When Mezzanine Debt Really is Next Level

Posted on: June 28th, 2023

mezzanine-debt

The physical position of mezzanine debt in a transaction structure belies its figurative role in value creation. Due to its overly legalistic description as subordinated debt, most visualize it under the senior debt, straddling the region between asset value and cash flow enterprise value. Often it gaps a funding shortfall between the equity investor and the bank, where an extra layer of capital is needed to complete the source of funds.

In this respect, mezzanine debt is often a means to a closing end, a mere functional piece of capital, whose higher-level attributes and use cases are overlooked. While mezzanine debt has been historically consumed in private equity buy-outs when banks come up short, it has evolved into a breakout form of capital in the direct lending market as an equity surrogate. The win to using mezzanine debt comes from its lower rate of return and the fact that 90% of this return is supplied by an interest payment.

Often in the middle market, companies are discriminated against due to their size and told by investment bankers the only way to fund a deal is with lots of equity. Equity investors look at growth potential and exit value potential when evaluating a deal. They are less focused on the company’s ability to carry debt and service interest payments and tend not to factor this into their pricing. They often need a very large percentage of the equity to make the deal work which is antithetical to the ownership goals of the owner.

Mezzanine Debt Lenders and Cash Flow

Because mezzanine debt lenders highly respect cash flow performance and rely almost exclusively on this in evaluating a deal, they do not need a large chunk of equity to make their returns work. If the company has debt service coverage of 1.25 times and is within 3.5 times on a debt to EBITDA basis, the lender can provide a loan that will meaningfully create value. Best of all to the sponsor or the owner, the mezzanine debt lender will only require a small piece of equity, usually less than 5%, to meet their all-in return requirement. When this type of deal is arranged, companies get next level value from mezzanine debt through its vertical scaling power.

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.