Posted on: September 28th, 2020
Mezzanine debt is a hybrid form of debt capital containing characteristics of both a senior loan as well as an equity investment. Like a loan, mezzanine debt principal must be repaid over a specified term. Not unlike an equity investment, mezzanine debt is usually unsecured and funds into the future growth of the company. Mezzanine debt does not conform to traditional loan parameters and is not based upon hard asset collateral. Mezzanine debt loans are based on cash flow or EBITDA of a company and are usually set at a multiple of EBITDA. For this reason, mezzanine debt is a highly flexible and customizable form of capital, often used for acquisition financing or growth capital financing. It is like a junk bond, that has a long term, little requirement for principal repayment and best of all, no personal guarantee.
What are the Most Common Uses of Mezzanine Debt?
Mezzanine debt is used most frequently as part of an acquisition where the buyer needs additional financing. It sits beneath the senior debt and between the equity layer of the capital structure. Because of its focus on future growth and cash flow, mezzanine debt lenders can stretch further and provide more financing than banks. It is used by private equity firms as well as independent buyers. It has great value to an independent buyer as it often can be used as equity by a buyer, allowing them to invest less of their own capital. Any company going through a rapid scale up can benefit from mezzanine debt as it is less expensive than raising equity and more valuable than senior debt.
Superior Returns from the Use of Mezzanine Debt
Middle market mezzanine debt rates are 10% current pay interest and 2% deferred interest range. All in returns are in the 12% to 15% range, which may require a small equity warrant of up to 3%. When replacing equity in a deal structure, mezzanine debt produces strong returns for a business owner. If a deal needs $5 million to close and this can be raised through either mezzanine debt or equity. The equity will require 20% of the shares. Mezzanine debt will charge 12% interest per annum and a 2% equity warrant. Assume the deal results in the acquiring company increasing its overall equity value $10 million over a 2-year period. The mezzanine loan will cost $1.2 million in interest expense over a two-year period ($600k per year) plus 200k of equity warrant for a total of $1.4 million. The equity will cost 8% per year in a PIK dividend, or $800k plus $2 million of equity value for a total of $2.8 million. The equity cost is nearly two times the mezzanine debt cost. Because much of the mezzanine debt cost is paid through interest expense, the owner of the business realizes superior returns on their equity value.
What are Important Criteria to Mezzanine Debt Lenders?
Mezzanine debt lenders require a strong management team and stable historical financial performance. They seek to lend to companies with an established customer base in a non-cyclical industry with steady repeat market demand. The probability of the growth plan is important to mezzanine debt lenders, as their future principal repayments will be funded through the EBITDA growth funded by their loan.
What is the Payoff from Mezzanine Debt?
Growth without massive equity dilution is the biggest payoff with mezzanine debt. Equity investors require a large percentage of ownership in exchange for their investment. With mezzanine debt, an owner will not incur large dilution and have all the capital needed to achieve their growth plan. Mezzanine debt can result in significant growth in value and increase the equity value of the business by 3 to 4 times.