The Blunt Instrument of LTV in Mezzanine Debt Lending

Mezzanine debt lending has always been as much an art as a science, especially in the creative finance arena of the middle market. While bankers hew to collateral ratios and advance rates, mezzanine debt lenders are unrestrained and able to tailor debt structures to cash flow and growth potential.

As private debt markets grow driven by institutional investors in search of yield, there are more private debt funds than ever. Most of these funds focus on private equity backed deals. In these types of deals, the PE fund is usually purchasing the company at a 6 to 10 times multiple of EBITDA, depending on the quality of the company.

At these healthy prices, PE firms invest a large percentage of the purchase price in equity, usually 35% to 45%. The lenders are asked to provide the remaining 55% to 65%. While these lenders also look at their debt multiple to EBITDA in the deal, they screen most heavily on the LTV. If you run the math, a 60% LTV debt deal on an 8 times EBITDA multiple buy-out results in a debt to EBITDA multiple of 4.8 times. This way of looking at the world is entirely appropriate for PE deals, but completely misses the mark for non-PE deals, especially independent sponsor deals.

Mezzanine Debt in Independent Sponsored Deals

Independent sponsored deals such as management buy-outs or company-sponsored acquisitions, usually involve a special relationship between buyer and seller. Because the buyers lack millions of dollars in equity, they resourcefully negotiate lower priced deals with more back ended seller financing, to minimize the cash required at closing. These deals are often priced at far lower values than PE deals, usually in the 4 to 6 times EBITDA level, and the total amount of equity is usually in the 25% to 35% range, leaving a mezzanine debt lender to provide 65% to 75% of the funding.

If a lender provides 70% financing on a 5 times deal, the debt to EBITDA multiple is 3.5 times. Most smart lenders understand the inherent differences between these two distinct types of deals. One is higher priced, but has more equity behind it, the other lower priced, with less equity behind it. Problems emerge when lenders use LTV as a blunt instrument and over apply the metric to all deals.

Just because you do mostly 60% LTV and 4.8 times debt multiple deals, does not mean you shouldn’t do a 70% LTV deal, especially when the debt multiple is only 3.5 times. The independent deal may have less risk and give you a higher return, even though you have a higher LTV. LTV is a but one way to measure deal attractiveness, and those that overuse it miss out on attractive opportunities.