Why Mezzanine Debt is a Different Solution than other Loans

Mezzanine debt has distinctive characteristics that make it different than just about any other loan. Despite the number of traits that make mezzanine debt incredibly unique in the lending world, we can sum it up in tips and steps that are easy to digest.

The key element of lending is the need for collateral, but mezzanine debt breaks the mold. This is a loan that is not collateralized, and is positioned beneath a bank loan.

Mezzanine debt lenders have a cash flow based mentality that allows them to make a loan against the Earnings Before Interest, Tax, Depreciation and Amortization, otherwise known as EBITDA, of the borrower.

Mezzanine debt is based on cash flow, which means that it is more inclusive and accepting of diverse companies that may struggle to get a bank loan.

Tip #1: For many borrowers, mezzanine debt provides a loan amount greater than their asset collateral, and goes deeper into the capital structure

In going deeper, it can provide a company critical financing at a point when capital is needed the most. This is usually during a transitional growth phase such as expansion or acquisition, where the Company has a big opportunity to scale.

Due to its cash flow orientation, mezzanine debt providers think more like equity investors, but use the structural elements of a loan to balance their desire for upside with the need to mitigate downside risk.

Tip #2: Because these loans are based on cash flow, they tend to be more creative in structure and more flexible in terms of use

Conceptually, cash flow can be measured in a number of ways which works to help the prospective borrower attain a larger loan. The EBITDA measurement, based on historical and current EBITDA, allows the lender to fund into future growth and provides vital access to capital at a much lower cost than raising equity.

To some borrowers, mezzanine is a high cost loan, to others it is low cost equity. Mezzanine earns its return through allowing a company to do something transformational, whether it is an acquisition or regional expansion.

It provides a stable, long term capital bridge for a company engaged in a high growth scenario. Many companies dream big and have long term vision, but lack the means to fund their growth vision.

Mezzanine debt gives you the ability to be proactive and expansive, as the funding vehicle for your growth vision. With it, new doors will open.  Without it, your company will certainly be smaller, have slower growth, and less innovation.

How Is Mezzanine Debt Structured?

It is provided by mezzanine debt funders who focus on different segments of the market. Usually, lenders provide loans to companies with revenue greater than $25 million and EBITDA greater than $3 million.

Step #1: Decide How Much Funding You Need

The first step in structuring mezzanine debt is to figure out your funding need, also known as the use of funds. Often, this is the amount of cash needed to close an acquisition.

This should include all of the costs including the payment to sellers, any closing costs, or any due diligence costs.

Step #2: Calculate Total Sources of Funding Available

The second step is to calculate your source of funds, which means all of the cash available to close the deal.

Usually, there is some cash equity and some bank loan coming in, and the difference between this sum and your total uses, is your amount of your mezzanine loan.

Step #3: Figure out Your EBITDA

The third step is to analyze your EBITDA and make any pro forma adjustments. Pro forma adjustments are justifiable add backs that reflect one time or non-recurring expenses.

They are added back due to the fact that they are not likely to occur again in the next twelve month period.

Step #4: Calculate Your Debt Multiple

Once you know pro forma adjusted EBITDA the fourth step is dividing this number into the total amount of loans, both bank and mezzanine loans.

This calculation yields a total debt to EBITDA multiple. This multiple metric is the key variable that a mezzanine debt provider uses in assessing the loan request.

Tip #1: The Lower the debt multiple, the better the deal

If the total debt to EBITDA multiple is low, the loan is viewed as less risky. If the multiple is high, then the loan is viewed as more risky. The multiple range can span from low of 2.0 times to a high of 4.5 times.

Tip #2: No two companies have the same debt to EBITDA multiple

The right total debt to EBITDA multiple is different for each company, depending upon its strengths, industry, and size. The level of collateral does not enter into this analysis, as mezzanine lenders are largely indifferent to collateral.

Some situations, where lower pricing or senior debt replacement is the goal, will result in more collateral sensitivity.

What are the Common Terms?

For middle market deals, most mezzanine loans have several distinctive features.

Term #1: Balloon Principal Payments on the Backend

These loans, as opposed to other loans, have back ended principal repayment.

Term #2: Term of Five to Six Years

The terms are usually 5 to 6 years and most require only interest to be paid during the term, with the entire principal due in a balloon payment at the end of the term.

This allows the borrower a lot of latitude and breathing room. You have the option to pay the loan back early if that is preferable.

Term #3: Fixed Interest Rate Around 12%

Mezzanine loans have interest rates of around 12% per annum.

The rate can be a bit higher or a bit lower, but generally the rate is in the low teens, which is required to compensate the lender for the level of risk they are taking.

Term #4: Upfront Fee & Extra Return of a Few Percentage Points

The lender also charges an upfront fee of approximately 1.5% and also seek some additional return kicker.

The return kicker, is also referred to as a warrant, and allows the lender to realize a few more percentage points (2% to 4%) on the overall return.

Tip #1: No need for a PG

Mezzanine loans do not require asset collateralization or personal guaranty. They view the theoretical cash flow value of the firm as sufficient creditworthiness for the loan.

Tip #2: Adjustments to EBITDA are allowed

Most mezzanine loans are made against the theoretical cash flow or equity value of the business. This concept allows for the use of pro forma valuation techniques which allows the borrower to justify a higher value, and hence receive a higher loan amount.

