Mezzanine Financing

What is mezzanine financing?

Mezzanine financing is a hybrid of debt and equity that ranks below senior debt but above common stock in a capital structure. It 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. Mezzanine funds require a higher return than senior lenders and a lower return than equity investors. They achieve this through a combination of higher interest rate and equity participation. Both corporate and real estate borrowers utilize mezzanine financing, but the focus of this overview is corporate finance.

Mezzanine-Financing

How is mezzanine financing structured?

Mezzanine financing has a flexible structure including the following alternatives:

  • Subordinated debt plus an "equity kicker" in the form of warrants to purchase common stock;
  • Subordinated debt plus an equity co-investment;
  • Convertible debt; and
  • Preferred equity.

The most common structure is a subordinated, unsecured term loan plus warrants. Interest payments are due monthly or quarterly but may accrue during an initial period (e.g. twelve months), increasing the principal balance. Normally, the principal is not repaid until the final maturity date.

How is it similar to debt?

  • Mezzanine financing minimizes dilution, so management or investors can keep a much larger percentage of ownership.
  • Principal and interest payments must be made according to an agreed upon schedule. Failure to make these payments can result in bankruptcy.
  • In a sale or liquidation of the company, mezzanine lenders must be repaid before common and preferred stockholders.
  • The cost of capital is less than common or preferred stock.

How is it similar to equity?

  • Mezzanine funds participates in any increase in value of the company.
  • The cost of capital is higher than senior debt due to the higher risk.
  • Mezzanine funds may require board seats or other direct involvement in the governance of the company.

When is mezzanine debt used in a capital structure?

Since mezzanine debt has a flexible structure, it is used in a wide variety of situations including:

  • Growth capital
  • Acquisitions
  • Leveraged buyouts
  • Management buyouts
  • Shareholder buyouts
  • Recapitalizations
  • Refinancings

What are the alternatives to mezzanine debt?

There are two primary alternatives:

  • A second lien loan is similar to senior debt but has a second rather than first lien on collateral. Combining a line of credit or senior term loan with debt that is slightly junior provides additional capital to a business at an attractive blended interest rate.
  • A unitranche loan combines senior and subordinated into a single facility with a blended rate.

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.

How does it compare to a bank debt?

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.

How does it compare to an MRR line of credit or revenue-based financing (RBF)?

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 vs. convertible debt?

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.

What are the benefits of mezzanine financing?

  • When properly structured, debt financing is substantially less expensive than equity financing. By utilizing mezzanine debt in its balance sheet, a company can lower its weighted average cost of capital (WACC).
  • Less dilutive so management or investors can keep a much larger percentage of ownership.
  • For companies that don't qualify for sufficient bank debt or have strong cash flow but need flexible terms, mezzanine funds can provide a “one-stop” debt solution.
  • Mezzanine financing can be a great alternative when a company needs growth capital but is not growing fast enough or is not large enough to attract institutional investors (venture capital or private equity) or is not satisfied with the terms offered by such investors.
  • Can be used as bridge financing prior to an equity financing or public offering.
  • Depending on the size of their equity interest, mezzanine lenders may not require board seats or other direct involvement in the governance or operations of the company.
  • Generally, mezzanine funds do not want to be long-term shareholders. Equity is a tool for boosting the return on their lending portfolio.
  • Personal guarantee is generally not required.
  • Collateral is generally not required for mezzanine financing.
  • Covenants are less restrictive than senior debt.
  • Borrower does not have to be sponsored by a venture capital or private equity firm.
  • Due diligence process is simpler and faster than an equity fundraising.
  • Mezzanine funds have been facing competitive pressure from other forms of finance, which may force them to improve their pricing and terms.

What are the drawbacks?

  • The business must be profitable and have sufficient cash flow to make scheduled principal and interest payments.
  • Mezzanine financing usually has a much higher interest rate than senior debt due to its riskier position in the capital structure.
  • Mezzanine funds require equity participation. In some cases, the investor has a “put” right, so the company has to repurchase the equity investment based upon a formula after a set period of time.
  • It can be difficult to estimate the cost of capital, especially if the company has substantial upside potential.
  • If a company is required to borrow the entire principal amount up front, the cost may be higher than lines of credit which are drawn as needed.
  • Since the business will have a senior lender and a subordinated lender, an intercreditor agreement will be required, which adds complexity, time and expense to the process.

