Why Mezzanine Debt can be a Double-Edge Sword in Middle Market Deals

Posted on: May 27th, 2025

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Mezzanine debt often functions as a gap-filler in middle market deals. As crossover capital, it provides equity-level funding with debt-like properties thereby providing more capital at lower prices for companies. Mezzanine debt also unlocks more aggressive growth scenarios unavailable through bank loan structures.

Often mezzanine debt lenders eliminate the need for an equity investor, creating a huge benefit to founder-owned companies who need acquisition capital but are resistant to taking private equity. The right mezzanine debt structure can create a virtuous cycle of continuous capital for funding of roll-ups and add-on acquisitions. When the company performs well, properly structured mezzanine debt is an abundant source of transformative value for the borrower.

Notwithstanding its benefits, mezzanine debt must be handled with care and managed within the capital structure to ensure it does not overexert its role as a lender. This is the double-edge sword duality of mezzanine debt existence for companies. This occurs when the lender feels their capital is more important to the business than it really is. This belief is usually caused by a lack of confidence or communication between the parties. Sometimes mezzanine debt lenders underappreciate the value of the operating company and management team. They feel that their capital and willingness to continue to fund acquisitions is the key differentiator of a business.

When this happens, the mezzanine debt lender thinks more like an equity owner and may become more active in the Company which is usually an unwelcome development for the owner. If the mezzanine debt lender is not subordinated to a senior lender and they are the only institutional capital provider to the company, this is more prone to happen. This also occurs with greater frequency if the lender is also a private equity investor with a proactive stance of adding value to portfolio companies. Companies can prevent this from occurring by properly managing the lender relationship and constantly communicating the underlying strengths of the operating platform.

Acquisition Finance Loan Agreements can be a bit of a sticky wicket. On the one hand, all the major terms have been agreed between the parties in the letter of intent. While these major terms are usually clear in the loan agreement, new language and rights often pop up for the first time, which makes it uncomfortable for the company. These new things are often traditional legalese, too minor for the acquisition finance lender to disclose up front in the term sheet.

The use of conventional structural parameters to evaluate the strength of a deal has not changed much in the acquisition finance world over the last 35 years. There is a bit of smug overconfidence that acquisition finance professionals have regarding their ability to micro-calibrate deal quality using leverage multiples.