Are You Overleveraged But Too Undervalued to Sell?

Are You Overleveraged But Too Undervalued to Sell?

By John Hammett

November 13, 2009

Mezzanine Debt

Today’s economy has put many private companies in a tight spot.  Companies end up with too much bank debt as business volume and profits contract.  But lower earnings mean that company owners who would have been ready to sell their companies now can’t do it because they end up with too little after paying off their banks.

So, how can you reduce your bank debt, improve your cash flow, and stay tough while you wait for the outside economy and your earnings to recover?  One answer is mezzanine debt.

Mezza-what?  Mezzanine debt gets the name because it’s half way between senior bank debt and equity.  Because it’s kind of both, it serves really well in the right situation.  Mezzanine is semi-permanent capital, like equity, so the company does not have to make monthly or quarterly payments of principal.  It usually has a 5 to 7 year term.

Senior lenders, like banks, look at mezzanine, or mezz, as equity, because it is semi-permanent capital and because it is subordinated to the bank debt, which means that the bank gets paid first in the case of a problem.

For owners, mezz looks like debt, because it often does not dilute the ownership of the company, like selling stock would do.

So, a new investment of mezz into your company can pay off some of the burdensome bank debt with more patient capital without giving up a percentage of ownership that would come with selling equity.

Mezzanine lenders are very busy these days because their product is ripe for this market.  A well-structured Mezz investment will reduce a company’s leverage, improve immediate cash flow, and preserve the equity value for the owner in a sale a couple years down the road.

So, what’s not to like?  It’s a little expensive.  Compared to a bank loan, mezz carries an interest rate in the range of 12% to 14%, depending on the deal.  That’s more expensive than a bank, but the cash flow is often better because the principal does not need to be repaid until the end.  And those interest rates are less expensive than selling ownership shares in a company that has depressed valuation.  Sometimes, mezz deals include an “equity kicker” that gives the lender options to buy your stock at a fixed value so that they get an extra return when you sell the company down the road.  That’s not a bad thing because it brings in an experienced investor who shares you goal of a well-paid exit from the company.

If your bank is making you nervous, or if you are making them nervous, if you want to strengthen your balance sheet as you wait for the market to recover for you to sell the company, a mezz investment right now might make everyone happy.

posted by John Hammett