Mezzanine Debt – The Non-Binary Form of Capital

Posted on: August 19th, 2020

Mezzanine debt – the Non-Binary Form of Capital Throughout the middle market finance ecosystem, mezzanine debt holds a curious distinction. To some, it is simply a means to an end, a middle layer of financing that enables a buyout closing. To others, it is an equity substitute that enables significant growth transformation. While it appears loan-like in form and structure, it is more equity-like in substance and usage which makes it a true cross over, non-binary form of capital. The truth is that mezzanine debt is a versatile form of capital that has elements of both debt and equity but transcends both forms in terms of value and flexibility. Due to its unique form, mezzanine debt can be structured to fit a variety of different needs, as long as they align with the risk reward incentives of the mezzanine debt lender.

Often disrespected due to its double-digit interest rate, mezzanine is less a straight loan than it is an exciting equity hybrid with all the attendant benefits. It is flexible enough to fund all types of transaction uses including buyouts, refinancings and growth events. It is highly inclusive and will fund virtually any type of capital need, at times even simultaneously.

Mezzanine Debt as Direct Lending Substitute

Mezzanine debt emerged from the buyout world but has since developed as a direct lending substitute. The underlying theory of mezzanine debt has not changed much, as it is an unsecured loan, underwritten on EBITDA. What has exploded are the applications, the many ways that people use it as they learn more about it. The applications have expanded due to the underlying flexibility of the capital, its ability to impart time value and capital flexibility to a corporate growth plan.

Unlike a bank loan, mezzanine debt does not prescribe a one-size-fits all approach. It is nonjudgmental about the state of your hard collateral or the existence of a deep pocked investor in your business. Mezzanine debt focuses on a few simple to understand criteria such as EBITDA stability, future EBITDA, management quality and the risk level of the loan relative to the cash flow value of the business. The key in maximizing the value of mezzanine debt is to understand its key variables and engineer your funding solution mindful of these constraints.

Here are five things to keep in mind as you develop your plan to attract mezzanine debt financing.

Mezzanine debt lenders only back the best management teams. They are very selective and only work with strong, talented teams. They work with people that are experts in their fields and have accomplished something.
They prefer to provide all the capital you need. While traditionally beneath a bank loan, mezzanine debt lenders will take more risk and more eagerly lend if they are in a one-stop position.
They are cash flow valuation driven. If they believe their loan is protected by the cash flow exit value, they are happy to collect their interest and extend your maturity if need be.
Middle market mezzanine debt lenders are intensely relationship based and like to back companies run by dynamic relationship-oriented management teams.
Their loans are structured based on multiples of adjusted EBITDA, including run rate and contractually locked in revenue streams.

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.