Why Mezzanine Debt Is an Optimal Loan for Inflationary Times

Posted on: June 21st, 2021

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The signs of inflation are omnipresent from supply bottlenecks for tangible goods to hyper growth in the money supply. Whether caused by supply chain shocks or from white hot demand, inflation figures to be at least 2.4% this year, which is nearly double the inflation rate of FY 2020.

At the current rate it is running, there is a strong probability that it is over 3% this year. When enough supply bottlenecks arise simultaneously, and prices start rising they are difficult to stop. If inflation keeps rising, inflationary expectations can take hold which means prices of everything will reflect the market’s belief that prices will continue to escalate. With inflation, real purchasing power is eroded by rising price levels, which means you pay more for everything, receiving less quantity of purchased units than before. This applies to labor, services, raw material purchases as well as capital.

While a company may be able to pass through price increases to customers, rising input price levels constrains working capital and stresses the balance sheet. To get through inflationary periods, companies need to prepare their capital position and ensure it is optimally set up to buffer these economic headwinds. Mezzanine debt loans provide tremendous benefit as an inflation bulwark for several reasons. It will expand your capital base and put more money on the balance sheet.

Mezzanine Debt as Working Capital

New mezzanine debt capital can be used to strengthen working capital, invest in new growth, or scale the organization. Mezzanine debt lenders specifically fund business transformations and growth strategies which are essential to fight back against top line erosion in inflationary times. In addition, mezzanine debt is usually priced at a Fixed rate of interest, ranging from 10% to 12%. It does not have the floating rate mechanisms that bank loans have based on libor or prime. This means that the interest rate will not change, even if inflation accelerates.

While floating rate loans are charging borrowers more in interest expense each month because of rising interest rate indices, the mezzanine debt interest payment remains the same. Companies essentially lock in the mezzanine debt price for the 5- or 6-year term of the loan, which makes the cost of borrowing constant. The longer you can lock in a price, during a rising price environment, the more you win. Mezzanine debt provides the twin benefits of greater capital availability and debt cost predictability, delivering business prosperity during challenging, inflationary periods.

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.