The Upside – When Mezzanine Debt Behaves as Equity

Mezzanine debt is a high value added and versatile form of capital. It is often confused between more the traditional layers of senior loans and equity investment.

Mezzanine debt has increasingly become utilized on an independent basis over the past 10 years, as a form of direct lending available to acquisitive companies.

Historically it was used to fund the gap in a buy out, to address the portion of the unfunded transaction structure between the bank loan and the equity. When mezzanine is provided as a direct loan to a company, its qualification process is like that of an equity investment.

It’s based on the company’s cash flow enterprise value, it’s used to fund a transitional growth phase, and it has a long-term repayment profile. Compared to raw equity, mezzanine is a superior option for many companies, as you will receive close to the same amount of capital for a fraction of the cost.

Additionally, mezzanine lenders are less involved and intrusive in the strategic direction of the Company, so its easier to build and maintain a relationship with them post-closing.

Many investment bankers have a knee jerk reaction to companies in need of growth capital. They reflexively recommend first that a company raise equity if it cannot raise enough capital from its bank.

This is misguided advice and handicaps the business, as a direct mezzanine lender relationship can be a golden one for a growth oriented company. Here are the reasons why:

1. Mezzanine lenders utilize the same credit rating methodology as private equity investors. This allows them to provide funding through the equity layer and structure it as debt. This means you can get almost as much money from them, as you could an equity investor. This makes a huge difference in your capital plan.
2. Mezzanine requires an interest payment of 10% and a small return kicker down the road. You do not give up shares. Equity investors, depending on the valuation and amount of equity, usually require 15% to 25% of the shares. It is far better to pay 10% interest with a small kicker than 15% to 25% of your shares.
3. Equity investors are more apt to be controlling in how you run the business. They often feel more comfortable bringing in new management members, once they’ve invested. Mezzanine lenders are intensely relationship based and rely on the existing management team to build the company. This makes the mezzanine relationship more comfortable and manageable for the borrower.
4. It is easy to get follow on financing from your mezzanine lender. Most of these lenders are looking to increase the amount of business they do with existing borrowers. So, if you can continue to acquire or to expand rapidly, your mezzanine lender can be a continuous source of funding for you.
5. Mezzanine loans waive principal payments until the end of the maturity, which makes them a balloon repayment. This gives you a lot of time to invest and grow the business so it’s at a point where it can repay the loan principal. This long termism in repayment expectations, gives you the same breathing room you would get from an equity investor, at a fraction of the price.
6. Overall cost is lower than equity investment. Most growth equity investors target returns in the 18% to 22% range per year. Mezzanine lenders target all in returns in the 12% to 14% range per year. This is a significant savings for the company.