The traditional way to measure the cost of the acquisition financing structure is to look at the weighted average cost of capital for all layers in the structure. This shows you how much the money in the capital structure costs.
In general, senior debt is priced at a fixed spread to a floating interest rate such as Libor or Prime. Mezzanine debt is priced at a fixed current interest rate such as 12% to 13%. Mezzanine debt also contains either deferred interest or a small warrant to provide the mezzanine lender with an all in return of 18% to 20%.
The equity layer is usually structured as preferred stock and has a dividend which accrues to the principal balance. The preferred stock investor requires an annual return of approximately 25% to 30%, depending upon the risk/reward profile of the deal. The goal in many deals is to minimize the weighted average cost of capital. However, Attract Capital believes that the cost of capital is less important than the value of each layer of the structure. We call this “Structure Value”. Structure value is a very important element to determining the best type of acquisition financing. Each layer has a different cost and a different value as indicated below.
|Mezzanine Debt||Medium||Medium to high|
Senior debt is an important part of all acquisition financing structures. However, the principal must be paid back on a short term basis. In addition, senior loans are often based on a percentage of hard asset value so loan sizes are often limited. As a result, it is not very flexible and generally of low value. Mezzanine debt is long term capital with a 6 to 7 year term. Generally it is interest only for the first three years. It is not based on assets but rather the cash flow strength of the company. As a result, it is more flexible capital and of higher value. It is more patient capital than bank debt. Though it costs more than senior debt, it has a much higher value. Equity is the longest term capital and the most flexible capital. It is also the most expensive form of capital because it sits at the bottom of the acquisition financing structure.
The value of each layer and the need for patience and flexibility must be considered in designing an acquisition financing structure. For companies that need a longer term, more flexible and patient capital structure, mezzanine debt and equity layers are vital ingredients. For companies that require less flexibility, more senior debt can be used.
The saying “you get what you pay for” is very much the case in designing an acquisition financing structure. While you pay more for mezzanine debt and equity, you certainly get more safety and stability and an overall higher structure value.