How Does Mezzanine Debt Work

Posted on: June 24th, 2019

How Does Mezzanine Debt Work

Mezzanine debt is a form of financing designed with features of a loan and features of equity, that provides a safe, long-term funding solution for acquisition financing and other corporate borrowing needs.

Like a high yield bond, these loans allow companies to maximize their credit capacity through measuring credit availability as a multiple of EBITDA.

Mezzanine lenders often lend into the funding gap of an acquirer beyond the hard collateral of a business.  They frequently provide a loan where repayment is based on future cash flow growth.

The credit evaluation of mezzanine lenders focuses on the long-term financial performance of the business and its ability to service debt over the term of the loan.

As part of their credit evaluation, mezzanine lenders validate the private equity enterprise value of the business, to ensure that their loan is within the private equity enterprise valuation.   Mezzanine debt costs 10% to 13% for middle market companies with revenue ranging from $25 million to $100 million.

Due to this cost of funds, it is ideally suited for situations where companies can significantly increase the size of the enterprise.  Mezzanine debt often substitutes for equity investment in the capital stack of an acquisition.

It shares a common valuation approach as private equity yet has significantly lower cost.   Its lower cost is a function of its debt like interest feature. Mezzanine lenders receive nearly 90% of their total return in the form of interest payments, which reduces their pricing requirement for additional return.

When mezzanine debt is pushed to an equity level of risk, additional return in the form of warrants are issued to give the warrant holder participation in the equity upside.

A key element is the use of adjusted EBITDA in the calculation of debt capacity.  Through applying cost adjustments and addbacks to EBITDA, a company can expand its debt capacity and attract higher levels of borrowings.

Due to its cash flow-based approach, mezzanine loans bring greater borrowing power to companies than bank-based borrowing approaches.

How is Mezzanine Debt Used?

Due to its higher tolerance for risk, ability to go deep and to deliver customized structuring, mezzanine debt is versatile across use cases.

Most frequently it is used as acquisition financing but can also be used for corporate expansions and internal corporate investments.

Mezzanine debt is commonly sourced in combination with a senior loan, usually provided by a bank. In this instance, the mezzanine debt would be in a subordinated position to the senior bank loan.

There is no requirement however, for mezzanine debt to be only in a junior position in the capital stack.  In some transactions, it is preferable to use mezzanine debt as 100% of the financing requirement, in a one-stop financing package.

Mezzanine loans can be used by a wide spectrum of acquirors. These include independent sponsors, closely held businesses, and private equity funds.   Mezzanine debt is a long term dated loan – usually 5 to 7 years in term.

This term timeframe provides underlying capital strength to a company undertaking a risky long-term growth step, such as an acquisition.  Most acquisitions are complex, multi-faceted projects that require a 3 to 5-year time frame to pay off.

Bank loans are usually short term focused and require immediate principal repayment.  Mezzanine loans have relaxed repayment terms.  They usually don’t require any principal repayment until the maturity date, creating a high level of cash flow retention and balance sheet liquidity for the borrower.

Mezzanine lenders conduct comprehensive due diligence on their borrowers and invest in building relationships with management of the borrowers.

They originate loans with the intent to keep them in their portfolio, thereby reducing the agency conflict that affects other corporate loan markets.  This approach differentiates mezzanine lenders as capital providers.

As borrower-knowledgeable lenders, they are well positioned to support the company through the loan term and provide more capital to the borrower if needed.

A rule of thumb to gauge the need for mezzanine financing is as follows:

  1. Has your bank or an alternative bank rejected your request for a larger loan?
  2. Will the strategic event (acquisition or expansion) double the size of the company over the next 3 to 5 years?
  3. Will your future EBITDA cover the added interest expense by a 2 to 1 margin?
  4. Will your total debt post-closing be under 3.5 times future EBITDA?

If you answered yes to at least two of these questions, you should consider mezzanine finance.

In short, when a company has large growth opportunity at hand, and needs a strong finance option to execute it, mezzanine debt is a safe and intelligent option.

Where Do I get Mezzanine Debt?

Mezzanine debt is widely available throughout the financing markets in the US.  The companies that provide it are not highly visible companies but small, partnership type firms, called mezzanine debt funds.

These mezzanine debt funds tend to concentrate in the money center regions of the United States.  These funds have specific criteria they use to screen for loan opportunities and reject an estimated 95% of the deals they review.

Most funds are stratified according to deal size, region, and industry.  Additionally, middle market mezzanine funds are quite focused on the level of professionalism of the prospective borrower.

Companies with fully formed management teams, audited financials, budgeting discipline and strong internal processes, are preferred.

Due to the relationship nature of the mezzanine professionals and their underwriting process, these loans involve multiple approval steps including financial analysis, industry analysis, background checks, and legal due diligence.

Due to the high level of review, prospective borrowers are well served to hire an advisor and prepare for each step of the process.

Advisors also bring existing lender relationships to the borrower, easing their ability to connect with the right lenders.

What are the Advantages of Mezzanine debt?

Mezzanine debt is the best form of capital available to fund an acquisition.  If structured right, it can provide 100% of the needed capital.

Mezzanine finance dramatically reduces the share dilution from large equity investment into your deal. Most private equity investors want 60%+ ownership stakes.

Most mezzanine lenders require interest payments and a small warrant.  Mezzanine debt drastically lowers your cost of equity and simplifies your deal structure.

Mezzanine debt provides capital stack stability for an acquirer due to its long term and relaxed principal payments.  It offers more capital than a bank loan and less onerous repayment.

The relationship approach of a mezzanine lender brings advantages to the borrower.  They are more patient and more supportive than equity investors and seek to collaboratively build value.

In most mezzanine deals, companies can increase their equity value 2 to 3 times, creating a windfall gain, most of which drops into the pocket of the owner.