The Beneficial Time Horizon for Mezzanine Debt Borrowers

Posted on: May 15th, 2020

The post covid-19 period for many companies is likely to be a sloppy one. Most companies will experience fits and starts as the economy reopens rendering most Fiscal Year budgets from earlier this year moot. The need to focus on a specific growth opportunity, to address a new seam in this disrupted market may take precedence, as products and services change to conform to the new reality. This change or conformance adjustment will take time to get through as companies will need to plan, resource capital and labor, and operationalize. Historically reliable touchpoints within the supplier base may no longer be available, forcing a company to internalize previously outsourced activities in their value chain.

Pre-covid 19, the primacy of growth and cost competitiveness resulted in companies outsourcing non-core competencies to downstream players in their supply chain. The conventional thinking was always to leverage other companies’ strengths and outsource externally. The post-covid-19 period will likely turn this maxim on its head for many companies, forcing them to adapt their business models which will take time and resources to transform. Once new market seams are identified and new products are designed, it will take investment in marketing and sales to launch them. These new changes for a company will be occurring against the backdrop of interrupted sales, frozen supply chains, suspended internal activities and in many cases staffing cuts.

While the legacy business is in a state of suspended animation, the new growth requires feverish levels of planning and execution. Balancing these two opposite states requires tremendous management expertise in several areas including crisis management, turnaround management and new business development. It also takes formidable support from your lender to not pull the plug and continue to support the company through these challenges. Mezzanine debt lenders are well suited to provide valuable stability during this time of transition due to their focus on long term lending.

Mezzanine debt loans are usually fixed at 5- or 6-year maturities and allow the borrower to only pay interest on the loan for the entire term. This means the mezzanine debt structure allows you to have a balloon or bullet repayment of all the loan principal at the maturity date, at the end of 5 or 6 years. Not having to repay the loan principal for such a long-term period is a huge benefit for a borrower, especially during a challenging period.

This long repayment flexibility provides a virtuous time horizon for the borrower allowing them to rebuild their capital and make strategic investments in future growth. As long-term focused lenders, mezzanine debt providers also understand that not all growth happens in a perfectly smooth manner. New growth and restarts often hew to a stair step or asynchronous growth pattern, according to the pace of investment and new customer acquisition. Mezzanine debt lenders are experts at understanding the behavior and volatility of cash flow and grasp the importance of the underlying revenue drivers. This allows them to be more patient than a bank in giving the company the time to get things back on track.

Most mezzanine debt lenders are even flexible about the extending out the maturity date if they believe in the company’s new growth story. The ability to be flexible about how and when the loan gets repaid uniquely differentiates mezzanine debt lenders from other lenders. It also provides companies a virtuous time horizon for rebuilding their companies, which in turn will result in full repayment of mezzanine debt principal.

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.