Mezzanine Debt vs. Senior Debt: How to Strike the Perfect Balance

Balance is a virtue that underpins soundness in thought, life and debt structures. Finding balance is very beneficial in deciding how much senior debt vs. mezzanine debt to use in your financing solution. There are a number of practical and high-level strategic things to consider when making this calculation. It is an analytical and risk assessment exercise that goes beyond mere rule of thumb measures such leverage or loan to value ratios. It starts with deciding how much risk the acquisition integration poses to the borrower.

If the integration is likely to go smoothly with the borrower not missing an operational beat, then more senior debt can be used. If the outlook for integration is less clear with major operating hurdles, more mezzanine debt should be used. Senior debt is less forgiving and must be repaid more rapidly than mezzanine debt. It is hard for a company struggling with integration, which inevitably cascades into cash flow issues, to pay back senior debt principal right away post-closing. Too much senior debt and the need to pay it back quickly causes excessive focus on short-term management thinking at the expense of long-term growth. When a company is constantly tight on cash, it is much more focused on getting through the day than investing in long term growth for the future.

Mezzanine debt, as a hybrid of debt and equity, naturally allows room for investment in long term growth and naturally provides more time to the borrower to repay the principal. Even though senior debt is less expensive, it imposes a much higher short term debt service requirement on the borrower. This ultimately increases the opportunity cost of non-growth due to lack of cash to invest in long term growth. Though mezzanine debt is more expensive than senior debt, it provides a more relaxed expectational environment for the borrower within which they are free to pursue multi-faceted growth on top of the acquisition. These considerations need to be viewed through the prism of the borrower and the acquisition to arrive at the optimal blend between the two. In our experience, due to the innate risk of mergers and acquisitions, more mezzanine debt and less senior debt is the winning choice for striking balance.