Posted on: August 27th, 2020

The Mezzanine Debt Paradigm Mezzanine debt is an obscure form of capital available in the private credit markets for middle market sized companies. It helps independent business owners and sponsors finance acquisitions and growth. Its primary value is in framing debt capacity on adjusted EBITDA, as opposed to asset collateral, allowing for a larger loan amount that can fund major growth steps. Most high growth businesses have strong cash flow yet small asset bases.

Mezzanine debt functions as a form of equity, as it delivers hard to raise capital, that banks cannot provide, in the form of a loan. The loan-like features reduce its ultimate cost, making it more attractive than straight equity investment.

If structured by an expert, mezzanine debt can take the role of equity, and provide a company an unbeatable combination of capital availability, flexibility, and scalability. These three benefits form the mezzanine debt paradigm, which holds great value for middle market companies.

Capital availability means mezzanine debt lenders provide more capital than can be raised from traditional asset-based lenders. Scale up situations such as acquisitions or fast growth require large funding amounts within a short window. The capital required is usually beyond the yearly cash flow or the line of credit availability. Capital has maximum value when its invested at a strategic inflection point.

Mezzanine debt participation is almost always in supporting a strategic funding need, when above average growth rates are available to a business. Having a larger supply of capital enables a company to execute its scale more aggressively and confidently up plan. Flexibility is the second leg of the mezzanine debt paradigm.

Understanding Mezzanine Debt Structures

Mezzanine debt structures are elastic and conducive for acquisition integration and corporate growth. Principal repayments are usually made at the end of the loan, and most structures have a balloon repayment at the end of the term. The term of the loan is 5 to 6 years, providing a long performance runway for the business to build its cash flow and asset base.

The structure is set in a way to encourage high short-term growth, that allows for cash flow and asset increase over the medium term. Once the business scales in size, it can pay down the loan out of higher EBITDA or a balance sheet refinance. Scalability is the reason that so many growth companies make mezzanine debt a central part of their capital plan. Companies with continual high growth, consume a lot of capital in their growth plans. Most of this capital is needed for acquisitions or investment into new growth areas.

Mezzanine debt lenders are great for funding ongoing growth needs including add on acquisitions and other organic initiatives. Their ability to fund a dynamic, fast moving company, is a key differentiator for them. If the Company is on track and within the debt capacity framework, mezzanine debt lenders will provide follow on financing if they believe the long-term strategy. Mezzanine debt lenders bring availability, flexibility, and scalability to their borrowers, providing a reliable way to fund long term growth.

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.