Mezzanine Financing: An Essential Tool for Middle-Market Companies

Summary: Mezzanine financing is a hybrid of debt and equity financing that provides middle-market companies with flexible and customized capital solutions. It can be used for various purposes, such as growth, acquisitions, recapitalizations, management buyouts and debt refinancing. Mezzanine financing offers several benefits to both the borrower and the lender, such as higher leverage, lower cost of capital, tax deductibility, alignment of interests and potential upside. However, mezzanine financing also comes with some challenges and risks, such as higher interest rates, subordination, dilution, covenants and exit options. Therefore, it is important for middle-market companies to understand the features, advantages and disadvantages of mezzanine financing and to work with an experienced advisor when pursuing this type of funding.

Table of Content

- What is Mezzanine Financing?
- Why Use Mezzanine Financing?
- Benefits of Mezzanine Financing
- Challenges and Risks of Mezzanine Financing
- How to Access Mezzanine Financing

What is Mezzanine Financing?

Mezzanine financing is a layer of financing that fills the gap between senior debt and equity in a company. It can be structured either as preferred stock or as unsecured debt, and it provides investors with an option to convert to equity interest in case of default or under certain conditions. Mezzanine financing is usually used to fund growth prospects, such as acquisitions and expansion of the business.

Mezzanine financing is typically provided by specialized lenders, such as mezzanine funds, private equity firms, hedge funds and family offices. These lenders are willing to take more risk than senior lenders, such as banks, but expect higher returns than equity investors, such as venture capitalists. Typically, mezzanine lenders charge interest rates between 12% and 20% per year, which are higher than the rates on ordinary debt but lower than the cost of equity. Mezzanine lenders can also earn returns from other sources, such as:
  • Cash interest: Based on the portion of the outstanding mezzanine funding balance, investors receive cash periodically. The interest rate may either be fixed or variable over the loan period.
  • Payment in Kind (PIK) interest: It is also a periodic method of payment. However, the interest amount is not paid in cash. Instead, it is added to the principal sum of the security, and the total amount is paid at the end of the loan period.
  • Ownership: Similar to a convertible bond, mezzanine financing often includes an equity interest in the form of a conversion feature or warrant. Usually, the PIK interest or the cash interest follows the ownership portion of the securities.
  • Participation payout: In place of equity, investors may take a return on equity in the form of a percentage of the company’s performance as measured by net sales or EBITDA (earnings before interest, taxes, depreciation and amortization), or profit.
  • Arrangement fee: Mezzanine investors are also required to be paid an arrangement fee upon closing the transaction.

Why Use Mezzanine Financing?

Mezzanine financing can be a valuable tool for middle-market companies that need capital for various purposes but face challenges in accessing traditional sources of funding. Some of the common reasons why middle-market companies use mezzanine financing are:

  • Growth: Mezzanine financing can help companies fund organic growth initiatives, such as expanding into new markets, launching new products or services, hiring new staff or investing in new equipment or technology.
  • Acquisitions: Mezzanine financing can help companies finance strategic acquisitions that can enhance their competitive position, diversify their revenue streams or achieve synergies.
  • Recapitalizations: Mezzanine financing can help companies restructure their balance sheets by replacing existing debt with more flexible and less restrictive mezzanine debt or by providing liquidity to existing shareholders who want to exit partially or fully.
  • Management buyouts: Mezzanine financing can help management teams buy out existing owners or shareholders who want to retire or pursue other opportunities.
  • Debt refinancing: Mezzanine financing can help companies refinance their existing debt that may be maturing soon or carrying high interest rates or unfavorable terms.

Benefits of Mezzanine Financing

Mezzanine financing offers several benefits to both the borrower and the lender compared to other forms of financing. Some of these benefits are:
  • Higher leverage: Mezzanine financing allows companies to raise more capital than they could with senior debt alone. This can increase their financial flexibility and enable them to pursue more opportunities for growth or value creation.
  • Lower cost of capital: Mezzanine financing can lower the overall cost of capital for companies by reducing the amount of equity they need to raise. Equity is usually the most expensive form of capital, as it requires giving up ownership and control of the company. Mezzanine financing is also tax-deductible, which can further lower the effective cost of capital.
  • Alignment of interests: Mezzanine lenders are typically long-term partners who share the same vision and goals as the borrower. They are not only interested in receiving interest payments, but also in participating in the upside potential of the company. They can also provide strategic advice, industry expertise and network connections to the borrower.
  • Potential upside: Mezzanine lenders can benefit from the equity interest or participation payout that they receive in addition to the interest payments. This can increase their returns and align their interests with the borrower’s success.

