Difficult Deal Types for Mezzanine Debt Lenders

Posted on: May 20th, 2023

mezzanine-debt

Mezzanine debt is a superior form of capital replete with flexibility, patience, and situational versatility. It unlocks greater funding availability for companies in need of scale-up capital for transitional periods. Unlike more staid loans such as bank and asset-based loans which help fund day to day capital needs, mezzanine debt is like jet fuel in its ability to fund large growth steps, such as acquisitions and accelerated growth. Despite its clear advantages in the lending market, it has very particular use cases.

Many new sponsors or entrepreneurs are instantly attracted by the prospect of a larger loan size and try to apply a mezzanine debt framework to their growth plans. This is a judicious exercise to undertake, and has big educational value for the participant. Nonetheless, their deal’s use case falls short of qualifying for mezzanine debt for several reasons. Often it is a startup which is too risky to underwrite. Other times it is the type of business, in an industry, that is off limits. Here are profiles of deals that middle market mezzanine debt lenders generally avoid.

Real estate or big project-based businesses.
Overly concentrated customer or regional businesses.
Commodity-type businesses.
E-Commerce businesses with overly virtualized business models.
Firearms or Ammunition businesses.
Start up or loss-making businesses.

Real estate development or acquisition businesses are a different field of finance and not focused on by middle market, corporate focused mezzanine debt lenders. Overly concentrated businesses lack the all-important spread of risk that mitigates downside. Commodity businesses are generally low value added, and not differentiated enough. E-commerce businesses are generally highly competitive and lack long-term staying power. Firearms or Ammunition business are prohibited per their limited partners. For a deal to work, a mezzanine debt lender must see stable historical cash flow and a high likelihood of cash flow growth in the future. If your deal profile aligns, a mezzanine debt structure will provide significant value to your acquisition strategy.

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.