Posted on: October 19th, 2020

Acquisition Financing Rates of Return Acquisition financing loan structures are priced in interest rates on a nominal basis. Middle market bank interest rates in today’s market are approximately Libor plus 300 to 400 basis points.Non-bank middle market rates run from Libor plus 400 to 700 basis points depending on the risk. Mezzanine debt interest rates range from 10% to 12% which seems high relative to the bank and non-bank rates. This comparison is illustrative in highlighting the mutual exclusivity of these forms of capital.

Mezzanine rates are higher because they have more risk in a debt structure and provide a riskier layer of capital than a bank or even a non-bank provides. On a nominal comparison basis, there is a 100 to 300 basis point spread between bank and non-bank rates. There is a 700 to 800 point spread between bank and mezzanine rates. This same nominal relationship exists in the bond market with the 10-year treasury at .65% as of today and the average junk bond rate of 5.45%. Ostensibly, the junk bond rate is nearly 5% higher and certainly nominally more costly. Yet, junk bonds are far riskier than Treasuries which carry a government guarantee and a AAA credit rating.

Most companies especially middle market companies are no where near triple A credit rated. Companies seeking significant growth through acquisition and fast organic growth need high levels of capital relative to their company credit rating, and non-bank and mezzanine debt are a great way to finance it. You pay more for these forms of debt capital because they provide far more capital than a super safe, triple A credit rated loan would provide. The way to think about higher priced forms of debt capital is not to overfocus on their cost, but on their value. If a 10% interest rate loan allows you to fund 100% of your acquisition need, without any equity dilution, then it has a very low real debt cost.

While its nominal interest rate may seem high, its real cost is quite low. Viewing debt costs through this real rate of return prism allows you to clearly see the cost to value relationship. It may cost more, but provides significantly more value, thereby allowing you to generate a superior internal rate of return on the acquisition.

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.