Proactive Capital Building with Mezzanine Debt

Posted on: January 23rd, 2023

mezzanine-debt

Most business owners see esoteric forms of capital such as mezzanine debt in a situational, transactional light. They usually know someone who was doing M&A and brought in mezzanine debt to close their deal. It is true that most of the mezzanine debt use cases are transactions and specifically change of control deals. When a sponsor is unable to finance the purchase price solely with bank debt, mezzanine debt is used to fund the gap enabling the deal to close.

Mezzanine Debt Funding

Aside from acquisitions, mezzanine debt has a low profile amongst companies, yet it still brings significant value in funding corporate scale-ups. Mezzanine debt lenders advance based on the future cash flow value of a business and size their loans to the current equity valuation. For most businesses this means they can advance far beyond what a bank can lend, enabling a company to have a large amount of precious scale-up capital to fund all kinds of growth investments. This application intelligence, that mezzanine debt can be used to fund corporate scale-ups, is instructive for middle market companies in their strategic planning.

Most companies when planning growth revert to a means tested capital availability assumption. They view their growth as limited to level of cash or line of credit availability and tend to view their growth potential incrementally, through the lens of historical investment activity. If they have consistently invested $1 million each year in new growth, they tend to be locked into this $1 million as a baseline. Mezzanine debt is a tool that unlocks proactive capital building thereby releasing a company from the strictures of historical investment levels. Instead of starting with the thought “We have $1 million to invest”, a proactive capital build approach starts with the unconstrained question “How much growth is available and how much capital will it take to fund it”.

Starting your planning this way opens up your scale-up possibility in an empowering way. It enables you to first decide exactly how fast you want to grow, and then proactively capital build to fund the growth step. Mezzanine debt is an ideal way to fund this higher-level growth with more capital, more repayment flexibility, and a patient, experience-based partnership approach.

Mezzanine debt loans occupy the risky echelon beneath the bank but ahead of the equity in a capital structure. They are naturally subordinated to the bank loan via an intercreditor agreement wherein the senior lender retains the power to block their interest or force them to standstill.

In the middle market, acquisition financing providers are regarded as super intelligent and hardworking. They have distinguished themselves at elite banks or consulting firms and possess the ability to synthesize voluminous levels of info into a coherent, succinct takeaway or observation. This skill is extremely valuable in attributing causation to business drivers in a financial model used to foretell the future.

The deal world thrives on the belief that the institution providing acquisition financing will deliver on their promise. Lenders usually telegraph their capital capabilities early on during the sales pitch and give their deal sizes and hold levels for their fund.