Posted on: August 23rd, 2022
Mezzanine Debt is commonly used to finance acquisitions and buyouts. Through mezzanine debt’s ability to provide larger sums of capital it frequently funds 100% of the capital needed for acquisitions and even corporate scale-ups. Through loan sizing via an EBITDA multiple scale, borrowers often raise 3 to 4 times adjusted EBITDA, unlocking significant borrowing power.
At times, buyers unilaterally focus on using the mezzanine debt to fund the purchase price as opposed to allocating proceeds to growth capital investment. This stems from the difficulty most buyers have accessing this form of capital and their reticence to ask for a larger quantum. Despite having a strong growth thesis to the acquisition, buyers tend to assume that any growth investments can be handled through cash flow post-closing. This action creates a fundamentally flawed capital structure situation for the company and the lender. While the acquisition can be closed, the lack of upfront investment in activating growth will hurt the Company’s ability to grow. It is likely to underperform relative to its projection. Once closed, the lender is locked into a starting leverage position, and usually is not receptive to increasing the leverage post-closing.
Most lenders rely on the company to tell them the amount of capital they need to invest as growth capital in the business. Despite the growth capital need being modest to the overall loan size, most sponsors neglect this aspect of capital structuring. Sponsors who envision value creation through growth, yet do not allocate the proper amount of capital to support growth, are unserious business people more akin to asset flippers and speculators. All acquirors should carve out a healthy amount of mezzanine debt structure for growth capital, to ensure they have enough financing to capitalize their growth plan. In today’s competitive M&A market, post-closing growth is the single biggest determinant to exit value. Savvy acquirors are those that understand that it is the availability of capital, as opposed to the price of capital, which dictates valuation success over the long term.