As Credit Tightens, Mezzanine Financing Plays Bigger Role
by Franz von Bradsky and Mark French
The continuing turmoil roiling the financial markets has exacerbated the credit crunch and made lenders more risk averse. Lenders continue to reduce the availability of credit and limit leverage, which ensures that mezzanine financing will play a larger role in financing the growth of privately owned “middle market” companies in the future.
Mezzanine debt, also called subordinated debt, is a hybrid of debt and equity financing used to finance acquisitions, product development, plant expansion and new equipment purchases. Company owners also use it to take money out of a company in order to diversify or invest in other opportunities.
Management buyout transactions are often consummated using mezzanine financing because it fills the gap that arises when the cash flow of a business is able to support a higher level of debt than a senior lender is willing to lend against the business’s assets. In these transactions, mezzanine debt lets the equity investor reduce the amount of equity contributed to the investment, which increases the equity’s expected return.
Mezzanine financing combines some of the debt features associated with traditional term debt (including interest payments, covenants, and in some cases, amortization) with an upside in the form of an equity interest. Mezzanine debt is typically secured by the equity of the company rather than its tangible assets, and is subordinated to the debt provided by banks and commercial finance companies.
Mezzanine debt is more expensive than secured debt or senior debt due to the increased credit risk assumed by the subordinated lender. To compensate for the increased risk, mezzanine debt holders receive a higher interest rate than senior debt, as well as a quasi-equity stake in the company. In comparison to equity financing, though, mezzanine debt is a much less expensive source of capital; perhaps more important, existing equity holders are subject to significantly less dilution.
On a balance sheet, mezzanine debt is found between senior debt and equity. It is subordinate in priority of payment to senior debt, but senior in preference to common stock if a company is liquidated. It can take the form of convertible debt, senior subordinated debt or debt with warrants.
In the middle market, mezzanine lenders look for a fixed current coupon rate of 10 percent to 14 percent, which equates to a spread of 4 to 8 percentage points above the prime rate, plus the additional return from the equity stake in the company. This compares to a rate of 1 to 3 percentage points above the prime rate for term loans from senior debt lenders.
Mezzanine investors look for annual returns of between 15 percent and 25 percent compared to 25 percent to 35 percent required by most equity investors. Mezzanine debt can be a useful form of financing as lenders tend to be flexible in tailoring the structure of the investment to meet the borrower’s operating and cash flow needs.
Most mezzanine loans are from five to seven years in length, with the possibility of early repayment. Repayments are often not required until maturity, unlike bank debt, which usually requires amortization. Thus mezzanine financing allows a business owner to reinvest cash flow in growth opportunities rather than paying back senior debt.
Because their return is largely driven by their equity upside, mezzanine lenders are more accommodating during difficult business conditions. As a result, when employing subordinated debt, a business owner may lose some independence, but rarely loses outright control of the company or its direction. Provided a company continues to grow and prosper, owners are unlikely to encounter much interference from a mezzanine lender.
Amounts raised via mezzanine financing can be substantial. A company can leverage its cash flow and obtain senior debt between two times and 3.5 times cash flow. With mezzanine debt, it can raise total debt to four to five times cash flow depending on the risk appetite in the debt markets.
Mezzanine lenders are usually paid off through a recapitalization of the business with less expensive senior debt or through the accumulated profits generated by the growth of the business.
In good times and bad, mezzanine debt has proven to be a viable source of growth capital to finance privately owned “middle market” companies.
Franz von Bradsky is president of Green Tree Capital. Franz can be reached at MandA@greentreecapital.com or 360.510.3490. Mark French is a principal of Greyrock Capital Group. Mark can be reached at French@greyrockcapitalgroup.com or 415.288.0282. The article was originally published on June 13, 2008 in the Puget Sound Business Journal.
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