Mezzanine debt is a form of capital that allows companies to make acquisitions and grow faster. Unlike bank loans, mezzanine debt is based on the profitability and growth potential of a business. Where banks are only interested in making asset based loans, mezzanine lenders look to the company’s cash flow, growth potential and management character when making their lending decision.
Mezzanine can be a game changer for a company, as it allows you to do things that are not possible with a bank loan. Mezzanine lenders generally get involved in acquisition situations where one group is purchasing another. The key to getting the most out of mezzanine debt is understanding how it works and how it is structured.
The loans are 5 year terms and are usually interest only for the term. There is no personal guarantee involved with the loans. The loans are based on a multiple of the Company trailing twelve month EBITDA, which is earnings before interest, taxes depreciation and amortization. A multiple is the basic metric used by the mezzanine industry to assess the riskiness of the loan.
An EBITDA multiple of 2 times means the total loans divided by EBITDA is equal to 2. This is a very low multiple. The multiple selected for the loan is usually a function of the strength of the company and the attractiveness of the industry. If the company is doing poorly or in a turnaround mode, it will not qualify. If the company is in a cyclical or dying industry, it will not qualify.
Companies that have stable financial performance, in non-cyclical industries with revenue greater than $20 million are the prime targets for mezzanine. The mezzanine loan is in second position to the bank loan on the company’s balance sheet. Due to the second position, and the fact that the loan is not collateralized, the lender requires an interest rate higher than a bank loan.
Mezzanine lenders also require additional upside return, tied to the success of the company. Mezzanine works best for companies that have a transitional capital need that exceeds the company’s flow or available line of credit. This is usually the result of a big strategic opportunity such as a new product launch, acquisition opportunity, or a buy out of an owner.
Mezzanine provides the transitional capital required to capitalize on strategic opportunity, causing growth in the size and profitability of the business. This gives the company more cash flow or borrowing base to pay back the loan at the end of five years. In short, mezzanine debt is a low cost way to fund long term growth.
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