Mezzanine financing is a hybrid of debt and equity that ranks below senior debt but above common stock in a capital structure. Since mezzanine financing is usually structured as subordinated debt, the terms mezzanine financing and mezzanine debt are often used interchangeably. Both terms are often shortened to mezz financing and mezz debt.
Due to the risk profile of mezzanine financing, lenders require a higher return than senior lenders and a lower return than equity investors. Lenders achieve this through a combination of interest payments and equity participation.
Mezzanine debt is used when a company has maximized its bank and asset-based loans but needs additional funding to expand operations, make an acquisition, or buy out a partner. Although it’s unusual, some borrowers only have mezzanine debt due to an inability or unwillingness to borrow senior debt for several possible reasons (e.g. lack of collateral or reluctance to provide personal guarantee).
Both corporate and real estate borrowers utilize mezzanine debt, but the focus of this overview is the corporate market.
If you have a company with EBITDA of $1 million or more, then you might be able to obtain mezzanine financing. At Find Venture Debt, we have a fast, easy process to determine whether you qualify. Contact us to get started.
Mezzanine financing is a flexible form of long-term capital which includes the following structures:
The most common structure is a subordinated, unsecured term loan plus warrants. Since the loan is subordinated and unsecured, borrowers must have positive cash flow. Interest payments are due monthly or quarterly but may accrue during an initial period(e.g. twelve months), increasing the principal balance. Normally, the term is five years with no amortization; principal is repaid at final maturity.
In recent years, mezzanine debt has faced increased competition from other types of debt financing, especially second lien term loans and unitranche financing. As a result, mezzanine lenders have been forced to lower their interest rates and reduce or eliminate their demand for warrants.
In prior years, mezzanine funds had targeted blended returns (interest plus equity participation) in the high teens and pricing was relatively uniform across lenders. Currently, expected returns range from approximately 10% to the high teens, depending on the borrower’s characteristics.
Two primary considerations are whether the borrower is sponsored (backed by a private equity firm) or non-sponsored, and the EBITDA of the borrower. In most sponsored deals, the mezzanine lender does not receive warrants. For pricing purposes, the EBITDA brackets are roughly $1-5 million, $5-20 million, and over $20 million. As expected, the higher the EBITDA, the lower the pricing.
To boost their portfolio returns, in lieu of warrants, some lenders will request the right to make an equity co-investment.
There are many uses for mezzanine debt. Since mezzanine debt is the most expensive form of debt, it is only used when the alternative would be raising additional equity. Mezzanine is commonly used to facilitate a transaction such as an acquisition or shareholder buyout. It can also be used to fund organic growth opportunities that are relatively low risk (otherwise equity should be used).
Since mezzanine debt typically has a five-year term and is interest-only until principal is due at maturity, it is considered patient capital. The borrower has five years to build its business prior to repaying the debt or replacing it with a lower cost alternative.
Specific use cases for mezzanine debt include:
For technology and growth companies, the biggest hurdle to obtaining mezzanine financing is that borrowers need to be cash flow positive with EBITDA of at least $1 million, and preferably more than $2 million.
There are two exceptions to the EBITDA requirement:
Mezzanine financing is one of the most flexible sources of growth capital. If your company qualifies, Find Venture Debt provides a fast, easy process for connecting with lenders. Contact us today to learn more.
Mezzanine loan terms depend on the risk profile of your company and the preferences of each lender. As previously discussed, terms also vary depending on sponsorship and EBITDA. Mezzanine debt terms include the following:
If the business has multiple lenders, an intercreditor agreement is usually required. This is an agreement between the senior and subordinated creditors, which specifies how their relative rights and obligations are enforced in a distress or bankruptcy situation.
Unfortunately, lenders often write term sheets in an overly technical manner. This can make it difficult to understand the key business terms and even more difficult to compare term sheets from multiple lenders. At Find Venture Debt, we have extensive experience reviewing term sheets. Let us know if we can help you.
