The economic outlook for 2008 remains suspect, as the turbulent conditions plaguing financial markets have created a turbulent business climate for middle market companies that is likely to continue unabated well into 2009. Commercial banks and investment banks recently they have become the model of the financial services industry. marginalized in less than a year.
However, adversity creates opportunity, and indeed, many companies have been successful in obtaining financing amid collapsing credit markets. Middle-market companies looking to grow and need capital to do so shouldn’t panic when banks cut funding and credit tightens. The money is still available for companies with strong business prospects – you just need to know where to find it and how to get it.
Mezzanine financing can play an important role in financing the growth of privately owned “middle market” companies in good times and bad. This type of debt financing, however, is not really understood by many outside of the industry.
Often called subordinated debt, mezzanine debt is often considered quasi-equity. As such, it is a hybrid of debt and equity financing that is often used to finance acquisitions, product development, plant expansion, and new equipment purchases. Business owners also use it to diversify or invest in other opportunities.
Lenders that provide mezzanine financing, for the most part, lend based on a company’s cash flow rather than a company’s assets. Since there is little or no collateral to back the loan, this type of financing commands a significantly higher price than secured bank debt. Mezzanine financing is advantageous because it is treated as equity on a company’s balance sheet and can make it easier to obtain standard bank financing. It is also very attractive to a business owner as it reduces the amount of equity dilution, which increases the expected return on equity.
Mezzanine financing has many of the debt characteristics associated with traditional term debt, including interest payments, covenants, and, in some cases, amortization. But it also has an advantage in the form of equity participation. Mezzanine debt is generally secured by the company’s equity rather than its tangible assets and is subordinated to debt provided by banks and commercial finance companies.
Mezzanine debt is more expensive than secured debt or senior debt because of the higher credit risk borne by the subordinated lender. Debt holders receive a higher interest rate than the principal debt, as well as a quasi-equity stake in the company to offset the increased risk. It is a much less expensive source of capital than equity financing; perhaps more important, existing shareholders are subject to significantly less dilution.
On a balance sheet, mezzanine debt sits between senior debt and equity. It is subordinate in payment priority to senior debt, but is 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 mid-market, mezzanine lenders look for a fixed current coupon rate of 11% to 15%, which equates to a 5% to 9% spread over the prime rate, plus the additional return on equity interest in the company. This compares to a rate of 1% to 4% above the prime rate for term loans from senior debt lenders.
While most equity investors look for returns of between 30 and 45 percent, mezzanine investors look for annual returns of between 20 and 30 percent. Lenders tend to be flexible in tailoring the investment structure to meet the borrower’s cash flow and operational needs, making mezzanine debt a useful form of financing.
Most mezzanine loans have a term of five to seven years with the possibility of early repayment. Unlike bank debt, which generally requires repayment, interim repayments are often not required until maturity. This allows a business owner to reinvest cash flow in growth opportunities instead of paying down principal debt.
Because their performance is largely due to their capital improvement, mezzanine lenders are more accommodating during difficult business conditions. While a business owner may lose some independence, he or she rarely loses complete control of the business or its management. Owners don’t typically encounter much interference from a mezzanine lender, as long as the business continues to grow and prosper. The amounts raised through mezzanine financing can be substantial. A company can leverage its cash flow and obtain senior debt between 2 and 3.5 times the cash flow. With mezzanine debt, you can bring total debt to 4 to 5 times cash flow, depending on risk appetite in the debt markets.
Mezzanine lenders are typically paid through recapitalizing the business with less expensive senior debt or through retained earnings generated from business growth. For years, mezzanine debt has proven to be a viable source of growth capital to finance “middle market” private companies, whether the economy is running at peak or when it’s in the tank.