Proactive Capital Building with Mezzanine Debt

Posted on: January 23rd, 2023

mezzanine-debt

Most business owners see esoteric forms of capital such as mezzanine debt in a situational, transactional light. They usually know someone who was doing M&A and brought in mezzanine debt to close their deal. It is true that most of the mezzanine debt use cases are transactions and specifically change of control deals. When a sponsor is unable to finance the purchase price solely with bank debt, mezzanine debt is used to fund the gap enabling the deal to close.

Mezzanine Debt Funding

Aside from acquisitions, mezzanine debt has a low profile amongst companies, yet it still brings significant value in funding corporate scale-ups. Mezzanine debt lenders advance based on the future cash flow value of a business and size their loans to the current equity valuation. For most businesses this means they can advance far beyond what a bank can lend, enabling a company to have a large amount of precious scale-up capital to fund all kinds of growth investments. This application intelligence, that mezzanine debt can be used to fund corporate scale-ups, is instructive for middle market companies in their strategic planning.

Most companies when planning growth revert to a means tested capital availability assumption. They view their growth as limited to level of cash or line of credit availability and tend to view their growth potential incrementally, through the lens of historical investment activity. If they have consistently invested $1 million each year in new growth, they tend to be locked into this $1 million as a baseline. Mezzanine debt is a tool that unlocks proactive capital building thereby releasing a company from the strictures of historical investment levels. Instead of starting with the thought “We have $1 million to invest”, a proactive capital build approach starts with the unconstrained question “How much growth is available and how much capital will it take to fund it”.

Starting your planning this way opens up your scale-up possibility in an empowering way. It enables you to first decide exactly how fast you want to grow, and then proactively capital build to fund the growth step. Mezzanine debt is an ideal way to fund this higher-level growth with more capital, more repayment flexibility, and a patient, experience-based partnership approach.

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.