Mezzanine: The Ins and Outs of Financing
Raising funds for a healthcare business start up or expansion is a process full of choices for borrowers to make. One of the more unusual choices for financing comes in the form of mezzanine debt. The Ambulatory M&A Advisor takes a close look at the process of obtaining mezzanine debt, the risks and advantages, and what reasons people have for using it.
Rodger Davis, Partner at Northcreek Mezzanine says there are multiple reasons for a company to consider mezzanine financing. These reasons range from the goals of a company to the wish to avoid equity.
Davis explains that with equity comes more ownership dilution, and that may not be what the owner is looking for.
“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,” Davis says.
Anette Yelin, partner at the law firm of Lubell Rosen LLC in Fort Lauderdale, FL says that mezzanine financing gives access to funding that might not otherwise exist without giving up equity. It really opens up the possibility for business owners to obtain capital to operate their business, expand, restructure etc.
“There are all sorts of different uses you can find for that mezzanine financing without diluting the ownership of your company,” she says.
“Mezzanine debt is a good tool, for example, to take a company that has been primarily financed by the investment of the owners and founders of the company. They may have senior debt but not the sufficient collateral to go out and get additional loans. Mezzanine fills that gap so that the owners of the company can pull out their own investment and diversify their risk, and also provides an opportunity if restructuring or recapitalizing, to take out some equity holders who want to get a larger percentage of the equity interest in the company.”
What is Mezzanine Debt?
Yelin explains that there are certain factors that differentiate mezzanine debt from two more common sources of financing. Yelin says mezzanine debt is a type of debt that is intermediate between a traditional loan and equity financing of a company.
“Typically there is senior debt, which is a loan from a lender, such as a bank, to an entity. Often it is secured, and sometimes requires the personal guarantees of the principals of the borrower. It typically bears the lowest interest rate of any kind of loan due to the fact it is secured, provided that you have the collateral to support it,” Yelin says.
“At the other end of the spectrum is equity financing, in which a company raises capital by selling equity interests in the company. The investors don’t typically receive interest on their investment, the way lenders do, but if things go well, they may get a return on their investment in the form of distributions or due to increases in the value of the equity shares of the company.”
Mezzanine lenders occupy an intermediate position between traditional lenders and equity investors: mezzanine financing is subordinate to the senior debt, and generally has a higher rate of return in the form of higher interest rates, but has priority over equity holders with respect to priority of repayment, Yelin says.
“Mezzanine debt is often not secured, and consequently carries a higher interest rate. For example, if senior debt loans are being made at prime, mezzanine will often be several percentage points higher. In healthcare financing transactions, I have seen mezzanine lenders charging interest rates in the mid to high teens. They are taking more risk, so they get a higher return on investment,” she says.
Yelin goes on to say that the process of obtaining mezzanine financing can be more complicated from a transactional standpoint in comparison to other means of obtaining debt.
“When you take on mezzanine debt you have to deal with all of the requirements and all of the documentation of the mezzanine lender; but in addition, you typically have to get the consent of a senior lender in order to take on the mezzanine debt. Senior lenders are often concerned with the liquidity of the company and the company’s ability to make the debt service payments,” Yelin says.
“So, it is more complicated because in addition to needing to get approval to incur additional debt,the borrower will have to deal with two sets of lenders, and their counsel. Companies’ risk is higher when they take advantage of mezzanine lending because the combined debt service of the senior loans and mezzanine loans is higher.”
James Hill, Vice Chairman of the law firm Benesch says that as far as using mezzanine financing for the start up of a healthcare business, it is unusual. Hill says when taking on such debt borrowers have to deal with an inter-creditor agreement between the senior lender and the mezzanine lender.
“Oftentimes, the mezzanine lender will want a security interest, but they’re second in priority being mezzanine lenders in the middle of the “tree,”” Hill says.
“As a mezzanine backer, you may ask for warrants that are a penny conversion, but it’s rare with startups because typically you need senior secured debt. Senior secured has priority and if they don’t pay the debt, then the sub debt accelerates, the senior debt accelerates, and that’s it.”
As far as interest rates go in the current market, Hill says typically, mezzanine would be 12 or 13 percent current pay, and they take warrants, but not all mezzanine funds, as they may take PIK interest.
“Mezzanine has become kind of an oddity because many BDCs give you the senior, they give you the mezzanine unitranche and it is usually 8 or 9 percent,” Hill says.
Yelin says aside from the potential difficulty in getting mezzanine financing, the main risk once obtained is the burden of the increase in debt service payments.
“The company will have to make payments on its senior debt as well as the mezzanine debt. On the other hand, one of the attractive features of mezzanine debt is that it generallydoes not require amortization of the principal. Typically, the debt service on mezzanine debt is comprised of interest only, until some future maturity date,” Yelin says.
“For example, mezzanine loans are similar to interest-only second mortgages in the real estate industry. The borrower makes interest payments during the term of the loan, but the principal amount is repaid at a future due date.
In addition, mezzanine loans often include convertible features, for example, on the due date of the principal repayment, the lender may have the option toconvert the debt to equity by investing the principal amount of the loan in the company, although usually for a smaller share than an original equity investor might have received for the same dollar amount.”
If you have an interest in learning more about the subject matter covered in this article, the M&A process or desire to discuss your current situation, please contact Blayne Rush, Investment Banker at 469-385-7792 or Blayne@AmbulatoryAlliances.com.