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- Mezzanine Debt.
What is a mezzanine debt fund? How do you calculate the all-in cost of mezzanine financing? How Does Mezzanine Financing Work? Mezzanine financing is a flexible form of long-term capital which includes the following structures: Subordinated debt plus an "equity kicker" in the form of warrants to purchase common stock; Subordinated debt plus an equity co-investment; Subordinated debt without equity; Convertible debt; and Preferred equity.
Use Cases for Mezzanine Debt There are many uses for mezzanine debt. Funds can be used for investment in product development, sales and marketing, equipment purchases, or facility expansion. Acquisitions: Mezzanine debt is often used for acquisition financing. Acquisitions can provide access to complementary technologies, products and customers, and facilitate entry into new distribution channels and geographic markets.
Leveraged buyouts: Private equity funds often utilize mezzanine debt to reduce the equity they invest in a transaction. If the transaction is successful, the additional financial leverage will increase the internal rate of return on their equity. Since management teams often have limited equity, mezzanine capital can be a critical element of the financing structure.
Shareholder buyouts: Mezzanine debt can be utilized if a company needs to repurchase shares from a retiring founder, family member, passive investor, or disgruntled shareholder. In effect, equity is replaced by debt in the capital structure. A common reason for a recapitalization is to provide partial liquidity to shareholders through a dividend or share repurchase. As with other types of debt , companies with recurring revenue business models are particularly attractive.
Mezzanine lenders avoid early-stage, turnaround, or highly cyclical businesses. Practically speaking, there is no maximum. Interest rates and terms are generally better for sponsored companies. There are two exceptions to the EBITDA requirement: Recurring revenue: Some mezzanine lenders will provide funding to companies with recurring revenue business models, solid growth, strong gross margins, and a clear path to profitability in years.
Mezzanine funds that are equity-oriented: A key characteristic of mezzanine financing is its flexibility. While most mezzanine funds are lenders first and equity investors second, there are some that are more equity-oriented. Of course, since their perceived risk is higher, they require a higher return on investment but not as high as pure equity investors. Does my company qualify for mezzanine financing? Historically, the mezzanine lender received an "equity kicker" in the form of warrants to purchase common stock. The ownership percentage will vary depending on the lender's required return, the risk and projected growth of the business, and other factors.
However, the lender will likely require affirmative covenants and negative covenants. Affirmative covenants require the borrower to take certain actions such as paying required taxes, maintaining financial records, maintaining adequate insurance, etc. Negative covenants limit actions that the borrower can take without the lender's permission such as borrowing additional money, paying dividends to shareholders, selling the company's assets, or other actions that may affect the company's ability to repay. It also depends on the specific situation, especially the lender's ownership percentage.
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The Pros and Cons of Mezzanine Financing Mezzanine financing is one of the most flexible sources of growth capital, and can be a great alternative to raising equity. The pros advantages of mezzanine financing include: When properly structured, debt financing is substantially less expensive than equity financing. By utilizing mezzanine debt in its balance sheet, a company can lower its weighted average cost of capital WACC.
Less dilutive so management or investors can keep a much larger percentage of ownership. Mezzanine financing can be a great alternative when a company needs growth capital but is not growing fast enough or is not large enough to attract institutional investors venture capital or private equity or is not satisfied with the terms offered by such investors. Can be used as bridge financing prior to an equity financing or public offering. Depending on the size of their equity interest, mezzanine lenders may not require board seats or other direct involvement in the governance or operations of the company.
Generally, mezzanine funds do not want to be long-term shareholders. Equity is a tool for boosting the return on their lending portfolio. Covenants are less restrictive than senior debt. Borrower does not have to be sponsored by a venture capital or private equity firm. Due diligence process is simpler and faster than an equity fundraising.
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Mezzanine funds have been facing competitive pressure from other forms of finance, which may force them to improve their pricing and terms. The cons disadvantages of mezzanine financing include: The business must be profitable and have sufficient cash flow to make scheduled principal and interest payments. Mezzanine financing usually has a much higher interest rate than senior debt due to its riskier position in the capital structure. Mezzanine funds require equity participation.
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It can be difficult to estimate the cost of capital, especially if the company has substantial upside potential. If a company is required to borrow the entire principal amount up front, the cost may be higher than lines of credit which are drawn as needed.
Mezzanine Finance
Since the business will have a senior lender and a subordinated lender, an intercreditor agreement will be required, which adds complexity, time and expense to the process. Ready to start the process? What are the alternatives to mezzanine debt? A unitranche loan combines senior and subordinated into a single facility with a blended rate. In its most common form, mezzanine financing is a hybrid of debt and equity. How is mezzanine financing similar to debt? Typically, in a mezzanine deal, the transaction period is for 5 to 8 years, with the possibility of an early mezzanine debt exit.
In most cases, mezzanine investments are taken out either through a change-of-control sale or recapitalization of the company. While an IPO is a rarity in a mezzanine deal, some mezzanine providers may look to invest in companies that represent strong IPO candidates. However, most frequently the mezzanine capital provider is bought out by the initial owner through a recapitalization with inexpensive senior debt, through the accumulated profits generated by the business or through an acquisition of the company by a competitor.
To explain further, a mezzanine lender may exit through any one of the three exit strategies listed below.
Mezzanine Finance: Mezzanine’s brief hour in the sun | Magazine | IPE
Whatever exit strategy is chosen, whether through the sale of the company, a recapitalization, a refinancing, and on a smaller percentage an initial public offering, all are potentially viable liquidity events. Always be sure to consult an expert financial advisor with sufficient experience in mezzanine deals. Equity fundraising, meanwhile, sells shares in your business to investors, and your new stakeholders will benefit from any growth in your company and suffer any losses too!
In other words, unlike debt finance lenders, equity investors are usually in it for the long-haul. Mezzanine is the third way. In this way, mezzanine finance allows you to leverage future profits for the maximum return with the cash contribution you have available. How mezzanine finance can help ambitious SMEs to grow.