Posted on: January 12th, 2023
The term mezzanine debt exists in a vacuum for most businesses, an odd sounding word with no connection to their acquisition strategy, that is until they need it the most. Acquiring companies usually land on mezzanine debt as a useful option once they have exhausted their bank options for acquisition capital.
Most companies in need of a significant quantum of acquisition capital start with their existing bank. They may ask their bank for $12 million, only to be told the bank will give them $4 million. They then tell their bank again that they seriously need all $12 million, and the bank then moves to $5 million. This leaves the company with a $7 million acquisition capital gap, a seemingly insurmountable number. Filling this with institutional equity would result in a huge share give-up in the range of 30% to 55%, likely resulting in a change of control for the current owners. This causes significant heartburn and soul searching because while the acquisition is a gamechanger, the cost of capital is prohibitively high and simply does not work for the current owners.
Upon further research, the company identifies mezzanine debt as a possible way forward, as the loan is based on the combined adjusted EBITDA. As long as the existing company has a strong value and the loan ask is less than 3.5 times combined EBITDA, the deal may fit the mezzanine debt parameters. There are a host of additional criteria pertaining to deal size, revenue, industry, deal type that mezzanine debt lenders adhere to. However, mezzanine debt is usually the best way to fill that hard to plug acquisition capital gap, as it goes far beyond the bank at a cost far less than what an equity investor needs. It is a perfect hybrid form of acquisition capital that combines the best elements of a loan structure with the best elements of an equity investment.
Mezzanine debt lenders think like equity investors and employ cash flow enterprise valuation as their basis of their underwriting approach. They are less growth sensitive than equity investors, resulting in a less intrusive, more management friendly investment personality. Because they charge an interest rate and have a relatively low risk-adjusted return target, the bulk of their return is paid through interest payments as opposed to payment in shares. Moreover, they are legendary in their ability to provide follow-on scale-up capital, to fund a roll-up or extended capital runway for a fast-growing business.