Challenges and Risks of Mezzanine Financing

Mezzanine financing also comes with some challenges and risks that both the borrower and the lender need to be aware of and manage carefully. Some of these challenges and risks are:

  • Higher interest rates: Mezzanine financing carries higher interest rates than senior debt, which can increase the debt burden and cash flow pressure on the borrower. The borrower needs to ensure that they have sufficient cash flow to service the mezzanine debt and meet their other obligations.
  • Subordination: Mezzanine financing is subordinate to senior debt, which means that in case of default or bankruptcy, mezzanine lenders are paid after senior lenders. This increases the risk of mezzanine lenders losing their principal or interest payments. Mezzanine lenders need to conduct thorough due diligence and monitor the borrower’s performance and financial health.
  • Dilution: Mezzanine financing can dilute the ownership and control of the existing shareholders or owners if the mezzanine lenders exercise their conversion option or warrant. This can reduce the value of their shares or their influence on the company’s decisions. The borrower needs to negotiate the terms and conditions of the conversion option or warrant carefully and balance their capital structure.
  • Covenants: Mezzanine financing may come with certain covenants or restrictions that limit the borrower’s operational or financial flexibility. For example, mezzanine lenders may require the borrower to maintain certain financial ratios, such as debt-to-equity or interest coverage, or to obtain their consent before making certain decisions, such as issuing new debt or equity, paying dividends or making acquisitions. The borrower needs to comply with these covenants and communicate with the mezzanine lenders regularly.
  • Exit options: Mezzanine financing may have different exit options for both the borrower and the lender, depending on the structure and terms of the deal. For example, the borrower may have the option to prepay or refinance the mezzanine debt at a certain premium or penalty, or the lender may have the option to sell their mezzanine debt or equity interest to a third party or to participate in an initial public offering (IPO) or a sale of the company. The borrower and the lender need to understand and agree on these exit options and plan accordingly.

How to Access Mezzanine Financing

Mezzanine financing is not widely available in the market, as it requires specialized knowledge and experience from both the borrower and the lender. Therefore, it is important for middle-market companies to work with an experienced advisor when pursuing mezzanine financing. An advisor can help them with:

  • Identifying suitable mezzanine lenders: An advisor can help companies find and contact potential mezzanine lenders who have relevant industry expertise, track record and appetite for their deal size and type.
  • Preparing a business plan: An advisor can help companies prepare a comprehensive and compelling business plan that showcases their growth potential, competitive advantages, financial performance and funding needs.
  • Negotiating terms and conditions: An advisor can help companies negotiate favorable terms and conditions for their mezzanine financing, such as interest rate, maturity, conversion option, warrant, covenants and exit options.
  • Closing the transaction: An advisor can help companies complete the due diligence, documentation and legal formalities required to close the transaction successfully.

Conclusion

Mezzanine financing is an essential tool for middle-market companies that need flexible and customized capital solutions for various purposes. It offers several benefits to both the borrower and the lender, such as higher leverage, lower cost of capital, tax deductibility, alignment of interests and potential upside. However, mezzanine financing also comes with some challenges and risks, such as higher interest rates, subordination, dilution, covenants and exit options. Therefore, it is important for middle-market companies to understand the features, advantages and disadvantages of mezzanine financing and to work with an experienced advisor when pursuing this type of funding.

                                                                                                                

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Why Mezzanine Financing?
  • Flexible Financing Structure for Growth & Expansion
  • Fill the Gap Between Senior Debt & Equity Capital
  • Preserve Ownership & Control of Your Business
  • Customized Repayment Terms and Conditions
                                                                                                               

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