Using Mezzanine Debt for Growth

Axial
July 21, 2015

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There are many forms of financing to consider when looking to raise growth capital or sell a business. For CEOs, understanding the entire capital spectrum before entering into a transaction is essential to determining whether debt, equity, or a hybrid financing, is the best structure for your business.

Particularly for mid-sized companies growing at a pace that cannot be supported by earnings alone or even other forms of debt financing, mezzanine debt may be one compelling option.

What is Mezzanine Financing?

Mezzanine financing is a hybrid form of debt and equity because it incorporates a company’s assets and equity-based securities options. Typically in an organization, mezzanine debt will rank below senior debt, senior subordinated debt and subordinated debt, but is senior to the owner’s equity. Therefore, the mezzanine lender is the second-to-last to get paid in the event of failure, making it an expensive and high-risk debt. However, it also offers high returns between 12 percent to 20 percent per year.

Mezzanine financing is commonly used for adolescent or mature companies that have positive cash flow but need additional capital for growth opportunities.

Related Reading: Mezzanine Debt 101

Benefits of Mezzanine Debt

One of the chief benefits of mezzanine financing is that it does not require amortization throughout the term of the debt. Mezzanine debt has longer maturities, so that CEOs need only pay the principal at maturity, which is typically five to seven years. This enables companies to pay down senior debt, invest capital into the company, and accrue revenue on the balance sheet. Ultimately, companies can leverage their increased cash flow to take advantage of future growth opportunities.

Mezzanine capital can also be customized to meet a company’s financial needs. Due to the fact that it is an unsecured investment, there is no need for collateral. Therefore, as mezzanine investors are more interested in equity than senior lenders, there is greater flexibility to meet the cash flow and operational needs of a company.

Ultimately, mezzanine financing is less costly than equity because it works with senior debt. Therefore, with less equity required in a business, mezzanine debt lowers the after-tax costs of capital and increases the return on equity. It is also less dilutive than traditional equity financing, as common equity is the most expensive form of capital due to the fact it is not tax deductible.

Investor Advantages

Investors see several benefits from mezzanine financing, including a free kicker. This is a small ownership stake or an option where the debt investor is entitled to buy equity in the future. If the company is a success, the kickers can grow to be much higher multiples than the amount invested. Mezzanine financing also generates higher returns, similar to equity, which makes investors more willing to take significant risks. Ultimately, borrowers have contractual obligations to make interest payments according to the deal terms, providing investors with steady returns on a regular basis.

Borrower Advantages

There are multiple advantages for borrowers because all interest on debts is tax deductible. Therefore with a 35 percent corporate tax rate and a 20 percent pre-tax interest rate, borrowers only pay 13 percent after taxes. Although mezzanine capital also offers unique flexibility if they cannot make the normally scheduled payments because a borrower can roll their interest balance into one lump sum or a period of payments.

Using Mezzanine Debt

Mezzanine debt can fill the space between a senior bank loan and available equity to fund the cost of a transaction. It is commonly used for acquisition financing and ownership restructuring (such as in a leveraged buyout), although it can also be applied to growth opportunities or to finance dividend payments for company shareholders.

Deciding when to use mezzanine debt can be tricky as there is no standard transaction where it is deemed appropriate. However, for a business that needs to grow above and beyond what other forms of financing can support and is confident in its ability to generate returns beyond the higher cost of this form of capital, the answer may be yes.