Posted on: August 5th, 2020
Many middle market company CEOs see mezzanine debt in a one-dimensional light, to finance a buy-out or an acquisition. Because mezzanine debt lenders are usually associated with private equity investors, it is easy to understand why. These lenders are unique, niche oriented and not household names. They do not have highly visible profiles and tend to fly under the radar. Moreover, mezzanine debt lenders historically have focused on M&A related deal flow as opposed to direct lending to companies.
This has changed dramatically as non-bank lenders have pursued hybrid growth strategies which include funding independent companies outside the private equity and acquisition related universe. Due to the specialized nature of cash flow lending and its focus on highly professional, growth oriented companies, mezzanine debt lenders tend to cast a wide regional footprint and do not effectively market directly to companies in their back yard aside from the occasional capital convention or lender outreach. What mezzanine debt lenders lack in public visibility they more than make up for in value added, as they provide a great platform for growth capital for aspiring middle market businesses.
A key point with these lenders is to present a compelling professional growth story to them to hook them on the company’s ability to scale up. The cost of their capital and amortization profile of their loan requires them to only focus on companies that can grow rapidly and increase their size 20% or more per annum over the life of the loan.
Mezzanine Debt Pricing
Mezzanine debt pricing is 10% interest per annum with 2% interest payment in kind and depending on the risk, a small amount of equity warrants. Given the loan size, cost of the loan and the back ended nature of the principal repayment, strong growth is required for the transaction to make sense for the lender.
Mezzanine lenders look to cash flow growth for their ultimate principal repayment and tend not to rely on balance sheet-based senior debt take outs. If cash flow growth is weak, the lender may be stuck in the deal far long than originally expected.
Here are four great uses of mezzanine debt, where you can accelerate your company’s growth rate.
- Innovation investment – investing in a potential new product that will open a new market is a great use of mezzanine debt. Funding salaries and product development is often too risky for a bank. Through presenting the growth business separate from the base business, a mezzanine debt lender can use the underlying EBITDA to structure debt to fund innovation development.
- Ramping up capacity and internal function – Companies often lack human capital bandwidth to break through to the next level of growth. So often, with outsourcing and use of technology, companies get overly dependent on suppliers and realize too late they have a business model vulnerability. Mezzanine debt can allow you to build up the necessary internal structure to ensure control over critical functions and ameliorate supplier overdependencies.
- Distribution Channel expansion – funding new salespeople is often cost prohibitive for many companies as it takes a while for a new salesperson to become self-sufficient. It is more cost effective to bring on a proven sales team or to acquire existing account relationships. This will likely require a greater upfront investment but is ultimately more impactful and a safer way to pursue growth.
- Product line expansion – most companies could add ancillary products if they focused on market research, product design and prototyping. Often this falls between the cracks due to the lack of formal product line development. Mezzanine debt lenders will allow you to focus on this and monetize the full value of your product portfolio.