Mezzanine Debt’s Use as a One-Stop Solution

A lot of deal doers, including fund less sponsors and search funds, focus on lower middle market deals of companies with EBITDA ranging from $1.5 to $3.0 million. There is less competition at this end of the market, and savvy buyers can capture an illiquidity premium. Often these buyers come to realize, after they have executed the LOI with the seller, that the universe of lenders is smaller than they envisioned. The amount of total financing needed may range from $2.5 million to $4 million which is a bit of a no-man’s land for the institutional debt market. When the financing amount is split between senior debt and mezzanine debt, it becomes an even smaller loan size. Smaller deals are harder to get done in the lower end of the middle market and require high level conceptualization of the deal structure to have a fighting chance of funding success.

Many companies turn to mezzanine debt and the structuring efficiency it offers to bridge this market asymmetry. Through redesigning the risk layers of the financing, you can create a one-stop solution for mezzanine debt. These one-stop solutions are increasingly popular, and many get marketed as unitranche loans. This helps you bring in 100% of the financing needed, as well as the option to fund part of the equity layer due to the risk mitigation this structure affords the mezzanine debt lender. Additionally, a one-stop mezzanine debt structure offers greater optionality for more mezzanine debt in the future or for carving out a layer of senior debt to support future acquisition and growth needs.

How a One-stop Mezzanine Debt Solution Works?

Most acquisition debt structures have a senior debt and a subordinated debt component. The senior debt is usually provided by a bank and is low cost, shorter term debt. The mezzanine debt is provided by a mezzanine debt lender and is higher cost, long term debt. The mezzanine debt is a cornerstone of the funding package because it allows the senior debt to get repaid ahead of it. It stays in place for 5 years and bases its repayment on the future cash flow growth of the company. In a one-stop mezzanine debt solution, instead of having two layers – a senior and a mezzanine layer, the senior layer is replaced by the mezzanine debt layer. So, if the original structure was $2 million of senior debt and $1 million of mezzanine debt, the one-stop structure is $3 million of mezzanine debt.

Instead of having two separate lenders, you have one lender. Instead of having to repay principal right away to your senior lender, you usually have a 3 year no-principal repayment runway. This frees up a lot of cash flow, usually about 75% of the senior loan amount. The price of your loan will likely go up as the market rate for mezzanine is 10 to 12% versus the market rate for senior debt of 6%. The extra interest cost is a small price to pay for not having to repay heavy principal back in the early years of the deal.

Why the One-stop Solution is Preferred by the Mezzanine Lender

In most deals, mezzanine debt lenders plug the hole between the senior debt and the equity. When you redesign your financing package and ask them to fill the senior role, you are removing one of the biggest risk elements for them. In each deal, mezzanine debt lenders are contractually bound to a certain level of subordination to the senior lender pursuant to an intercreditor agreement. This limits their right to receive interest and other rights such as acceleration and default calling, under certain conditions. This is set up in the event the company underperforms, and the senior lender must take certain measures against the borrower.

The senior lender does not want to worry about the mezzanine debt lender if the company is in a work-out scenario. Often the bank can act irrationally and act against the company which is against the interest of the mezzanine lender. This happens quite frequently as banks are usually collateral focused, at the expense of the long-term growth of the company. They can do things that will affect the long-term cash flow growth of the business. This long-term cash flow growth is the all-important engine of mezzanine debt loan repayment. By removing the senior debt lender, the company de-risks the intercreditor risk, which lowers the entire risk profile of the borrower for the mezzanine debt lender.

How De-risking leads to a Larger Mezzanine Debt Loan

When a mezzanine lender is the only lender to the company, they are in a more comfortable position. They do not have to worry about the senior lender and have a direct relationship with the company. This gives them a greater ability to control their own fate throughout the relationship with the lender. With more control and less risk, mezzanine lenders can stretch further and provide a larger loan than originally contemplated. Often the larger loan will extend into the equity layer of the financing package, and result in more capital at a lower cost for the company.