An analysis on the growth of the mezzanine debt market

An analysis on the growth of the mezzanine debt market

The mezzanine market, presently a multi-billion dollar market, with investments from professional investors, insurance companies, pension funds, and specific mezzanine investment funds has been around for 30 years. Apart from being leveraged by large companies, mezzanine capital for smaller and mid-sized investments in the $2-$15 million range is witnessing a new phase of growth. This growth can be attributed to the varying reasons listed below.

Traditional lenders being too cautious is aiding the mezzanine debt market

Although companies that made it through the recession are seeking growth capital, traditional sources of credit such as commercial banks are remaining cautious. Traditional lenders proceed only if collateral is available to support the entire loan. Also, commercial banks are sometimes unwilling to ‘look beyond’ the historical operating losses. The collateral advance rates for commercial finance having witnessed a sharp decline also does not help.

This leads to private companies turning to alternative means of financing. Equity capital, however, is quite expensive because a company is forced to issue shares or ownership interests in exchange for the cash investment, and the existing ownership gets diluted. Mezzanine finance on the other hand, offers an attractive alternative since it provides a generous cash advance, on flexible terms to the borrower. Mezzanine loans are customizable and can be used in a number of creative ways. This has led to a growth in the mezzanine debt market.

New evolving roles aid the growth of the mezzanine debt market

The rapid growth of mezzanine financing can further be attributed to its new evolving role. Apart from the traditional uses of mezzanine capital being deployed for acquisition financing, mezzanine capital is increasingly being sought to provide growth capital to growth-oriented companies on a direct basis. Instead of going to the bank, companies are seeing the value of working with a more sophisticated, cash flow value oriented lender. Mezzanine lenders are historically far more patient and far less threatening to a borrower that is going through a rough patch of performance.

Another trend in mezzanine financing is the rise of ‘mezzequity’. This describes mezzanine funds moving further down the capital structure in companies to fit into the more traditional target profile, which results in taking control of equity positions. In contrast to this, another trend shows some mezzanine funds have moved to provide a solo ‘unitranche’ or high-coupon senior debt-like product to riskier borrowers. The new evolving ways to deploy capital and achieve target returns are fueling the mezzanine debt market.

Specific benefits spur growth of the mezzanine debt market

Certain advantages specific to mezzanine debt capital are also fueling the growth of the mezzanine debt market. For example, mezzanine debt is attractive because the borrower pays only interest payments for the first three or four years of the loan. The advantage of not paying principal payments in the initial years is extremely attractive to companies. It gives them more cash to grow the business. Most new growth paths take time for a company to see results. Banks require loan payments right away, which can cause operating cash shortfalls. Mezzanine loans allow you to fund a new growth path initially and to continue funding it until it starts to pay off.

Furthermore, mezzanine loans take a longer time to mature- usually five to seven years. This proves to be attractive for businesses seeking growth capital. Mezzanine funding is generally calculated based on a multiple of the companies EBITDA. The most common amount offered is three or five times EBITDA. This allows for more cash flow, especially in mergers and acquisitions.

Although the mezzanine debt market is continuously growing, it still remains a niche market and comes with its own set of limitations. If used properly, it can provide capital coverage for corporate acquisitions, recapitalizations and other transitional periods when supplemental financing is required.

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