The Upside: When Senior Debt Behaves as Mezzanine Debt

In the world of middle market corporate finance, a lot of focus is placed on transaction layers such as senior debt, mezzanine and equity. Market watchers track the movement of leverage multiples for each of these layers carefully, creating a statistical mindset of what is and isn’t market.

These leverage multiples are usually highly aggregated data points from a large swath of middle market deal sizes across a wide swath of industries.

The truth is that they probably have little relevance to your deal. Often, they create a perception of a sacred level that can’t be passed, lest the deal gods frown upon you.

Given the inherent subjectivity of risk assessment, it’s rare that two lenders will come out at the exact same leverage multiple when proposing on a deal. Some lenders like an industry, while others are repelled.

Some lenders place more value on cash flow growth, while others on assets. The line between debt and equity is blurred one, as one man’s debt multiple is another man’s equity multiple.

Cash flow mezzanine lenders in particular are more apt to call their loans super equity as opposed to sub debt, as the line of demarcation between debt and equity is expedient at best and artificial at worst.

Using them as rigid guidelines to create a layered structure because they are “market” is misguided and may likely cause mis-structuring of your deal.

The key in structuring your deal is to get as much value out of each layer as possible. This is achieved through optimizing the quantum and flexibility of each layer.

There is huge value when you can arbitrage these layers and get a senior lender to stretch further into the capital stack. Here are the reasons why.

1. Lower cost capital – Senior debt is lower cost than mezzanine debt and will result in lower debt service over the long term, improving your equity returns on the transaction. While principal repayments are required, they can provide long 7 & 10 year terms which make debt service more manageable.
2. Coverage of funding gap – when senior lenders act like mezzanine lender, they provide that extra turn of funding gap, critical to rounding out the full sources of funds. Filling this hard to fill gap has outsized impact on the growth of the company, allowing it to scale rapidly.
3. Reporting requirements – Banks can be more relaxed than mezzanine lenders, and dig less into granular business issues. They tend to confine their view to financials, which means less time educating them on operations and business strategy.
4. Flexibility with Distributions – Senior lenders look to keep good assets on the books, and allow owner’s flexibility in distributions, once the loan has been reduced to a lower level.
5. Low Cost Resource Base – Companies always have a need for funding, regardless of where they are in their lifecycle. Having a strategic relationship with a purveyor of low cost capital is a valuable resource for all phases of business growth.