The Scalability Factor – The Hidden Benefit of Mezzanine Finance

Posted on: August 24th, 2022

mezzanine finance

Mezzanine debt lenders compete in a lending segment driven by growth transformation including mergers & acquisition and organic growth. This growth transformation lending market is a subset of the larger middle market which includes direct lending, equipment financing and asset-based finance as well. Mezzanine debt lenders charge higher rates for their capital, commonly in the 10% to 12% range. These rates are high compared to banks, but the value of a mezzanine debt lending solution far surpasses that of a bank loan, rendering the comparison apples to oranges.

Mezzanine debt lenders fund into the future growth of a company by underwriting their adjusted EBITDA, allowing them to offer loans based upon cash flow growth, as opposed to static asset values of a bank approach. This alternative structuring approach provides a significantly large capital quantum than an asset-based approach, giving the company the means to scale their business at a much faster rate. This key difference – the scalability factor of a mezzanine loan is continually borne out by market feedback.

Many companies engaged in an acquisition need a quantum of capital pegged to a multiple of EBITDA, not the asset base, of the target. The company may ask their current bank for a loan of $10 million, only to find the bank will lend only $3 million, due to the collateral limitations. A mezzanine debt lender can easily provide $10 million, as long as the loan size is within their EBITDA multiple ranges, usually 3.5 times adjusted EBITDA.

In capital, as in most things in life when you pay more, you usually receive more. By agreeing to a higher interest rate, the buyer unlocks the ability to scale their business through acquisition or hyper growth. This creates a virtuous cycle of growth, wherein a company not only grows larger but also multidimensional in ways of specialization and competitive advantage. Mezzanine debt provides a scalability factor that asset-based loans are unable to deliver.

During their underwriting processes, acquisition financing providers analyze probable performance projections for their proposed borrowers. The underwriter often toggles between a few scenarios to sensitize the growth variables leading to slower revenue and margin growth over time. The lender’s underwriting view is usually an extension of its credit intelligence and historical experience.

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.