The Power of Mezzanine Debt

Mezzanine debt is a widely available yet infrequently used outside of leveraged buyouts in the middle market company ecosystem. It is a layer of financing between the bank loan and equity, needed to complete the capital stack and close the deal. Mezzanine debt is a hybrid type of capital and possesses elements of a loan as well as an equity investment. As a hybrid, it is highly flexible and valuable for middle market companies of all stages. While a buyer of a business has an obvious need for this type of capital, any middle market company seeking growth can put mezzanine debt to profitable use. The key to understanding how to use mezzanine debt and its power is to first understand how it is different than other loan.

How is Mezzanine Debt Different than Other Loans?

Most loans, particularly senior loans from banks require asset collateral or a personal guarantee from the owner. The loan size is determined by the level of collateral with some loans also receiving a small amount of non-collateralized loan, called an over advance. These senior loans require annual principal repayments, usually over 4 to 5 years. This formula results in small loan sizes and fast principal repayment. This limits your ability to make sizable growth investments which need time to mature and pay off. Small loan sizes are by themselves a big problem because most strategic growth plans require large levels of investment, beyond what is provided by bank loans and internal cash flow reinvestment.

Ambitious growth plans such as regional expansion or acquisitions, require multiples of your existing EBITDA, not fractions of your existing assets to properly fund. Without this level of funding, your company will not be able to grow rapidly, and certainly not be able to take a transformational growth step. Senior bank lenders who lend on collateral are more concerned with return of their principal than the long-term growth of your company. Mezzanine debt loans are structured on a multiple of your EBITDA, not your asset value, resulting in much larger loans, giving you much more financing to fund your growth investment. For most emerging technology companies, the difference between a mezzanine debt and bank loan size is dramatic. For a company with $2 million in assets and $2 million in EBITDA, a bank can likely lend less than $2 million whereas a mezzanine lender can lend up to 3 times or $6 million.

What is the Mezzanine Debt Advantage?

Mezzanine debt requires only interest payments and generally not principal repayment over the life of the term. This means that instead of paying principal back over a 4-year period to the bank, you can keep that cash in the business and reinvest it in growth. This cash flow reinvestment benefit has an accelerative effect on your strategic growth investment plan. At closing of your mezzanine debt deal, you received a large sum to invest in growth. When you continue to reinvest your free cash flow each successive year in your strategic growth plan, you achieve much higher levels of growth from this consistent, systematic re-investment. The total cash flow investment impact on your business is starkly different than taking a bank loan.

The growth investment upfront from a mezzanine loan is usually 3 times that of a bank loan. The cumulative cash flow reinvestment is also far greater for a mezzanine debt loan as opposed to a bank loan. You have higher EBITDA over the term of the loan and have higher levels of free cash to reinvest in growth, given the lack of principal repayments. The cumulative cash flow reinvestment advantage is usually at least 4 times for a mezzanine loan than a bank loan. This means that, if you reinvest $1 million in free cash over 4 years from a bank loan-initiated growth investment, you will likely reinvest at least $4 million from a mezzanine debt-initiated growth investment. This is a significant capital advantage – both more capital upfront and more capital reinvested over the term of the loan.

The Power of Mezzanine Debt for You

With this significant capital advantage of 3 times upfront and 4 times over the life of the loan, you have 7 times the capital to invest in your growth plan. This lets you invest for the long term and make very powerful strategic investments. Mezzanine lenders intentionally set their maturity at 5 or 6 years, which is long way out, and the principal is generally due at this time. This gives you a very back ended principal amortization structure, which gives you valuable time to expand before having to repay the loan. The longer the time period to perform and expand, the more valuable the loan to your company.

Mezzanine debt providers are the most patient of lenders. They get paid higher interest rates and other return sweeteners to be patient and allow the company to transit through its strategic growth transformation. Because they’ve lent against the cash flow, they are aligned with you and have a vested interest in the growth of your cash flow. In their repayment scenario, there is only one way out and that is through the cash flow. This fact makes them especially supportive throughout the various performance blips you may encounter. So, the power of mezzanine debt can be distilled down to the following key advantages:

7 times the capital to invest in your strategic growth plan.
An extended 5-year time period for loan repayment, giving you more time to expand and grow.
An aligned partner in your cash flow growth.
A supportive lender who understands the ups and down of a business.

As the Fed decides to ease interest rates, middle market acquisition financing structures will benefit in a number of ways. The underlying values of middle market companies will increase leading to a higher enterprise value and lower loan to value ratios for existing portfolio companies of acquisition financing lenders.

The role of acquisition financing is infrequently elevated above a functional transactional one. When a business needs financing to acquire, they go to the market and source acquisition financing to supplement their equity investment to close the deal. Despite existing in many different forms, acquisition financing is rarely explained in terms of the value it brings to the acquirer.

Acquisition financing underwriting usually focuses on business and financial issues that underpin the stability of cash flow. Providers of acquisition financing usually validate the durability of a company’s competitive advantage and the depth of its resource base. Environmental issues are usually not a major part of the analysis in today’s service and technology-based economy.