The Role of Mezzanine Financing in Leveraged Buyouts


Summary: This article explains what mezzanine financing is, how it works, and why it is often used in leveraged buyouts. It also discusses the benefits and risks of mezzanine financing for both borrowers and lenders, and provides some examples of recent deals involving mezzanine debt.

Table of Content:
- Introduction
- What is Mezzanine Financing?
- How Does Mezzanine Financing Work?
- Why is Mezzanine Financing Used in Leveraged Buyouts?
- What are the Benefits and Risks of Mezzanine Financing?
- Examples of Mezzanine Financing in Leveraged Buyouts
- Conclusion

Introduction

Leveraged buyouts (LBOs) are transactions in which a company or a business unit is acquired by a group of investors, usually with the help of debt financing. The investors, often private equity firms, use the assets and cash flows of the target company as collateral to borrow money from banks and other lenders. The debt is then repaid over time from the operating income of the acquired company.

LBOs are attractive for investors because they allow them to acquire companies with a relatively small amount of equity, thus increasing their potential returns. However, LBOs also involve a high level of risk, as the acquired company may not generate enough cash flow to service the debt, or may face operational or market challenges that reduce its value.

One way to mitigate the risk of LBOs is to use mezzanine financing, a hybrid form of debt and equity that provides additional capital beyond senior secured debt. Mezzanine financing can bridge the gap between the amount of debt that banks are willing to lend and the amount of equity that investors are willing to contribute. Mezzanine financing can also offer more flexibility and lower cost than pure equity, as well as some protection and upside potential for lenders.

In this article, we will explain what mezzanine financing is, how it works, and why it is often used in leveraged buyouts. We will also discuss the benefits and risks of mezzanine financing for both borrowers and lenders, and provide some examples of recent deals involving mezzanine debt.

What is Mezzanine Financing?


Mezzanine financing is a type of subordinated debt that ranks below senior secured debt but above equity in the capital structure of a company. Mezzanine financing typically has a higher interest rate than senior debt, reflecting its higher risk and lower priority in case of default or bankruptcy. However, mezzanine financing also has some features that make it more attractive than pure equity for both borrowers and lenders.

First, mezzanine financing usually has embedded equity instruments, such as warrants or conversion rights, that give the lender the option to convert the debt into an equity stake in the company in certain scenarios. This allows the lender to participate in the upside potential of the company if it performs well or is sold at a high valuation.

Second, mezzanine financing often has payment-in-kind (PIK) interest, which means that instead of paying cash interest periodically, the borrower can add the interest to the principal amount of the debt. This reduces the cash flow burden on the borrower and allows it to reinvest more money into its operations or growth initiatives.

Third, mezzanine financing usually has longer maturities and less restrictive covenants than senior debt, giving the borrower more time and flexibility to repay the debt or refinance it with lower-cost capital. Mezzanine financing also does not dilute the ownership or control of the existing shareholders as much as pure equity.

How Does Mezzanine Financing Work?


Mezzanine financing can be structured in different ways depending on the needs and preferences of the borrower and the lender. However, a common example of mezzanine financing is a subordinated note with warrants.

A subordinated note is a type of unsecured debt that ranks below senior secured debt in terms of repayment priority. A subordinated note usually has a fixed interest rate and a maturity date that ranges from five to 10 years. The interest can be paid in cash or in PIK form.

A warrant is a type of option that gives the holder the right to buy a certain number of shares of a company at a predetermined price within a specified period. A warrant can increase the value of the subordinated note by providing
the lender with an opportunity to profit from the appreciation of the company's stock price.

For example, suppose a private equity firm wants to acquire a company for $100 million with 80% debt and 20% equity. The firm can obtain $60 million of senior secured debt from a bank at an interest rate of 8% per year. However, the bank is not willing to lend more than 60% of the purchase price, leaving a $20 million gap between the senior debt and the equity.

To fill the gap, the firm can seek mezzanine financing from another lender, such as a mezzanine fund or a hedge fund. The mezzanine lender agrees to provide $20 million of subordinated debt at an interest rate of 15% per year, with 10% paid in cash and 5% paid in PIK. The mezzanine lender also receives warrants to buy 10% of the company's equity at a strike price of $10 per share, which is equal to the pre-money valuation of the company.

