The Scale up Capital Value of Mezzanine Debt

Posted on: May 23rd, 2021

mezzanine debt

Most forms of private capital are described legally in a way that pinpoints their collateral position or ranking. Terms such as senior debt, asset-based debt and mezzanine debt are easy for lawyers and deal experts to understand. Lost in the technical translation of these terms is what these different debt forms can do for your company.

The private equity centricity of middle market platforms and information services do not help make it easier for independent sponsors or business owners to understand their benefits either. If a form of capital is best understood as what it can do for you, then there is no better name for mezzanine debt than scale-up capital. While any form of capital such as a bank loan or equity can be used to scale-up, mezzanine debt is uniquely equipped to help independent sponsors and companies scale up.

The Flexible Structure of Mezzanine Debt

Mezzanine debt’s value as scale up capital is a function of its flexible structure and willingness to lend on future cash flow growth. Most lenders such as banks or asset-based finance companies can only structure loans based on historical value. Mezzanine debt lenders use a combination of historical and pro forma projected values when deciding how large a loan to provide. This is inherently a more expansive and business-friendly approach and allows them to not only provide larger loans but also more flexible and patient repayment.

The analytical approach of a mezzanine debt lender is like an equity investor. Rather than solely relying on past performance, they look to the current market value and the growth potential of a prospective borrower when making investment decisions. They distill the business down to its underlying elements – such as market position, management quality and operational scalability. They assume their capital can be used to expand the organizational mass and intensity of market development thereby propelling the revenue and profitability.

This dynamic growth scenario achieved through either an acquisition or internal growth, allows them to think about your debt capacity in a big picture way, enabling them to lend larger and longer than others. Whether this is reflected in a higher debt multiple of 4 times EBITDA or a longer term of 6-to-7-year bullet maturity, mezzanine debt provides superior scale up value for middle market companies

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.