The Big Value in Mezzanine Debt-Centric Structuring Approaches

Posted on: November 25th, 2022

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When independent sponsors go forth to finance their deals, they hew to a standard view on structuring. While they understand and may have even interacted with mezzanine debt lenders, they often do not see how it can unlock value for them. Independent sponsors focus on bank financing and seller notes as the primary components of their capital stack. They try to extend these capital forms to reduce the amount of their equity contribution.

Often the amount of equity required by the bank exceeds the resources of the buyer, creating an equity gap to be filled through a family office or private equity fund. This is a dilutive path for the independent buyer resulting in the inevitable minority equity position. This equity gap can also be filled with mezzanine debt, especially in a transaction where the debt multiple is conservatively set. Mezzanine debt providers have a lower rate of return than equity investors and receive most of their return through their coupon. They require only a small warrant in cases where they provide equity like capital and aim for all in returns in the 15% to 17% range. It is a much better deal for a buyer to borrow more from a mezzanine lender to fill the equity gap, than to bring in more equity. An additional 1 turn of EBITDA of a mezzanine debt loan for a company with $5 million in EBITDA, will result in extra interest of $600k annually and an estimated 10% give up of equity. This same $5 million in equity may result in an investor requiring an additional 35% of the shares, thereby diluting the independent sponsor to a minority position.

Ultimately, the key to doing this rests on the mezzanine debt lender’s view of the value beneath them in the capital stack. If there is a solid amount of equity coming in or being rolled over along with a good amount of back ended seller note or earn out, mezzanine debt lenders will usually reach deeper. Deal structuring is always done on a case specific basis and depends ultimately on the strength of the company and the purchase price. However, mezzanine debt should always be considered by a buyer as a great way to fill their equity gap. By taking a mezzanine debt centric structuring approach, the independent sponson can unlock big value and maintain a controlling position.

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.