How Mezzanine Debt Reduces Execution Risk in Leveraged Transactions

Mezzanine debt is rarely seen as a lubricant for execution risk in a leveraged transaction. Often it is viewed negatively as a symbol of “too much debt,” thereby creating more execution risk for the buyer.

Deals conceived on paper in the mind of theoreticians often create their own execution risk through their unreasonable assumptions. Deals that rely on instant revenue growth or rosy cost reductions often run aground on the shoals of naïve thinking.

Mezzanine debt brings two critical elements to the table that helps buyers mitigate execution risk in the touch and go world of leverage transactions. Mezzanine debt lenders bring a pragmatic perspective to each deal they review to ensure the business can achieve their cash flow objectives.

With little hard collateral to secure their loan, mezzanine debt lenders must verify the fundamental underpinnings of the business to ensure that future profit can pay their interest and principal back. This is not a simple cursory review but a full-blown analysis that covers a battery of tests. They dig into the market, customers, employees, market share, industry growth, as well as product competitiveness and value.

They also roll up their sleeves to assess management’s ability to execute in an uncertain environment. Leveraged transactions involve acquisitions and new growth paths, which introduce unknowable factors and unforeseen lags into the execution equation. It creates execution fog for a management team that they need to fight through, different from the day-to-day management tasks.

Mezzanine Debt and Execution Discipline

Mezzanine debt lenders have the powers of discernment to pick capable management teams can get through execution challenges. Their mezzanine return is dependent on this perceptive ability.

Additionally, mezzanine debt lenders bring the advantage of balloon maturity to the table for the buyer. Their entire principal is paid at the end of 5 or 6 years, not on a quarterly basis. This is a big benefit to companies that take longer to get on track after the deal closes.

When the principal payments start right away, it exerts unnecessary pressure on the business and can impact the company’s liquidity, creating more execution risk. When the principal is due short term, management becomes victim to short term thinking and its attendant consequences. When the principal is due long term, there is ample time and space for the company to invest and nurture its true long-term potential.