that most banks put in place.