What is a Mezzanine Fund and What Type of Loans Do they provide?

Posted on: October 20th, 2016

Mezzanine Financing

Mezzanine Financing is a type of financing that shares features with both debt and equity. Like equity, mezzanine financing is best for funding major, long term investments such as expansion and acquisition.

Like debt, mezzanine financing is in the form of a loan, has a specified term, an interest rate, required principal repayment and performance levels called covenants.
The beauty of mezzanine financing is that it is less expensive than equity and does not require the business owner to give up control.

Because it is a loan, the mezzanine lender is relatively passive in their engagement style with the company. As long as their interest is current, a mezzanine financing lender is relatively satisfied. Using mezzanine is a great, low cost way to build long term value.

Mezzanine financing is provided by mezzanine funds which are private lenders consisting of a small group of successful business people. These funds are scattered across the US and usually fly beneath the radar screen due to their small size and their specialized their focus.

Most funds range in size from $200 million to $1.5 billion, and they provide loans only to successful companies, and on the basis of their cash flow generation.

Most mezzanine funds will be attracted to firms that has good track record within its own industry. If the firm has been profitable in the past, then it is more likely to receive mezzanine funding.

Mezzanine lenders structure loans through applying a multiple of a company’s projected EBITDA. They operate much like the high yield bond market does in assessing borrower creditworthiness.

Mezzanine Loans

Usually, a middle market mezzanine loan ranges in size from $5 million to $50 million. Most lenders have a generalist focus and seek good companies run by talented management teams.

Generally speaking, mezzanine is best suited for companies that have strong EBITDA but may lack hard asset collateral in their balance sheet. The lack of collateral requires a lender who can base their loan on cash flow versus asset collateral.

Most mezzanine successful companies have gross margins percentages of greater than 30% and EBITDA margins greater than 10%. Mezzanine can be used very effectively as an equity substitute, so that the business owners does not have to sell shares and get diluted by an investor.

Mezzanine loans can come in a variety of specific structures, as each loan is customized to the needs of each deal. Loans can be interest only for 5 years.

Loans can be principal amortizing over 5 years. Loans can include both the senior and subordinated debt in one unified structure. They can be in second position to the senior lender or bank.

A good rule of thumb is to estimate a company’s total debt structure as a multiple of 3 to 4 times projected EBITDA. Subtract existing loans from this number and that is a good approximation of the mezzanine loan quantum.

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.