Five Common Misconceptions about Mezzanine Debt

Posted on: March 10th, 2020

Mezzanine debt is a high value form of financing for companies seeking transitional capital for growth. It is usually deployed as part of a bespoke structure in a M&A transaction. Because it is bundled with other forms of capital as part of an integrated solution, its true value is often obscured. Additionally, mezzanine debt lenders tend not to be large, highly visible funds that middle market businesses frequently encounter. They are not known brand names like a Goldman or a Blackstone. Notwithstanding their low market profile, they still provide a lot of benefit to companies that take the time to understand how best to use them. In general, mezzanine debt functions like a mini-high yield bond providing risk capital to companies investing in growth scale-ups.

These loans are riskier than bank loans because they are largely uncollateralized and rely on growth in the underlying borrower’s EBITDA for ultimate repayment of principal. Most middle market business owners, once they become fully educated on the strengths of mezzanine debt and how it applies to their growing business, become enthusiastic converts. Often business owners have misconceptions about what mezzanine debt is and how it works, which prevents them from taking full advantage of it. Here are the five common misconceptions business owners’ have on mezzanine debt.

Mezzanine debt misconception #1 – It’s used only by Private Equity funds when buying companies.

Mezzanine debt has been a go-to source of financing for private equity funds since inception. However, use of mezzanine debt has expanded far beyond funding private equity acquisitions. It is routinely used by companies without the involvement of a private equity firm. It is also routinely used by independent sponsors, entrepreneurs using their own money to buy companies. You do not have to be a private equity fund to be able to use it. It’s true that there are mezzanine funds that will favor funding private equity acquisitions. But the mezzanine debt market has greatly expanded and accommodates acquisition funding for any type of legitimate buyer.

Mezzanine Debt misconception #2 – It’s used only for acquisitions of businesses.

In the beginning, this was the case. However, mezzanine debt is used for a whole host of capital applications. These include funding any type of growth scale-up, including investment in staffing, distribution, new product, increased capacity and regional presence. It also includes investment in working capital, where greater levels of working capital bandwidth are needed. It can also be used to bridge a transitional restructuring period which are too risky for a bank to lend into. It can be used for any growth event where long-term capital is needed to mitigate the execution risk of the investment strategy.

Mezzanine Debt Misconception #3 – It’s too expensive and I can’t afford it.

It is true that it’s priced higher than a bank loan. But comparing it to a bank loan is like comparing an apple to an orange. Mezzanine lenders give you extra capital in addition to your current bank loan, even though you lack collateral. They fund into the equity value of the business, based on EBITDA. Mezzanine debt is priced higher because it has a higher risk adjusted profile than a bank loan. It also has far greater value to you, because most mezzanine debt loans give you all the capital you need to complete your growth investment.

Companies that have large growth potential usually need a large sum of capital upfront to make the investment, which can’t be filled by internal cash or a bank loan. Without the required level of capital, they can’t get from point A to point B, which means they cannot scale their size or value. If there is a large growth opportunity, such as the potential to double your business size over 3 to 5 years, the opportunity cost of not having capital is huge. When looked at in relation to the ability to dramatically increase the future value of your business, the cost of mezzanine debt is low. It’s more about can you not afford to have this capital, as opposed to can I afford it. Any fast growth scenario can afford mezzanine debt.

Misconception #4 – It has strict provisions and requires a personal guarantee.

Mezzanine debt does not require personal guarantees. Only in rare instances where the loan has a unique risk that can’t be mitigated alternatively. It may get a pledge of your stock and will have fixed charge and leverage ratio covenants. These covenant levels are usually more liberal than a bank. While they may have other prohibitions on change of control and distributions, these are designed to ensure that the company does not deviate from the agreed upon strategic plan and to ensure cash remains in the business.

Misconception #5 – Mezzanine debt is widely available in any size loan depending upon my need.

Mezzanine debt is not available for smaller companies generally defined at revenue under $15 million and EBITDA under $2 million. The loan sizes start at about the $4 million check size. So, if you are trying to get your deal done with a bank and are $1 million short, it’s not likely an institutional mezzanine lender can help you.