How Mezzanine Debt Structures Help Companies with Little Collateral

Posted on: July 23rd, 2020

How Mezzanine Debt Structures Help Companies with Little Collateral Most lenders think in terms of collateral or security for their loans. If I advance you a loan, how can I ensure that I have a second way out of the loan, in lieu of just receiving loan repayments. Collateral is usually the answer and banks have all sorts of rules and guidelines covering what is appropriate collateral and the best way to be secured by it, should there be need to foreclose. For this reason, banks’ primary focus in lending is to assess the collateral base of the company and see how much debt it can support.

The vexing issue for the American growth economy is that many companies are both technology-based and specialized. They may provide a technology service which requires very little in the way of traditional assets to be tied up in the business. They may also have a sales-focused only business model. This means they have no accounts receivable because all receipts are handled up front and digitally. Any inventory they have will be held by their supplier. They may have strong cash flow, led by above average gross margins and very low working capital requirement, yet they fail spectacularly in the traditional bank collateral assessment test.

Mezzanine Debt for Acquisitions Without a Traditional Balance Sheet

What is a fast growth, tech-based service company to do when it wants to invest in growth or make acquisitions without a traditional balance sheet? The answer is mezzanine debt or mezzanine debt like loans, which place emphasis on EBITDA generation, and not hard assets.

Over the last 35 years, mezzanine debt has carved an important niche in the leveraged finance industry of supplying capital based on cash flow. Through using a holistic, cash flow underwriting approach, mezzanine debt lenders can safely supply loans based on a multiple of EBITDA ranging from 3.0 to 4.5 times adjusted EBITDA. Often these companies have current assets less than their EBITDA, and very little property, plant, or equipment to boot.

Traditionally, they would qualify for a de minimis amount of financing on a collateral-based approach. Through the lens of a mezzanine debt lender, their strong EBITDA is a valuable currency they can use to obtain a large mezzanine debt loan. This concept of cash flow finance is vitally important to the rebuilding phase of the American economy, as it provides the initial capital kickstart that middle market companies need to regain their momentum following the Covid crisis.

Companies in a steady state of growth, exercising their growth rate lightly, can make do with a traditional collateral approach to finance. They never need a large upfront investment because they rarely accelerate their rate of growth exercise beyond slow growth mode.

Fast moving and rebuilding companies need large amounts of capital upfront to accelerate their rate of growth exercise. These companies have large demands for capital to invest in new staffing, new product expansion and R&D for the next product generation. Mezzanine debt is the way that smart fast growth companies fill their capital gap to activate outsized growth.

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.