What do mezzanine lenders look for in potential borrowers?

  • Industry: Can be technology or non-technology sector but mezzanine lenders avoid sectors where business models are subject to rapid change.
  • Business model: Business model should be proven and stable. Mezzanine lenders avoid early-stage, turnaround, or highly cyclical businesses.
  • Size: Minimum size varies widely. It is usually defined based on EBITDA rather than revenue. However, annual revenue of at least $5 million is a reasonable guideline for minimum. Practically speaking, there is no maximum.
  • Growth: Positive historical and projected growth.
  • Profitability: Business must be profitable, usually with at least $1 million of EBITDA.
  • Existing debt: Senior obligations are permitted but mezzanine lenders may require limits.
  • Ownership: Company are often sponsored by a private equity group, but it is not a requirement.

What are the key provisions of a mezzanine financing term sheet?

  • Structure: The most common structure for mezzanine financing is subordinated debt, with the lender receiving an "equity kicker" in the form of warrants to purchase common stock.
  • Amount:  Depends on the revenue, profit margins, existing financial leverage, and other factors. The minimum is typically $500,000. The maximum can exceed $100 million.
  • Term: Usually 5 years.
  • Amortization: Usually structured as interest-only with 100% of principal due at final maturity (also called a "bullet loan").
  • Interest: 10% to 14% annually.
  • Equity participation: Mezzanine lenders require warrants or other equity kicker to achieve their target return on investment. The ownership percentage will vary depending on the lender's required return, the risk and projected growth of the business, and other factors.
  • Collateral requirements: Usually none. Mezzanine debt is generally an unsecured obligation, which is the primary reason it’s only available to profitable companies. Unlike second lien, mezzanine financing is a true “silent second” behind the senior.
  • Restrictive covenants: Generally, includes minimal financial maintenance covenants such as coverage ratios. However, the lender will likely require affirmative covenants and negative covenants. Affirmative covenants require the borrower to take certain actions such as paying required taxes, maintaining financial records, maintaining adequate insurance, etc. Negative covenants limit actions that the borrower can take without the lender's permission such as borrowing additional money, paying dividends to shareholders, selling the company's assets, or other actions that may affect the company's ability to repay.
  • Governance: Some, but not all, mezzanine funds require board seats or other direct involvement in the governance of the company. It also depends on the specific situation, especially the lender's ownership percentage.
  • Personal guarantee: Usually not required.
  • Access and audit rights:  Requires access to financial statements and bank account data to monitor company's financial performance and verify compliance with loan agreement.

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.

What is the all-in cost for mezzanine financing?

The all-in cost of capital is typically in the range of 14-20% per year including the following:

  • Interest;
  • Equity participation; and
  • Fees (one-time or periodic).

Due to the equity feature, the cost of mezzanine financing must be estimated using an Excel model. There are two primary methods:

  • Method #1 treats the equity as an upfront fee paid by the borrower.
    Step 1: Calculate the value of the participation as of the issuance date using the Black-Scholes option pricing model. Of course, if the equity kicker is in the form of warrants with an exercise price of $0.01 (also known as "penny warrants"), they are basically worth the value of the underlying security.
    Step 2: Deduct the value of the equity and any upfront fees from the principal amount (similar to an original issue discount or "OID").
    Step 3: Calculate the effective interest rate.
  • Method #2 is a more traditional cash flow analysis.
    Step 1: Deduct the value of any upfront fees from the principal amount at issuance (the equity is not included in the calculation).
    Step 2: Estimate the timing and amount of proceeds from an exit event for the equity.
    Step 3: Calculate an internal rate of return for the investment including all cash flows. This approach is more complicated than the first since it requires estimating the future value of the business.

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.

What companies provide mezzanine debt?

  • Non-bank lenders and mezzanine funds, including Business Development Companies (BDC), Small Business Investment Companies (SBIC), and hedge funds. Examples of mezzanine lenders are RBC Mezzanine Finance and Pricoa Capital Group.

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