When it comes to securing debt financing, small and mid-market businesses often face difficulty. Ever since the 2008 financial crisis, tightening federal regulations have left banks and traditional lenders increasingly hesitant to lend to smaller organizations with insufficient collateral, poor debt-to-income ratio, or inconsistent cash flow.
As a result, middle-market businesses have sought out alternative financing solutions — like mezzanine financing — to support growth opportunities, acquisitions, and the like.
Business development companies (BDCs), private equity firms, and venture capitalists have risen in prominence to meet the growing demand. Since alternative financiers are less beholden to federal regulation, they have become particularly attractive financing options for small enterprises who are unable to secure bank financing.
In fact, by 2018, 40 percent of private credit managers were actively lending to companies with an EBITDA lower than $25 million.
So, what is this popular form of alternative lending? What is mezzanine debt and how does it work?
Below, we’ll discuss the ins and outs of mezzanine financing, some common examples of debt structuring, and why it’s so attractive to both borrowers and lenders.
What is Mezzanine Debt?
Mezzanine debt is a type of financing that bridges the gap between senior debt and equity. Sometimes dubbed subordinated debt, it is a hybrid of debt and equity that isn’t fully backed by the value of a company’s assets, it is instead backed by the value of the enterprise based on its cash flows. In contrast with other types of loans, mezzanine financing provides flexible repayment terms and enables the borrower to finance unsecured intangible assets.
Unlike other forms of debt, mezzanine financing is based on historic and projected cash flow. This makes it a much more attainable form of funding for small companies.
If mezzanine debt helps to bridge the gap between senior debt and equity, it begs the question: Why might there be a gap in the first place?
There are multiple reasons, the first being that banks, heavily regulated as they are, have leverage limitations — i.e., they can only loan so much senior debt to a given enterprise.
At the same time, a business owner may only want to pursue equity financing to a limited degree so as to avoid giving away too much ownership stake in the business.
A third factor is market disruption, like that which has occurred during the coronavirus pandemic.
E-commerce sales, already on the rise, have increased markedly during the outbreak according to a Fortune Business Insights report, which has resulted in a need for more warehouses and distribution centers. Traditional lenders have been reluctant to meet the construction needs of the e-commerce industry, leaving mezzanine financing to fill the breach.
The result is a massive market for mezzanine capital, with experts predicting $9.43 billion worth of business by 2026, an annual growth rate of 4.6 percent.
The term mezzanine comes from architecture, referring to the intermediate story between two main levels, as in a concert hall or sports arena. As such, mezzanine debt describes capital that has seniority between equity and senior debt.
Mezzanine financing dates back to the ’80s, when insurance companies and savings and loan firms dominated the US debt space. Ten years later, limited partnerships entered the market, which were quickly followed by hedge funds, pension funds, big-name insurance companies, leveraged public funds, and even some boutique banks.
Owing to its flexible structuring, mezzanine financing has managed to survive economic turbulence much more successfully than other forms of debt financing. In contrast with traded equity, traditional mezzanine financing occupies a stable and consistent market.
Over a five-year period from ’98 to ’02, average internal rates of return (IRR) for mezzanine financing remained around 16 to 25 percent, never dipping below a 15 percent rate of return. The same has held true throughout the ’08 financial crisis and COVID-19 pandemic. Of course, return rates differ based on company performance and loss ratio.
Still a little lost? It might be helpful to go over some common examples of how mezzanine financing is structured.
How Mezzanine Debt is Structured: Common Examples
Typically, the borrower is the first one to get the ball rolling in a mezzanine financing agreement.
Businesses will usually seek out mezzanine capital because they want to grow without giving up additional equity during an early-stage funding round. Since mezzanine debt is so flexible, the company will often refinance it down the line into a consolidated senior loan for a lower interest rate (assuming the company achieves its growth goals).
Sometimes, companies will employ mezzanine loans similarly to a second mortgage, since it can later be used to pull equity out of the company. Though it’s treated like equity, generated interest is tax-deductible.
Mezzanine financing usually provides five to 25 percent of the capital for any given loan, thus making it supplementary to senior loans, which typically feature a loan-to-value (LTV) ratio of 60 to 65 percent. Any remainder from common equity is then factored into the deal.
In essence, mezzanine lenders function as “gap financiers” that have to be comfortable — in terms of payout priority — being superior to common equity yet subordinate to senior debt.
