Is Mezzanine Financing Right for Your Company?

In the architecture world, a mezzanine is described as an intermediate floor of a lesser width that’s positioned between two main floors, while theater buffs know the mezzanine is the lowest balcony or forward part of a balcony.

A mezzanine seat often is considered second rate – although some mezzanine views actually offer the most-coveted sightlines.

In the financing world, so-called mezzanine debt also often has a so-so reputation – a reputation that isn’t necessarily deserved. In fact, it’s been used successfully for years.

“Mezzanine debt gets its name because it blurs the lines between what constitutes debt and equity,” the Motley Fool writes.

For our purposes, mezzanine debt is cash flow that sits in the second lien position behind asset-based lenders; in return for their risk, lenders often incorporate an equity kicker such as stock warrants or bonus payments tied to company valuation. Typical loan lengths are three to five years.

That sounds troubling, but it’s not necessarily a bad thing for the right company.

Mezzanine debt can be put to good use, especially for companies that have a strong cash flow to support the debt. It’s not generally tied to secured assets, but is lent based on a company’s repayment ability – also known as free cash flow. And mezzanine debt allows a business to obtain financing without having to issue equity and dilute ownership. That increases leverage.

Corporate expansion projects, acquisitions, leveraged buy-outs (LBO), management buy-outs and recapitalizations may all be financed by mezzanine debt. It’s often used for smaller LBOs that otherwise don’t have access to the junk bond market.

One catch, however, is that pricing can be across the board. Given its subordinate position, interest rates are going to be relatively high to start, so be sure to shop around for the best deal.

But why would borrowers want to pay those higher rates, which might be 20 percent or more?

For one thing, smaller companies often have limited options.

And remember that the IRS considers the interest on debt a tax-deductible expense, which bring the effective interest rate way down.

Mezzanine lenders may also include features that can make payments more management. PIK toggles – where interest is added to the loan balance – are one example. Thus, if a borrower can’t make a normally scheduled payment, the interest (or at least part of it) can be deferred.

Firms that are growing quickly won’t need a mezzanine loan for too long. That’s because as the company grows, its value increases as well. At that point, you could be able to refinance all debt into a single senior loan at much more palatable terms.

So, who exactly invests in mezzanine debt?

Large institutional investors such as commercial banks, insurance companies, private equity firms and mezzanine funds are common investors.

“In an ideal transaction, the mezzanine fund hopes to make a profit through a combination of current interest, the exercise of warrants, the sale of the underlying equity upon a sale of the business or by requiring the company to repurchase the warrants after a period of time,” states the law firm Duane Morris. “Most mezzanine lenders are not interested in becoming long-term shareholders in your company because they need to make distributions to their own limited partners.”

All of this begs the question, “Is mezzanine financing right for you?”

That depends on how aggressive you want to be, but it should be a real consideration if the cash infusion would bolster your revenue growth far beyond what you could do organically. The same is true if you want to boost company valuation in advance of a sale or going public.