Mezzanine debt is often viewed as a bridge between debt and equity financing. That is because mezzanine loans contain warrants (options), enabling the lender to convert the debt into stock. Even though interest rates are exorbitant (sometimes as high as 20%), this form of capital can be much cheaper than issuing a similar amount of equity as a form of financing.
So from the borrower’s perspective, mezzanine loans are either expensive debt, or cheap equity.
Quick Breakdown
Capital Type: Mezzanine Term Loan or Subordinated Term Loan
Typical Use: Finance growth, mergers and acquisitions and dividends
Funding Mechanism: Fully funded at close
Security: Typically unsecured. Some capital providers may require second priority lien on all assets in certain cases
Collateral: No collateral when structured as unsecured debt. When structured as a second lien debt, all assets of the company and pledge of equity.
Payment Priority: To be repaid only after all secured debt has been completely paid off
Who Should Consider Mezzanine Debt?
Businesses with the following attributes are strong candidates for mezzanine financing:
- Stable, largely predictive cash flows and a demonstrable track record of consistent financial performance. Ownership by a party (such as a PE firm or independent sponsor) that can provide ongoing capital support during downturns certainly helps
- Attractive growth expectations leading to a material increase in the EV of the company
- Secured or senior debt to EBITDA of 3.0x or less, and senior debt to EV of 40% or less
Mezzanine loans are often used to finance M&A activity or other growth initiatives with a short-term time horizon. LBOs are a common vehicle for mezzanine loans, with private equity firms often looking to purchase a company for more than what a traditional lender or a bank will loan against. To bridge this gap, PE firms will secure mezzanine debt in lieu of putting its own capital to work.
Advantages of Mezzanine Debt
Borrowers of mezzanine debt enjoy numerous benefits, including:
- Cost-Effective Equity Alternative: Mezzanine loans provide cheaper capital than equity, while allowing capital seekers to minimize equity dilution
- Cost-Competitive when Rates are Rising: Mezzanine loans are typically priced with a fixed rate of interest, e.g. 11%. When compared to other non-bank debt instruments such a Unitranche, which are priced in reference to a floating index, e.g. SOFR + 7.5%, fixed rate Mezzanine becomes more attractive as indexes such as SOFR increase due to the interest rate actions of the FED.
- Full Utilization of Debt Capacity: When used in conjunction with secured debt, mezzanine debt fully monetizes the enterprise value of a company
- Low Maintenance: Reporting obligations are limited to financials, and other reports provided to secured debt
- Attractive Features: A non-cash or pay-in-kind (“PIK”) interest feature reduces the debt service burden, and no amortization is required, meaning cash flow is available for other corporate needs
Drawbacks of Mezzanine Debt
Despite the above benefits, there are also risks to consider:
- High Interest Rates: While cheaper than equity, the combination of PIK and equity warrants ultimately make mezzanine loans one of the most expensive debt capital types
- Involved Legal Documentation: Separate credit agreements are needed for secured debt and mezzanine debt, and an intercreditor agreement amongst the debt structures is also required
- More Hands On: It is not unusual for capital providers to require a seat on the board of the company, or board observation rights
- No Early Repayment Option: Mezzanine debt usually cannot be repaid for the first couple of years, and includes meaningful call premiums or prepayment penalties
Mezzanine Debt Underwriting Process
Capital Providers: Typically, non-bank credit funds, Small Business Investment Companies (SBICs) and Business Development Companies (BDCs)
Underwriting Thesis: Recovery through ongoing cash flow generation of Capital Seeker or through refinancing. In distressed situation, recovery through sale of Capital seeker as an ongoing business
Underwriting Focus: Confirmation of business’ ability to generate cash flow and repay debt, ability of owner or sponsor to inject additional equity and liquidity
Underwriting Process:
- Typical credit underwriting process for Mezzanine loans focuses on the ability of the business to generate consistent cash flows and risks that may disrupt consistent cash flow generation. Underwriting involves analysis of business model, competitive dynamics, ownership history, historical financial performance as well as financial projections, operations and background of key stakeholders, including key executives
- Quality of earnings report produced by an accounting firm to validate the EBITDA of the business as well as any adjustments and an industry study to validate the company’s competitive position, size of the market, customer feedback, etc.
Amortization: Typically, none
Financial Covenants: Mezzanine debt typically has the same type of covenants as secured debt, however, covenant levels allow for more variability in cash flows compared to levels set for secured debt. Common covenants are leverage ratios (senior debt to EBITDA and total debt to EBITDA) and fixed charge coverage ratio.
Ongoing Reporting: Company prepared unaudited monthly financials, audited annual financials, annual financial projections
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