Here’s an example:
Consider the example of Company A that wants to acquire Company B valued at $100 million. A senior lender might only be comfortable lending 75 percent of the value of the acquisition, while Company A doesn’t want to front the additional $25 million.
So, Company A finds a mezzanine investor that is willing to provide $15 million. Now, $90 million is available in debt financing, so the company only needs to contribute $10 million of cash equity towards the buyout.
The result? The buyer’s potential return is leveraged and the amount of immediate capital needed is minimized.
Let’s try another:
Take an entrepreneur who needs $10 million to expand their business. He has raised $5 million of senior debt and has $3 million of equity. He has a $2 million shortfall, and can’t find any more equity, because all his equity investors don’t want to over-equitize the deal. This is where mezzanine financing comes into play.
One more example might be a CEO who is looking to expand his business, and has already accrued so much senior debt that his bank, for reasons mentioned above, will not allow him to take on anymore. His options are equity — which, again, means losing some control of the operation — or mezzanine financing.
As mentioned above, there has been a greater need for mezzanine capital during the COVID-19 pandemic than ever, for while mergers and acquisitions are proceeding at a breakneck pace, traditional lenders have shied away, as indeed they tend to do during periods of economic turbulence. Mezzanine debt, offering its highly flexible financing, has emerged as a viable alternative, as indeed it has in other instances.
Benefits for Investors
Mezzanine financing isn’t just favorable for borrowers; lenders love it, too. Compared to other forms of debt, mezzanine debt offers some of the highest return rates, often generating returns between 12 to 20 percent per year.
In contrast with equity, mezzanine debt provides a return that is less variable than equity. Equity returns differ depending on the current supply and demand trends in the market, whereas the returns generated by mezzanine are contract-bound and paid in full.
Generally, mezzanine debt features repayment terms that are set at a fixed amount and secured before cash is paid out to equity investors. Because of this, mezzanine capital is less risky and has some buffer against the cyclical nature of the market.
Investors often seek to balance out their portfolio by offering mezzanine debt since it provides a secure way of realizing a return on investment. Meanwhile, lenders that operate completely at the mercy of the market are less protected when operations go south.
Lenders also mitigate risk by doing some due diligence before agreeing to a deal. They’ll typically take two primary factors into account: One, whether the borrower has a proven track record of profitability and, two, whether or not the business has a detailed plan for how the funding will be used.
Some deals even provide lenders with the option of an ownership stake in the borrowing company, either via warrants or other terms for converting debt to equity. If the borrower becomes more successful, this can be a mutually-beneficial and attractive option.
Benefits for Borrowers
When seeking funding, business owners can find themselves with a gap between equity and senior debt for a variety of reasons, as mentioned above. Whether it’s fixed assets that may never realize their value or ceilings on the amount of debt that can be raised from a bank, mezzanine financing provides companies an avenue to bridge that gap and secure the full amount of funding they need.
Mezzanine funding has other major benefits as well. For one, it reduces a company’s immediate need for equity, so the business owner does not lose any stake in the company. Since mezzanine lenders have no ownership in the enterprise, they tend to be long-term funding sources rather than “angel investors” that want outsized rates of growth.
For another, borrowers can achieve a cost-effective capital structure and the best funding possible. Additionally, mezzanine debt is tax-deductible and banks are more willing to lend to a company with it included in the capital structure, as the presence of mezzanine lenders reduces the risk they incur.
The right lender can offer valuable strategic assistance, as they want to receive regular payouts on schedule over a set period of several years. Borrowers can achieve their goals through the flexible funding provided by mezzanine lenders, allowing them to best expand into a new mode of production, pursue an acquisition or breach target markets.
Final Thoughts
In an era of increasing bank restrictions, mezzanine financing remains one of the most flexible forms of funding that borrowers can access from alternative financing institutions.
Like the intermediary story between two floors, mezzanine capital occupies the space between equity and senior debt. And it affords enterprises the opportunity to grow ever bigger, ever higher — to, perhaps, literally add floors to their own buildings.
That said, mezzanine debt isn’t right for every enterprise. Mezzanine financing is only available to companies that have a proven track record of profitability and a feasible plan for expansion. Consider your financial goals and obligations to determine whether mezzanine debt would be the most helpful form of lending for your organization.
If you’re interested in speaking with a business development company (BDC) that can provide the sort of flexible, borrower-friendly loan agreements mentioned above, check out Saratoga’s investment profile to see if your company might be a good fit.