The Big Value from Mezzanine Debt Structuring

Posted on: April 9th, 2021

mezzanine debt structuring

Most acquirers of businesses approach their funding need through the prism of private equity standards. In private equity buy-outs, the equity piece of the deal is the transaction driver which unlocks the ability to bring in the remaining pieces of financing. Private equity funds can infuse 35% to 45% of the purchase in equity, making it a low-risk lending proposition for a bank or a debt fund.

Equity heavy capital structures provide a sound foundation to absorb the uncertainty and integration risk inherent in all acquisitions. The carrying cost of the equity requires low-cost financing to ensure the target rate of return for the buyer. This primacy of this heavy equity and low-cost debt approach obscures an important truth about structuring deals.

The first truth is that debt cannot be solely judged by its price. The second truth is that some debt structures are higher value than others and bring more relative value to a deal than even equity does. In the debt markets, as in life, you get what you pay for. The key in debt pricing is to focus three variables -availability, length, and size. Cheap senior acquisition loans are made available only when there is a large equity layer. They amortize rapidly and generally are not available to non-PE-backed companies.

What are Mezzanine Debt Loans

Mezzanine debt loans are the opposite. They fund into thinly equitized deals and are focused on independent deals as opposed to just PE-backed deals. In fact, mezzanine debt is best thought of as a form of inexpensive equity, that happens to be called debt and is structured with classic loan elements. Mezzanine debt structuring provides independent buyers with many advantages over the standard PE-based capital approach.

They will count seller notes and rollover equity as buyer contributed equity, enabling the buyer to leverage their finite cash equity contribution. If the buyer needs more cash to pay the price, mezzanine lenders can stretch to the equity layer and provide all the financing required. Mezzanine debt lenders will also fund into the cash flow growth of the company, providing the buyer extra financing to fund organic growth after the deal is closed.

Finally, if the debt multiples work, mezzanine debt lenders will provide follow on acquisition financing for subsequent acquisitions. These benefits are available to all buyers who pursue a mezzanine debt centric structuring approach, where the mezzanine debt lender essentially plays the role as the primary institutional capital provider. In this case, mezzanine brings the same level of value to the transaction as a PE fund would, without all the equity dilution.

In the acquisition financing arena, capital availability is destiny as companies require reliable access to capital to grow over the long term. Unforeseen capital needs usually arise when acquirers least expect it. This can cause some concern for the acquisition financing provider, especially when covenants tighten up and that working capital availability is utilized faster than expected.

Mezzanine debt borrowing is usually a straightforward activity that many companies use for funding of transitional growth. Mezzanine debt lenders are highly transparent about their due diligence approach and their post-closing loan management making it easy for companies to engage with.

Elections have consequences and positive ones at that for the acquisition financing middle market. While much media attention is paid to the direction of the yield curve and the Fed’s likely rate cuts, scant attention is paid to the more important drivers of the acquisition financing market – business psychology and regulatory climate.