Mezzanine debt can be an excellent source of capital for middle market companies to fund acquisitions, develop new products and expand production facilities or pursue other growth opportunities. In recent years mezzanine debt has provided a source of liquidity for company owners who did not want to sell their company in the less than robust M&A market of recent years. Dividend recapitalizations have provided business owners with a means to take money out of the business and diversify their assets.
Mezzanine debt, which is often referred to as subordinated debt, is a layer of junior capital that is considered to be quasi-equity as it has some of the traits of equity. For accounting purposes it is recorded as a liability and will be found beneath the senior secured debt on a company’s balance sheet but above the stockholders’ equity section hence the term mezzanine debt.
Typically unsecured, mezzanine debt receives a significantly higher yield than senior secured debt. Generally the current pay coupon for mezzanine debt is a fixed rate of about 12%. Mezzanine lenders look for an annual return of 18% to 19% and usually bridge the gap with warrants or other equity like features. The warrants represent far less dilution than issuing common stock would and let the owner maintain control of the business. Another extremely attractive feature is that there is no amortization of principal over the life of the loan which usually has a term of five to seven years.
For larger transactions there may be a payment in kind (PIK) component option available to the borrower. This is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the amount of principal outstanding equivalent to what the lender would have received if it had been paid in cash. The following is an example to illustrate:
Loan principal – $10,000,000
Cash coupon – 12%
PIK – 4%
Monthly cash payment – $10,000
Loan principal at the end of the year – $10,400,000
Typically, a company with a proven track record and good prospects can obtain three to four times (during the height of the financial crisis it was half that!) its cash flow in senior secured debt. Mezzanine debt generally will be able to provide another one to one and a half times cash flow for total leverage of about four to five and a half times cash flow.
For well-managed middle market companies that have strong and predictable cash flows along with good business prospects, mezzanine debt can provide a viable solution for a company’s liquidity or expansion needs. Mezzanine debt is not suitable for every company and should be evaluated carefully in conjunction with a company’s professional advisors.