Tips for Raising Mezzanine Debt Growth Capital in the Post-Covid-19 Period

Posted on: May 6th, 2020

Capital raising requires corporate focus, process expertise and market connections. This is especially true in the Post covid-19 period when a large swath of middle market companies will simultaneously be rebooting their capital structures. Throughout the crisis period, most companies have been tested and have consequently adjusted their business models to survive the shutdown. As companies restart, they face a new uncertainty as to how quickly business will come back.

The answer to this question is critical for deciding how much growth capital is needed to support your restart. Mezzanine debt is available as growth capital in the market but requires specialized ways of articulating and framing your business plans. The key in attracting mezzanine debt is to show your pro forma level of EBITDA and your near-term growth plans. If you can credibly lay out equilibrium revenue and EBITDA on a pre-covid-19 and post-covid-19 period, you will make a strong case for growth capital and a strong impression on mezzanine debt lenders.

The Importance of the Revenue Bridge to Mezzanine Debt Lenders

This recent event is the mother of all extraordinary, one-time events and if presented properly, should not factor into the mezzanine debt lender decision. Companies need to show clear monthly revenue trends for the trailing twelve-month period preceding March 2020. This is historical equilibrium revenue. They also need to build a revenue bridge showing the transition back up to projected equilibrium revenue. The revenue bridge must credibly build the case that the ramp up is achievable.

The bridge should use operating metrics from the business and show the dynamics of the sales funnel, order book, delivery and revenue recognition. These should be based on historical data from the company’s experience with new business development and delivery execution. The key is having historical reference points to support the revenue bridge assumptions that hold up under scrutiny from the lender. Mezzanine debt lenders are ideal capital providers to fill the cash burn hole during this bridge period. However, the revenue bridge must be built with well-grounded assumptions and grounded in historical reference points. Through this exercise, the mezzanine debt provider gains comfort as to your ramp up and plugs the cash flow gap between the pre and post Covid-19 period.

The Importance of Pro Forma EBITDA to Mezzanine Debt Lender

When applying for growth capital, mezzanine debt lenders look closely at expense levels. As most companies have cut costs, the tendency for most companies is to project leaner expense levels into the future in their projection models. Expense budgets should reflect a realistic transition back to normal levels of the historical equilibrium revenue period before the crisis. There are two important considerations to bear in mind. Because we are presenting on a pre and post equilibrium basis, you will not be able to get credit for cost cuts made during the crisis. Unless you have permanently changed your cost structure, the lender will assume that costs will return to the pre-crisis period. Secondly, cost build up usually precedes revenue build up, particularly in a startup or growth scenario.

You should not be shy about spending more upfront in order to scale back up according to plan. Mezzanine lenders understand that certain strategic expense investments are necessary to be able jump start growth. If you spend more to achieve your revenue bridge and ultimate projected equilibrium revenue, you will be able to add back one-time start up growth expenses to your EBITDA. This is routinely done in venture debt and growth debt lending and is a technique that most mezzanine debt lenders are familiar with. The goal is to show a clear and detailed expense structure on a post covid-19 basis on a par with the pre covid-19 basis. This will enable you to show pro forma EBITDA on both a pre & post basis.

In assessing your growth capital request, the mezzanine debt lender is likely to focus on the level of operational execution required to achieve your post covid-19 EBITDA target. The more straightforward your execution plan, the more comfort they will gain. Also, the mezzanine debt lender will focus on the length of your revenue bridge and the magnitude of your cash flow gap relative to your Pro forma post covid-19 EBITDA level. If your pro forma EBITDA is $5 million and you need $15 million to get there, that will be viewed as risky. If you need only $5 million to get there, they are more likely to be comfortable.

In the acquisition financing arena, capital availability is destiny as companies require reliable access to capital to grow over the long term. Unforeseen capital needs usually arise when acquirers least expect it. This can cause some concern for the acquisition financing provider, especially when covenants tighten up and that working capital availability is utilized faster than expected.

Mezzanine debt borrowing is usually a straightforward activity that many companies use for funding of transitional growth. Mezzanine debt lenders are highly transparent about their due diligence approach and their post-closing loan management making it easy for companies to engage with.

Elections have consequences and positive ones at that for the acquisition financing middle market. While much media attention is paid to the direction of the yield curve and the Fed’s likely rate cuts, scant attention is paid to the more important drivers of the acquisition financing market – business psychology and regulatory climate.