What is “Mezz Debt” Anyway?

 
 

financing-availableMezzanine financing or mezz debt is any subordinated debt or preferred equity instrument that represents a claim on a company’s assets which is senior only to that of the common stock. Mezzanine capital can be structured either as debt, preferred stock or a combination of debt and warrants.

Mezz Debt is typically used by companies that are cash flow positive to fund growth through expansion or acquisition, or leveraged buyouts.

When mezzanine financing is used in conjunction with senior secured debt it reduces the equity required in a business. Since equity is the most expensive form of capital, it can be used to create a capital structure that obtains the most funding, offers the lowest cost of capital and maximizes return on equity.

Variety Of Different Structures …

Mezzanine financings can be completed through a variety of different structures depending on the objectives of the transaction and the existing capital structure of the company. The most common structure consists of debt and warrants. Mezzanine lenders look for a certain rate of return which can be made up of any of the following or, most likely, some combination.

  • Cash interest — a periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing. The interest rate can be either fixed throughout the term of the loan or can fluctuate (i.e., float) along with LIBOR or other base rates.
  • PIK interest — Payment in kind interest is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the principal amount by the amount of the interest (e.g., a $10 million loan with an 8% PIK interest rate will have a balance of $10.8 million at the end of the period, but will not pay any cash interest).
  • Ownership — Along with the typical interest payment associated with debt, mezzanine capital will often include an equity stake in the form of attached warrants or a conversion feature similar to that of a convertible bond. The ownership component in mezzanine securities is almost always accompanied by either cash interest or PIK interest, and, in many cases, by both.

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Arrangement Fees Are Common …

Mezzanine lenders will also often charge an arrangement fee, payable upfront at the closing of the transaction.  Arrangement fees contribute the least return and their purposes are primarily to cover administrative costs or as incentive to complete the transaction.

In structuring a mezzanine security, the company and lender work together to avoid burdening the borrower with the full interest cost of such a loan.

Because mezzanine lenders will seek a return of 14% to 20%, this return must be achieved through means other than simple cash interest payments. As a result, by using equity ownership and PIK interest, the mezzanine lender effectively defers its compensation until the due date of the security or a change of control of the company.

Playing An Increasing Role …

Mezz debt is playing an increasing role in a company’s capital structure due to a number of factors:

  • accounts receivable, inventories and fixed assets are often being discounted at greater rates than in the past for fear that their values will not be realized in the future;
  • many balance sheets now contain significant intangible assets, and,
  • as a result of defaults and regulatory pressure, banks have placed ceilings on the amount of total debt a company can obtain

Some closely held companies, particularly those that are family controlled, are reluctant to consider mezzanine financing because it requires relinquishing a certain amount of ownership.  However, a mezzanine investor’s goal isn’t to be a long-term shareholder, but rather to achieve a target return rate by some specified time. In fact, a typical mezzanine transaction has the mezzanine fund as a minority equity holder, with buyout terms to remove the mezzanine fund at the appropriate time.

Important To Analyze The Difference …

Growth-ChartIt’s also important for a business owner to analyze the difference in value between an ownership interest in a stagnant or underperforming business and an ownership in a growing company.  Having mezzanine debt in place actually can help a company secure more total capital and avoid the small business pitfall of being undercapitalized.

In some cases, mezzanine financing can improve a company’s cash flow.  In the case of a private company which is considering an acquisition, the acquiring company will probably need to finance some portion of the transaction.  A typical form of this financing is a seller’s note, which is both unsecured and subordinated to the senior debt. 

While helpful to the acquiring company, due to the more risky position of the seller, they will want to minimize their exposure by being paid in the shortest time. Regular interest payments and partial amortization with a balloon payment at some point in time are typical.

These payments impact the cash flow of the acquiring company and in cases where the acquisition does not generate the expected EBITDA margin, may have an impact on the company’s ability to obtain the secured debt structure it desires.

Communication Is Critical …

communication-skillsAs with most forms of funding, obtaining mezzanine financing requires proper communication between the parties and knowledge of how to best represent the company.

It is possible to have a term sheet and be well down the road in due diligence and have the financing fall through for reasons that are not understood by the company.  Maintaining flexibility and keeping all options open until “the check is in the bank” can be critical.

Properly establishing a company’s capital structure and acquiring the right debt is a complex matter. Unless you’re experienced and aware of the various options, it’s one of the areas where professional assistance can be extremely valuable.