Posted on: September 9th, 2020
Mezzanine debt is strategic capital that is raised to propel the growth rate of a company. Its cost requires a high value use for it to be beneficial for the issuer. At closing, the mezzanine loan is structured upon the company’s future cash flow value, as determined by the lender. This value is used as a proxy for the enterprise value of the business upon a sale or exit. If the lender buys into a future cash flow value of $20 million, they may assign a debt capacity of 70% to the company and provide a loan up to the 70% loan to value or $14 million.
The cash flow value is usually a large multiple of the existing current cash flow or EBITDA, and is an intangible, conceptual value. It cannot be readily accessed as collateral by the lender. It is something they believe in order to make the loan, but it does not mean the company has that level of liquidity to repay over the short term. This begs the question, how does mezzanine debt then get repaid, if the cash flow value is not monetizable in the short term? The answer to this reveals the true meaning of mezzanine debt and how it theoretically works.
Mezzanine debt lenders believe that strong companies can take their capital and use it to grow their businesses. It can be any kind of growth, internal or external, but they believe the company has the market potential and internal capability to grow. The critical thing about growth is giving it enough time to incubate and materialize and being reasonable about how long it will take. Growth does not occur in a matter of months or quarters but over the course of years.
How Mezzanine Debt Lenders Invest
Mezzanine debt lenders invest in companies that have immediate growth potential and allow them to fully realize the growth over the course of 2 to 3 years from the date of funding. An acquisition scenario is an illustrative example. When funding an acquisition, the acquirer needs time to integrate the business, convert its systems, align the two organizations, and develop a seamless market facing strategy. While much of this is done immediately post-closing, some of these activities take up to a full year to implement.
It then takes additional time to see the financial results from the changes and measure the effectiveness of the integration plan. If things are on plan, then the company has succeeded and significantly increased its bottom line. If things are not on plan, more adjustments must be made which involves more time and investment.
Mezzanine Debt Lenders and Principal Payments
Mezzanine debt lenders do not require principal payments in the first three years of the deal, so the company can instead keep the cash in the business to ensure its growth step is successfully achieved.
Principal repayments usually start in year 4 or in some cases can be completely back ended to the maturity date, often 5 years. It is only after the company has successfully transited through its growth phase and the cash flow and asset base is much larger, that the loan must be repaid.
At this point, the loans are usually repaid in one of three ways:
- Through cash flow – the company’s cash flow has grown significantly and can now make current principal payments out of current earnings.
- Through a bank refinancing – the company has grown to 2x the size and has increased its hard asset value on the balance sheet. A bank can now refinance the mezzanine debt loan on the strength of traditional collateral.
- Through a sale of the company – if the value of the company has grown enough and the timing is right, the owner can sell the company and repay the mezzanine lender through the proceeds of the sale.