Posted on: September 20th, 2022
Mezzanine debt sizing is an art as much of a science subject to the vicissitudes of market forces. However, there is a shortlist of rules that that help definitize debt capacity, despite different funds having their own views based on their lending experience. Throughout the last 30 years of middle market debt lending, two fundamental variables and three contextual variables have emerged as the primary components for mezzanine debt sizing. The two fundamental components are historical EBITDA and EBITDA multiple while the three contextual components are industry, deal type and loan to value ratio. Because future cash flow is the underlying credit driver in a mezzanine debt structure, mezzanine debt lenders are keen to look at historical EBITDA as a proxy for future EBITDA performance.
Historical EBITDA is viewed through the lens of historical fiscal periods as well as the most recent interim trailing twelve-month period. Within this analysis, mezzanine debt lenders allow for EBITDA adjustment, which permits adding back of one-time or non-recurring expenses to the historical actual level of EBITDA, thereby increasing the level of EBITDA used to derive the loan quantum. These addbacks play a key role in allowing mezzanine debt lenders to see the historical EBITDA in a more normalized light more suggestive of the future earnings capacity of the business. All addbacks should be vetted and documented before being presented to the lender as they need to withstand the rigor of due diligence.
If a company has $2 million of historical actual EBITDA and has $500,000 of adjustments, its pro forma adjusted EBITDA is $2.5 million. Using 3 times multiple, the debt capacity is then increased from $6 million to $7.5 million. The increased EBITDA creates a much larger loan size due to the effect of multiple multiplication. EBITDA multiples vary based on a number of credit related factors, but most mezzanine lenders operate within a 3.0 to 4.0 times band. For companies with a high degree of seasoned recurring revenue, the multiple will tend to 4.0 times or even higher. For companies with less seasoned, episodic revenue, the multiple will tend to 3.0 times or even lower. Mezzanine debt lenders have significant discretion around which addbacks and debt multiple they agree to, so it pays to have a high quality, compelling presentation that builds their comfort level.
Contextual variables usually feed into the level of sizing aggressiveness for the lender. If the deal is an acquisition or growth financing, mezzanine debt lenders are more generous in where they draw the line. If the deal is a cash out where money is leaving the company, they are likely to arrive at a more conservative multiple and adjustment level. Industry plays a large contextual role in both screening the deal and setting the loan size. Mezzanine debt lenders are captive to cash flow performance and eschew volatile industries where EBITDA performance is subject to extreme swings in market demand. Companies that have steady, predictable demand based repeat usage are prioritized. Finally, mezzanine debt lenders prefer structures with a strong level of equity beneath their loan. They are flexible as to whether this is cash equity, existing business value or roll-over equity, but they need to see that the business owner has significant skin in the game.