Mezzanine Debt and the Growth Company Funding Conundrum

Posted on: December 21st, 2023

mezzanine-debt

When funding a deal with risk, mezzanine debt lenders expect to receive a return enhancement known as a warrant. Despite its ominous -sounding name, the warrant is merely a contract right to participate in the future valuation gains of the company. The warrant is expressed as a percentage of share ownership and simulates a minority ownership in the company.

Mezzanine debt warrants are used selectively in certain types of deals. These include direct lending deals where the lender is the sole provider of institutional capital, high-priced deals with above-market level leverage ratios and roll-ups where there is a high degree of execution risk. Warrant values increase proportionately to the valuation growth of the enterprise. If the mezzanine debt warrant is 5%, and the company valuation grows from $5 million to $10 million, the warrant value increases by $250k. This is a manageable level of warrant accretion. However, big growth runs can lead to huge warrant value accretion. When this happens, the company may have a $2 to $3 million warrant value on its hands that needs to be reckoned with upon a refinancing or exit.

This example underscores the growth company funding conundrum. Prior to scale-up, growth companies are risky due to their size and attendant level of execution risk. Once they successfully scale up, the lender’s position is materially de-risked leading to above-market loan pricing. This creates a capital pricing misalignment where the company is no longer a mezzanine debt risk but is still paying mezzanine debt pricing. The solution to addressing the pricing misalignment is to plan ahead and start a refinance process early. Most mezzanine debt refinancings take 60 to 70 days or so once launched in the market. The earlier you start this process, the sooner you will bring the cost of your capital in line with the risk level of your company.

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.