Mezzanine financing is one of the most flexible sources of growth capital, and can be a great alternative to raising equity. Of course, no type of financing comes without drawbacks. Unlike equity, debt requires periodic interest payments and the principal must be repaid upon maturity.
There are hundreds of mezzanine finance providers in the U.S. Banks are not actively involved in mezzanine lending. Most loans are provided by specialized mezzanine funds and other non-bank lenders. These include Business Development Companies (BDC), Small Business Investment Companies (SBIC), mezzanine funds associated with private equity groups, and hedge funds.
Each mezzanine lender has a unique set of investment criteria. These primarily focus on borrower characteristics such as sponsored vs. non-sponsored, revenue, EBITDA, growth rate, industry, and geographic location.
In addition, mezzanine lenders have preferences regarding risk tolerance, return expectations, investment size and structure, and loan rates and terms.
To obtain debt financing, you need the right partner. Find Venture Debt can help you determine whether your company qualifies. If it does, we’ll identify the type of debt that best fits your company and provide access to our extensive network of bank and non-bank lenders that have the capital you need to grow your business.
We help you through the entire process. All you have to do to get started is fill out our simple online form.
Below we’ve answered the most commonly asked questions pertaining to mezzanine financing. If you don’t see your question here, please reach out to us and we’ll get back to you with an answer!
There are two primary alternatives to mezzanine debt:
Generally, these alternatives do not require equity participation. However, the trade-off is that the total funding available to a business is likely to be less than a combination of senior and mezzanine financing. Selecting the optimal alternative depends on the amount of capital needed and conditions in the lending market. For a relatively small company (EBITDA of $5 million or less), second lien is more likely to be available than unitranche.
In its most common form, mezzanine financing is a hybrid of debt and equity.
Mezzanine debt is normally an unsecured obligation of the borrower. In the event of default, the lender cannot claim specific assets of the borrower to satisfy the debt.
Technically, subordinated debt can be secured. However, it is likely that any senior lender would object to ranking below a secured, subordinated lender. Therefore, if subordinated debt is secured, it will likely have a second lien behind the senior lender rather than a first lien. This is commonly referred to as a second lien term loan.
Banks are highly regulated, which limits the amount they can lend to a company and requires stringent covenants. The use of mezzanine financing enables companies to increase the total amount they can borrow and provides flexibility in structure and terms. The trade-off is that mezzanine debt is more expensive than bank debt.
In some ways, they are more alike than different. All can be used to complement or replace traditional bank financing, and all are less expensive than equity. However, they differ in structure and the situations in which they are best used. From an equity dilution perspective, MRR lines and mezzanine financing tend to be minimally-dilutive, while RBF is usually non-dilutive.
Mezzanine financing usually has equity participation in the form of warrants. A convertible structure allows the lender to convert all or a portion of the principal into equity of the borrower. Convertible debt tends to have lower interest payments but higher equity dilution than a structure with warrants.
The most common structure for mezzanine debt is unsecured, subordinated debt so they are fundamentally the same. The key difference is that mezzanine debt usually refers to debt that is coupled with equity participation, which is not usually true for subordinated debt.
A mezzanine debt fund is a pool of capital that is dedicated to providing mezzanine loans to borrowers. In recent years, mezzanine debt funds have faced increased competition from lenders that provide second lien term loans and unitranche financing. As a result, many mezzanine funds have expanded their offerings to include second lien, unitranche, mezzanine, and equity co-investments.
The all-in cost of capital is typically in the range of 14-20% per year including the following:
Due to the equity feature, the cost of mezzanine financing must be estimated using an Excel model. There are two primary methods:
In theory, both approaches should provide the same answer but that is often difficult to achieve in practice. However, the reconciliation process can be beneficial for identifying the key factors that impact cost and understanding the sensitivity to different assumptions.
The cost of mezzanine financing should be evaluated in the context of other alternatives. Ideally, each alternative should be modeled using a consistent methodology with multiple scenarios (e.g. base, upside, downside) for comparative purposes. Of course, non-financial terms and conditions must also be considered in selecting the optimal alternative.