Debt, Equity, or Mezzanine? Choosing the Right Capital for Your Acquisition

The right capital to use, whether debt, equity or mezzanine debt is not an easy question to answer when deciding your acquisition financing. People usually default to market conventions such as 30% equity and 70% debt. Sometimes they may try an equity light approach, using a thin slice of equity burdened by a big wedge of debt. These decisions require deep thinking to analyze the underlying risk to the acquisition and the future growth of the company.

When Senior Debt Makes Sense

Senior debt is best in short term and less risky situations. Mezzanine debt and equity excel in longer term and riskier conditions. An acquisition purchased for asset value with little execution or growth risk is financeable with a large amount of senior debt and a lower equity amount. If the lender is fully asset collateralized, they are less concerned with the level of equity invested by the acquirer.

The Role of Equity and Mezzanine Debt

A company purchased well beyond the collateral value, based on the cash flow value of the company will require a more conservative balance including more equity investment and mezzanine debt. The higher the purchase price, the more the need for non-senior debt capital in the structure. The projected strategic growth plan of the company also figures into the formula.

Matching Capital to Growth Plans

All platform acquisitions have robust post-closing growth plans that need capital investment. The type of growth dictates the best form of capital to use for funding. New business development, such as hiring more salespeople and launching products is best with long-term capital such as mezzanine or equity, due to lack of visibility as to return and timeline. The investment certainly makes sense, but the company may have no way to accurately predict the ROI on the investment. On the other hand, growth through working capital or equipment investment is more easily handled through senior debt due to the familiarity of its cycle and short-term return.

Striking the Right Balance

Deal makers need to look at both the deal and the growth plan when deciding on their capital structure. Just because you can finance an acquisition with more debt does not mean that it is a good idea to do so. Long-term equity and mezzanine debt capital gives an acquisition more space for potential delays and business underperformance. While more expensive, it is an insurance policy that can pay off if things do not go as planned.