Mezzanine Debt vs. Minority Equity: Which delivers better returns in acquisitions?

In acquisitions, deal structure is destiny and yet too many investment bankers underwhelm in structuring between mezzanine debt and minority equity. Investment bankers often overuse equity as their go to capital. In many cases, mezzanine debt can be used in the transaction structure creating huge cost savings for the issuer. Minority equity has its strong points as a patient and durable form of capital, but it is very expensive.

Most growth equity firms target ownership of 20% to 30% of the shares of the company when pricing the deal in addition to a PIK dividend rate of 6% to 10% and return of their principal. The equity give-up coupled with the dividend and repayment of principal is steep and difficult to justify when you can achieve similar execution at a fraction of the price with Mezzanine debt. The market interest rate for mezzanine debt is 12% to14% which seems high, but this is the lions share of their total return. Mezzanine lenders also ask for a small equity warrant in certain deals ranging from 3% to 10%, where they are the only institutional provider of capital.

Minority equity will result in less current cash paid through the PIK dividend but will have approximately 25% of the shares. Mezzanine debt will result in higher current cash pay with their interest rate of 13% but they will have approximately 7.5% of the shares in the form of their warrant. If the Company has good cash flow and can handle the interest charge, mezzanine debt is the better low-cost option from an equity dilution standpoint. Some deals may be better suited for growth equity especially where the debt multiple is high. However, founder-owned companies should always look to mezzanine debt first when designing their acquisition transaction structures.