Just what is “Mezzanine” capital and does it help in the divestiture and sale of a business? In his recent “On the Left” newsletter, Randy Schwimmer calls mezzanine capital “equity dressed up as debt or vice versa”. Interestingly, it has characteristics of both equity and debt financing. In many cases mezzanine capital is used to fill in the gaps where equity and senior lender debt (generally from the bank) is not enough to fund the purchase of a business.
For instance, an investor is looking to make a strategic acquisition of a company. He/she has equity to put into the purchase and a loan from the bank, but what if their combined amount is not enough to cover the expected price and get the deal done. This often happens when banks are only willing to lend a specific amount based on corporate cash flows. In this case mezzanine capital can be brought in to add another 1x to EBITDA.
In the case of the mezzanine lender, they generally have second rights to the company in the event that something goes south later. That is, the senior lender has collateral if future issues arise while the mezzanine debt issuer has nothing really to fall back on. In this way, you could consider a mezzanine capital provider as something like a preferred equity holder–the cards shake out in a very similar way.
In fact, mezzanine capital is like equity in another way: mezzanine financiers get warrants on their loan. Warrants are similar to stock options that can be exercised based on what is written in the warrant contract at some future point in the life of the business to convert debt to equity. The amount of debt that can be converted to equity in the event of an exercised warrant is dependent on the interest rate of the mezzanine capital, the company’s future value at the time of warrant exercise as well as the structure written into the terms of the deal. Often such a structure will be dependent on company performance. To keep it simple, if a mezzanine lender exercises his/her warrants, they then become a true equity owner in the enterprise. In some instances, mezzanine warrants can be repurchased at a pre-set price by the company or its shareholders. It all depends on the terms which may be written into the deal. That’s why it is very important to ensure you know what type(s) of terms you are getting.
What is very interesting about mezzanine capital is that when it is introduced, it generally will drive the senior lender to want to lend more because the risk inherent in the deal is obfuscated by the mezzanine lender. The reason for this is because mezzanine lenders are often treated as equity holders. As an equity holder, the equity-to-debt ration is higher and the deal seems less risky to senior debt lenders. It’s an interesting catch 22 where you can only borrow when you don’t truly need the money.
By the nature of mezzanine funding, a mezzanine lender generally has the effect of increasing the purchase price of a business, thus increasing the return on investment to the private equity group that’s providing the equity to get the deal done. It is often essential to note that many sellers of the company’s keep some skin in the game once the deal is done and in such cases they are often wary of the higher interest rates charged by mezzanine funds. Don’t be too wary because understanding how mezzanine capital works will help sellers see that when a mezzanine fund takes that second bite of the apple, they essentially further increasing your ROI.
While typically not the first financing option, mezzanine financing is another way growing and established companies alike can obtain the financing to help their businesses expand, especially in today’s increasingly cautious lending environment.
Mezzanine financing is a debt/equity hybrid capital structure. Usually running on 5 to 6-year cycle with interest accruing for only the first three years, lenders offer financing at relatively high interest rates (anywhere from 12% to 30%) but under a unique set of conditions. In the case of mezzanine financing, there is an agreement that debts not paid back within the terms of the loan convert to ownership or equity interest in the company. Yet, despite the high stakes, for some companies, mezzanine financing is a highly recommended financing option.
Benefits and Risks of Mezzanine Financing
The primary benefit of mezzanine financing is that it can provide 100% of the capital required to finance an acquisition or owner buy-out. Mezzanine loans are usually at least 3 million and lenders often place no ceiling on loan amounts. In contrast to other types of financing options, mezzanine loans are also generally easier to acquire, because they are unsecured by assets. In addition, mezzanine loans are non-amortizing. While interest must be paid down on a regularly basis, then, there is no obligation to pay down the principle during the loan period, which can free businesses up to move increased cash flow to senior loans and other initiatives. Another key difference between mezzanine loans and traditional bank loans is that mezzanine lenders are typically more flexible than traditional lenders when it comes to customizing their investment to meet individual financial, operating and cash flow requirements. Finally, there is the length of loan term. Compared to the typically two- to three-year terms offered by traditional banks, mezzanine lenders generally run on a five- to six-year cycle, which is a key factor for businesses looking to execute a major expansion.
The primary risks associated with mezzanine loans are their higher-than-average interest rates and the associated penalties if and when they are not paid back within the stated terms. Once again, failure to pay back a mezzanine loan can result in a loss of ownership. Companies with strong cash flow and expert financial advisement, however, can easily avoid the associated risks of mezzanine financing, making it a recommended option under a wide range of conditions.
Assessing Whether Your Business is a Strong Candidate for Mezzanine Financing
If one or more of the following factors apply, your business may be a strong candidate for mezzanine financing: