How to Integrate Mezzanine Debt Principles into your Company’s Growth

Posted on: February 27th, 2020

Integrate Mezzanine Debt Principles into Company’s Growth

Mezzanine debt is a progressive, creative form of financing that is used to finance companies based on their cash flow growth. It’s most frequently used to finance acquisitions and buyouts. Yet it has great applicability to all companies transitioning through a growth stage. There are several defining principles of mezzanine debt that all mezzanine lenders apply to each prospect to determine their mezzanine debt eligibility. These industry principles have evolved over the last 35 years and bring a tremendous level of insight and strategic understanding. Whether or not your business takes on mezzanine debt, applying these principles and thinking like a mezzanine debt lender can help take your corporate growth to a new level. There are four major mezzanine debt principles that can help turbocharge your growth – strategic pro forma analysis, cash flow growth, competitive differentiators and financial reporting.

What is Strategic Proforma Analysis

Mezzanine debt lenders adjust historical earnings for one-time, non-recurring expenses to arrive at a pro forma level of earnings. This financial pro forma analysis is the foundation for identifying the best internal growth opportunities. When you scrub out the distortionary effect of one-time items, you see the true level of segment, product and customer profitability on a granular basis. This shines a light on those embedded areas in your current business, that can bring more growth and profit to the bottom line if financially nurtured with more capital. Usually this analysis highlights hidden growth opportunities that have significant scale-up potential, if provided more external capital. It can be hiring a new sales team, a new service team or bringing on more inventory. Through strategic pro forma analysis, you can develop a new growth plan for an existing low growth part of your company that has significant scale up potential.

What is Cash Flow Growth?

Mezzanine debt lenders focus intensely on your EBITDA growth as well as your free cash flow growth. Free cash flow is EBITDA after your capex, working capital needs, debt service and tax payments. It’s what’s left over after all is paid. By focusing on this bottom-line metric, you get a sense of the level of capital you need to invest in your business to generate growth. Financing growth to mezzanine debt lenders is not merely funding the upfront investment, but also the working capital increases. Fast growth creates higher EBITDA but also higher levels of working capital in your business which must be financed. Mezzanine debt lenders, as the last lenders to be paid in your capital structure, understand this and make sure the funding they provide you will cover all the uses of capital, both short term and long term. This way of thinking is very valuable to all ambitious growth companies seeking to elevate their growth rate.

What are Competitive Differentiators?

Mezzanine debt lenders are always in pursuit of companies with a high level of specialization with high gross and EBITDA margins. Specialized companies are competitively differentiated and usually combine several advantages such as low costs, wide product line, one stop solution, high service levels, and vertically or horizontally integrated. Companies that have a good level of competitive differentiation usually have strong, repeat customer relationships. Their gross margins are north of 30% and their EBITDA margins are north of 10%. Competitive differentiation gives companies staying power and pricing power in the market and allow them to generate consistent cash flow over time. Companies seeking strategic growth paths should first ensure they are specialized enough before they start a fast growth journey.

What is Financial Reporting?

Mezzanine debt lenders strongly prefer companies that have sophisticated financial reporting that provide two views of performance. The first view is the financial performance which measures sales, cost, backlog and the resulting balance sheet accounts. The second view is the operational performance of the company, which measures pipeline, operational efficiency and cost variances. Strong companies weave the financial reporting and operational reporting into their organizational DNA. Having monthly financials is not enough for a mezzanine debt lender, as they want to see the operational dashboard that management uses to run the business. If there is no operational dashboard, or it is in someone’s head then there needs to be one and it needs to be systemized. Fast growth creates a blur of activity and a lot of informational fog. Without good financial reporting, its hard to track where the investment is going, and the progress being made.

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.