The Arbitrage Value of Mezzanine Debt

The middle market is a large ecosystem, often viewed through the lens of pricing. Bank loans start at prime + 50 basis points and leveraged finance pricing often at prime + 250 basis points. This usually means that bank loans for low-risk borrowing starts at 3.75% and can range to 5.75% for leveraged lending deals. Unitranche loans often start in the 7% range and range to 10%.

Mezzanine debt loans usually start at 10%, giving it an unfavorable pricing profile versus these other loan options. What market neophytes often miss is that mezzanine debt has far great utility than a bank loan or unitranche loan. You pay more in interest for mezzanine debt, but you also receive far greater value in the form of loan size, flexibility, and commitment.

Mezzanine Debt as Cash Flow

Mezzanine debt lenders use future cash flow to size their loans, giving a borrower a much larger loan than a mere asset-based facility. They take greater risk and hence allow their borrowers to achieve greater returns. They push off principal repayment until the back end of the term, allowing the borrower to invest the newly generated cash flow into the business, accelerating growth. Mezzanine debt loans are geared to fund transitional growth spurts over a multi-year time frame leading to a larger, more diverse enterprise. Once the enterprise has achieved the growth goal, the Company is then well positioned to repay or refinance the loan.

Mezzanine debt often plays the role of a pivotal, long term equity investor. For savvy middle market practitioners, mezzanine debt is not expensive debt but a form of cheap equity. You can do many of the same things with mezzanine debt as you can with equity. When structured properly, mezzanine debt will provide all the capital needed for your corporate scale up, at a fraction of the price of private equity.

Whereas private equity requires a controlling stake, mezzanine debt lenders receive interest payments and occasionally, a small equity warrant. Where private equity investors often bring in their own management team, mezzanine debt lenders are pro-existing management teams. In addition, the return requirements for private equity are 20%+ per annum versus low to mid-teens for mezzanine debt. Within its return structure, private equity requires PIK dividends and principal redemption giving it a debt like framework.

The lack of a current cash payment results in private equity investors requiring massive ownership stakes to achieve their IRR’s upon exit. On the other hand, mezzanine debt lenders have a lower annual return, and most of that return is paid off each year through the interest payment. This makes mezzanine debt a great equity alternative and a high value arbitrage play for borrowers seeking equity.