The Mezzanine Lender as an Equity Wolf in Sheep’s Clothing

Posted on: December 13th, 2023

mezzanine-lender

In the beginning, mezzanine debt was conceived as a tool for financing deals beyond what banks could provide. When a deal needed $50 million in financing to close, and the banks could only provide $35 million, the remaining $15 million gap was filled by a mezzanine debt lender. Mezzanine debt lenders would charge a low double-digit coupon, a few points up front and a small warrant to generate returns in the mid to high teens. Throughout most of the 1990’s and into the early 2000’s, this was the primary practice of the mezzanine debt lender. As the private credit market expanded in the late 2000’s with the emergence of business development corporations and private debt funds, more capital flowed into the middle market.

Over the last 10 years, the private credit market has exploded with larger funds and new entrants creating the need for all mezzanine debt lenders to have specialized strategies to compete. Some funds have cleverly blurred the line between lender and equity investor by adopting an equity heavy approach. These types of deals start out as traditional mezzanine debt deals from a warrant percentage. Over time the lender seeks to dramatically increase their warrant ownership percentage, in some cases up to 25% of the total shares. These deals tend to be direct lending type deals where the lender is the single provider of debt capital to the company. The lender starts out with a small single digit warrant position but then rachets it up when providing additional funding.

In many cases, the additional pricing is justified by the additional risk the lender is assuming. Yet, too often, the lender pushes for increased equity pricing regarding of the risk equation. This move shows the true colors of the lender. They are not acting in a manner consistent with traditional mezzanine debt practices. They are really an equity investor, seeking premium returns at low levels of risk. Most acquiring companies do not want their lender to also be a significant equity owner of the company as it eventually becomes too expensive to fund continued growth. The key to avoiding this misalignment is to ensure the mezzanine debt lender is a dyed in the wool mezzanine player, and not an equity wolf in sheep’s clothing.

Acquisition financing loans are specialized loan structures with a decision process that involves multiple variables. As acquisition financing lenders have grown over the years, many have adopted a volume, asset under management approach.

In the deal world, there are two types of acquisition financing transactions – those that limp to the closing line and those that sprint full speed through the tape. While the diligence process will slow all companies down and inflict a bit of fatigue, strong performing companies show resiliency and rebuild momentum heading into their acquisition financing closing.

Acquisition financing functions as a growth elixir for ambitious, fast-growing companies. It enables growth at fundamental levels of a business thereby creating a compounded scale-up effect. This approach allows companies to have superior capital bandwidth which is a competitive advantage in their industries. Through acquisition financing, companies add more enterprise size and diversification in one large growth step which reduces risk and increases value.