Go Long with Mezzanine Debt and Growth Equity

Posted on: December 21st, 2020

All businesses go through growth spurts. Some are temporary and others, long lasting and transformative. Temporary growth usually occurs due to a market shift that provides a short-term window of opportunity. Long lasting growth usually occurs due to proactive business development strategy where a company attacks a new market or launches a new product or service.

Temporary growth may be strong for a few quarters and can usually be financed through internal sources through cash flow or a line of credit. With strategic growth, the company adds a new layer to the business model. New products need investment in R&D and new channel partners. New distribution approaches need new systems and people with the requisite expertise. Companies must invest in their infrastructures to widen their resource bandwidth and diversify their specialization to ensure they are equipped to manage strategic growth.

These investments cannot be funded solely through cash flow or the line of credit but require stable, long term forms of finance such as mezzanine debt and growth equity. Strategic investments require investors with long term hold horizons with capital repayment flexibility. Mezzanine debt lenders and growth equity investors understand the delicate process of strategic growth. Their capital is perfectly suited for businesses with heavy investment needs who need a few years for the investments to bear fruit. These investors exist to fund businesses because of their cash flow growth potential. They play further down the risk spectrum than banks, and receive a higher risk adjusted rate of return because they add more value.

Where a bank wants principal payments to start in the first year, mezzanine debt lenders usually start in the year 3, giving the company valuable breathing room. Mezzanine debt lenders fund at higher EBITDA multiples than banks, giving their borrowers more capital to invest and allow for longer repayment terms, giving them more time to repay the loan. The amplification of loan size and loan tenor gives borrowers a double benefit. This is why capital providers such as mezzanine debt lenders and growth equity investors, are strong long term funding partners. They allow companies to go long and fund their transformative, strategic growth visions.

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.