Keeping Control through Mezzanine Debt Financing
When a company, big or small, is in need of additional financing, there are several options to consider. One of these would be mezzanine financing.
According to Rodger Davis, Partner at Northcreek Mezzanine in Cincinnati, mezzanine debt financing is, “subordinated to a senior lender. It has a second priority lean on the assets of the business. Hence the word ‘mezzanine,’ because it sits between senior debt and equity.”
This form of financing is quite different from the traditional asset bank-backed route that many businesses choose to pursue.
Mezzanine vs. Asset Backed
Some of the major differences between mezzanine debt financing and other asset backed bank financing bring into play the factors of equity and collateral.
Firstly, mezzanine debt doesn’t involved hard collateral, according to Davis.
“In this case, that hard collateral has been pledged to a senior lender and the company in all likelihood doesn’t have the borrowing availability from the hard collateral,” he said. “Lenders really rely on the companies’ earnings and cash flow and value to repay loans. They really look at the enterprise value of the company.”
In contrast, asset backed bank debt is a first lien on the assets of a company.
“Mezzanine or subordinated debt is junior to that in a liquidation scenario,” said Robert Stewart, General Partner at Spring Capital Partners, L.P. “Asset backed loans are typically monitored. It’s a line of credit. I don’t know many asset backed lenders that are doing term loans, so in a sense mezzanine loans in that scenario would be longer term financing, typically second in lien position to the asset backed line of credit.”
This, however, results in mezzanine debt financing proving much more expensive on average than going with a loan from the bank. Stewart notes that the main reason for this is because in the event of liquidation the senior lender to the company must receive 100% before the subordinate lender would make a dollar.
Because of this, there can also be another component involved in the loan.
“Depending on the size of the financing, there’s also an additional granting, typically a warrant for equity for additional consideration on the sale of the business or the refinance of the sub-debt to compensate the subordinated debt lender for taking the risk of providing capital in the first place,” Stewart explains. “You’d have repayment in five years, current pay interest and a warrant typically issued by the company to the lender.”
There are multiple reasons for a company’s wish to consider mezzanine financing. These reasons range from the goals of a company to the wish to avoid equity.
“There are a lot of things that come along with equity,” Davis said. “It gives more ownership dilution. Mezzanine can be a cheaper form of financing than equity, and it’s less intrusive. Mezzanine lenders are not typically active partners in the business. It’s like a ‘rent-a-partner.’ You could borrow money for 3-5 years, get to where you want to go, or get to some event where you can pay everybody off, whereas with equity you really have to take on a partner.”
The terms of your typical mezzanine loan are 4-5 year terms, interest only. Interest rates can range from 10% on the low end to 14% on the high end.
There are several different structures available, according to Stewart.
“The majority of the time there is no amortization, so there’s a maturity where the entire principle is due in payable, typically five years,” he said. “There are some structures out there that may be interest-only for two years, amortizing over five years. There are also some that are interest only for a year, amortizing over four years. I think the vast majority of the marketplace is saying five years interest-only with a maturity on the fifth anniversary and repaying the entire principle on that fifth anniversary.”
Not for Everyone
Companies of all sizes have the option to pursue mezzanine debt financing. Many lenders target companies with $10 million in revenue and up. Companies with such small earnings as 1-2 million in EBITA can take advantage of it as well.
“A lot of small businesses take advantage of mezzanine,” Davis said. “It depends on the situation, but mezzanine should always be a part of the conversation. It is an effective tool for companies of all sizes.”
According to Steward, in order to best qualify for this type of financing, profitability is the key to whether or not a company will be successful in obtaining it.
“To qualify, you have to have profitable operations,” he said. “I would say that we are still very credit driven. What I mean by that is there is some credit under-riding that has to occur. Leverage ratios and all other types of covenants are usually put in place for this type of financing. It all depends on the company and the business model. I would say primarily to run an operation profitably and you will have all of those financing options available to you.”
The nature of mezzanine debt financing as a subordinate loan means that it’s not for every company’s situation. Interest and return rates of the various loan options should be taken into consideration when contemplating going the mezzanine route.
“Senior banks typically charge 4-6%, but there are ranges on both sides of that,” explains Davis. “Mezzanine lenders, depending on the risk, get anywhere from 12-20% returns. That’s a wide range, but there are a wide variety of transactions. Equity investors target 25%+ returns.”
If mezzanine debt financing is something an owner would like to pursue, there are various ways in which a lender can be located. Since SBICs are typically mezzanine providers, the SBIC directory website is a good resource.
“A lot of intermediaries, i.e. advisors, accountants, lawyers, are pretty aware of the mezzanine community and can assist with referrals and introductions,” Davis said. “I think if companies are interested, there are a wide variety of ways to locate a lender, and hiring an informed advisor is always a good idea.”
When making the decision of whether or not to go with mezzanine debt financing, there is quite a lot to take into account. Nonetheless, it can prove to be a helpful means of obtaining capital.
“Mezzanine is not for everybody, but in situations where a company has a need for capital and it’s not the right time to take on an equity partner and they can afford to pay comfortably the cost of a mezzanine loan, it can be a highly effective tool to help create value,” Davis said. “It’s not the right product for every company, but for the ones that it is, it can really help the entrepreneur grow his business and achieve something he wants to achieve.”
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