So, mezzanine debt can be summarized as long term, no principal repayment required, low teens rate, with a return kicker and no personal guarantee.

What Are the Most Common Uses?

Typically, large growth steps should be funded with mezzanine debt. The larger and more transformational the growth is, the more likely it should be funded with mezzanine debt.

Tip #1: Most acquisitions and strategic expansions are funded with mezzanine debt

Mezzanine debt is also ideal for fast organic growth, capacity expansion, or regional expansion. Any project that requires more than two or three years of time to mature is perfect for a mezzanine approach.

Tip #2: Mezzanine loans provide greater funding amounts, which is very important when buying and integrating a business

When one company acquires another, extra cash is needed to fund the growth of the combined operation. Acquisition or expansion require loans beyond asset value and longer terms.

Because of the variability of outcome and the circuitous path this can take, a smart lender that understands what makes the business tick is important.

Tip #3: Mezzanine funded acquisitions can help you scale in size and increase in exit value

When a business has an opportunity to buy a competitor, vertically integrate or to purchase customer accounts, they can expand rapidly. They can also increase their value upon a sale.

Successful execution of these strategic deals usually result in a three to seven fold increase in the overall value of the company. They have the ability to launch a company into the big leagues and put it on an entirely new playing field.

When a decision is made to pursue this type of transformational acquisition or expansion, mezzanine debt is best to use because of its long term, flexible nature and its patient support.

Mezzanine lenders, because of their cash flow orientation, business judgment, and long term patience, are ideal partners for strategic acquisition or expansion.

Why Is It a Better Alternative Than Equity?

There are several reasons why mezzanine debt is a better alternative than an equity investor.

Reason #1: Mezzanine Debt Costs A Lot Less Than Giving Up Shares

Mezzanine debt has an inherently lower cost than equity. Mezzanine lenders receive most of their return from interest payments from their borrowers.

A mezzanine lender may take a small equity warrant in a business ranging from 2% to 10%, depending upon the risk of the deal and the size of the loan.

Mezzanine debt uses the same theoretical valuation approach as an equity investor and can usually provide much of the same capital value as an Investor. They are usually far less dilutive to the company’s shares and an easier financial partner to work with.

Reason #2: Mezzanine Provides a More Supportive and Less Intrusive Relationship

Mezzanine lenders are generally passive in dealing with their borrowers. They set up covenants and received monthly financial reports. They do not get involved in the strategy of operations of the Company.

They are very supportive of their borrowers and will help with advice and more funding if needed.

Reason #3: Mezzanine Allows you to Attain Structural Flexibility

Most mezzanine lenders will allow a senior loan ahead of their loan. They will also provide follow on financing to fund more deals. You can flex the loan to suit your capital needs, which makes this a very valuable equity-like form of financing.

Why Is It a Better Alternative Than a Bank Loan?

Comparing bank loans and mezzanine loans is a bit like comparing apples to oranges. They are inherently different as banks need collateral whereas mezzanine lenders use cash flow for their loans.

There are several major reasons why mezzanine debt is a better alternative than a bank loan.

Reason #1: More Funding

For cash flow rich companies, a mezzanine loan will provide a lot more funding than a bank loan. You can get up to three to five times more capital with a loan based on cash flow than a loan based on asset collateral.

Reason #2: Easier Repayment Terms

You can wipe the sweat from your brow… Mezzanine loans do not require principal repayment nor personal guarantees.

Reason #3: More Creative Uses

Most banks are restrictive as to what their loans can be used for. Mezzanine loans can be used to fund any type of business development or acquisition. It can even be used to fund a change in ownership.

What are the best Types of Companies for Mezzanine Debt?

The best candidates for a mezzanine loan are companies with strong cash flow in niche markets. These companies generally have gross margin percentages of greater than 30% and consistent financial results.

This is usually characteristic of companies that have steady customers and repeat revenue from year to year. Usually, mezzanine candidate companies have a low level of assets relative to their cash flow, which is to say that their EBITDA is high relative to the assets on their balance sheet.

These businesses tend to be specialized and have multi-faceted business models with a range of functional activities.

Tip #1: Companies in niche businesses with stable growth

Tip #2: Companies with EBITDA margins of greater than 10%

Tip #3: It is a fit for manufacturers, technology companies, distribution companies, service companies, consumer product and industrial products companies. Can be any type of company except real estate, natural resources or commodity businesses

What is the Mezzanine Lender looking for?

Mezzanine lenders are very focused on the current and future financial performance and examine the business to identify the current financial trend. They are looking for companies with strong cash flow, a quality management team, and a strong growth plan.

Strong management teams are important to build confidence and trust factor. Because the loans are not repaid for 5 or 6 years, quality management teams are required to ensure that the business can grow to a larger size to be able to repay the loan back.

Lenders are partial to companies that have a professional approach to the management of the business. This includes the company’s communication style, financial reporting, and strategic business plan.

Before embarking on a mezzanine project, it’s important to make sure these pieces are in place before the process is started. If the historical financial statements are not audited, or if the company lacks a professional business plan, the company should take the time to improve this prior to embarking for a mezzanine loan.

At the end of the day, the mezzanine lender is looking for strong companies with strong growth potential that have a transitional financing need.

Tip #1: Strong management team and growth story

Tip #2: High margins and growing revenue

Tip #3: Professionalism in your engagement style with the lender