Funding Leveraged Dividends through Mezzanine Debt Capital

Posted on: March 21st, 2024

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Business owners are increasingly turning to mezzanine debt-based, leveraged dividend deals as a stopgap measure for liquidity in lieu of selling into a lukewarm market. This makes complete sense given the abundance of debt capital in the form of unitranche financing, mezzanine debt and structured equity. Leveraged dividends give the owner a cash out without giving up significant equity and can be combined creatively with other uses of funds such as growth capital, acquisition financing and working capital support.

Evolution of Mezzanine Debt: Enabling Holistic Capital Solutions and Liquidity Needs

This transaction structure can function as a holistic capital solution to both the needs of the owner and the liquidity needs of the business. The emergence of structured equity funds which provide an integrated package of debt and equity, provide another source of funding for this type of transaction. Historically, mezzanine debt lenders were less likely to consider large scale leveraged dividends due to their lack of alignment with the owner. They would fund dividends but usually on a small scale and as an adjunct to a more substantial pro-growth capital investment. With fewer sell side deals to fund, and a growing focus on founder owned companies, non-control capital providers are actively pursuing these deals as a way to deploy capital and build relationships that may convert to full sell-side financing opportunities down the road.

For companies with EBITDA greater than $10 million, these deals get done in the 4.0 to 4.5 times EBITDA leverage range. They tend to be for companies that have referenceable market valuation benchmarks. The goal of mezzanine debt lender or structured equity provider in these types of deals is to co-exist with the senior lender and be in a non-controlling, passive position. They are unsecured or in a second position and influence the company through covenants set a discount to the bank levels. Mezzanine debt lenders continue to adapt to the changing middle market and have proven their adeptness at developing value added approaches that keep them at the forefront of relevance as valued capital providers.

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.