The mezzanine financing allows the private equity firm to complete the acquisition with only $20 million of equity, or 20% of the purchase price. The firm's return on equity will be higher than if it had used more equity and less debt. The mezzanine lender, on the other hand, will receive a high interest income from the subordinated debt, as well as a potential upside from the warrants if the company's value increases.

Why is Mezzanine Financing Used in Leveraged Buyouts?


Mezzanine financing is frequently used in leveraged buyouts for several reasons. First, mezzanine financing can help bridge the gap between the amount of debt that banks are willing to provide and the amount of equity that investors are willing to invest. This can enable investors to pursue larger or more attractive deals that they otherwise could not afford.

Second, mezzanine financing can reduce the cost of capital for the borrower by providing a cheaper alternative to pure equity. Mezzanine financing typically has a lower interest rate than the expected return on equity, and also has some tax advantages as interest payments are deductible from taxable income. Mezzanine financing can also lower the dilution of ownership and control for the existing shareholders.

Third, mezzanine financing can offer more flexibility and convenience for the borrower than other forms of financing. Mezzanine financing usually has longer maturities and fewer covenants than senior debt, allowing the borrower more time and leeway to execute its business plan or exit strategy. Mezzanine financing also does not require an initial public offering (IPO) or a secondary offering to raise capital, which can be costly and time-consuming.

What are the Benefits and Risks of Mezzanine Financing?


Mezzanine financing can provide several benefits for both borrowers and lenders, but it also entails some risks that need to be considered carefully. Some of the benefits and risks are summarized below.

Benefits for Borrowers:

- Access to additional capital beyond senior debt
- Lower cost of capital than pure equity
- Less dilution of ownership and control than pure equity
- More flexibility and convenience than other forms of financing

Risks for Borrowers:

- Higher interest rate than senior debt
- Higher leverage and debt service burden
- Potential loss of equity value or control in case of conversion or default
- Subordination to senior lenders in case of bankruptcy or liquidation

Benefits for Lenders:

- Higher interest income than senior debt
- Participation in upside potential through equity instruments
- Diversification of portfolio and exposure to different industries and markets
- Relationship building with borrowers and sponsors

Risks for Lenders:

- Lower priority and security than senior debt
- Higher default risk and lower recovery rate than senior debt
- Potential dilution or impairment of equity value in case of restructuring or refinancing
- Illiquidity and longer holding period than senior debt

Examples of Mezzanine Financing in Leveraged Buyouts

Mezzanine financing has been used in many leveraged buyouts across various industries and markets. Here are some examples of recent deals involving mezzanine debt.

- In June 2021, Apollo Global Management acquired Verizon Media, which includes Yahoo and AOL, for $5 billion. The deal was financed with $4.25 billion of senior secured debt, $750 million of preferred equity from Apollo, and $750 million of mezzanine debt from third-party investors.
- In April 2021, Thoma Bravo acquired Calypso Technology, a provider of cloud-based software solutions for capital markets, for an undisclosed amount. The deal was financed with $1.9 billion of senior secured debt, $400 million of preferred equity from Thoma Bravo, and $400 million of mezzanine debt from third-party investors.
- In March 2021, Platinum Equity acquired Ingram Micro, a global distributor of technology products and services, for $7.2 billion. The deal was financed with $5.2 billion of senior secured debt, $1 billion of preferred equity from Platinum Equity, and $1 billion of mezzanine debt from third-party investors.

Conclusion

Mezzanine financing is a hybrid form of debt and equity that provides additional capital beyond senior secured debt. Mezzanine financing is often used in leveraged buyouts to bridge the gap between the amount of debt that banks are willing to lend and the amount of equity that investors are willing to contribute. Mezzanine financing can also offer more flexibility and lower cost than pure equity, as well as some protection and upside potential for lenders.

                                                                                                                

We can help you secure funding for your corporate objectives. 

Maximize growth, minimize dilution, and secure the capital you need with tailored financing options for mid-market and high-growth companies.
Unlock Your Business Potential with Flexible Mezzanine Financing Solutions

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
                                                                                                               

Popular posts from this blog

Mezzanine Financing for Biotech and Life Sciences Companies: Fueling Innovation

Mezzanine Financing and Capital Stack Optimization: Maximizing Value

Mezzanine Financing and Industry Disruption: Funding Game-Changing Ventures