Mezzanine Financing Can Close the Deal

Mezzanine Financing Can Close the Deal

By Roy Graham

November 04, 2008

Down economic cycles can offer excellent buying opportunities for well positioned companies but they may create funding challenges to getting a deal closed.  When credit is easy and senior debt lenders are liberal with leverage and terms, most buyers don’t need additional help in funding their deals.  In a down economy, it’s quite a different matter and mezzanine financing may be the solution.

Mezzanine financing is also known as subordinated debt and is junior to the security interest of senior debt while ahead of equity stakeholder rights.  Many of the features of a mezzanine loan are similar to a bank loan.  There will be provisions for interest payments, an origination fee, amortization terms, covenants, potential liens, default definition and remedies, and other items.  Additionally, mezzanine investors craft warrants into their structures to compensate for their risk as junior lenders.  Warrants provide the right to purchase equity at a later date.  Don’t worry, mezzanine investors don’t want to own your company so they will include “put” options, which when exercised, require the borrower’s company to buy-back the stock at a pre-determined price often tied to a valuation formula based on a multiple of the company’s earnings.  In short, it’s an in and out transaction designed to augment their return.

There can be considerable variance in the cost and terms of subordinated debt but a typical subordinated loan may include quarterly interest payments in the 11% to 14% range coupled with an equity kicker via warrants designed to boost the overall yield to a minimum compounded annual rate of return of 20% or more over the life of the loan.  The rate of amortization can also vary and may range from stepped amortization of principal to a balloon of the entire amount at maturity.  The term of the loan generally ranges from three to seven years.

During the first half of 2008, buyout firms and corporations raised $24 billion in mezzanine debt, a large increase over the same period in 2007, according to data from Dow Jones.  The number of providers has increased over the years and now includes a few public companies, in addition to many private funds and SBIC funds.  Because sources vary in focus and rates and terms can be complex, an investment bank may provide the most efficient and cost effective access to these funds.  Mezzanine debt may sound expensive when compared to senior debt but if it closes the funding gap on an attractively priced acquisition target, it may be an excellent choice.