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Mezzanine Financing – A Powerful Financing Vehicle for Growth

01-Oct / Articles / 1 COMMENTS / by cdobbin

Mezzanine financing is a little known tool available for privately held businesses and publicly traded companies that allows a strong performing company to increase its financial leverage in certain transactions. Generally speaking, mezzanine financing offers the features of both debt (regular interest and principal payments) and equity (options or warrants).   Mezzanine debt will rank behind senior debt but ahead of equity holders in terms of security. 

 

Mezzanine financing is available for companies with strong cash flows. Although there are some limited exceptions in Canada, the majority of mezzanine lenders require historical cash flows to be at a minimum of $2M when looking at historical performance over a three year term.

 

Companies should consider using mezzanine financing when traditional senior debt has been maximized but there are additional leverage opportunities available as a result of strong cash flows prior to raising dilutive equity. Mezzanine financing is generally used for acquisitions (including leveraged buyouts), expansion, recapitalizations, and management buyouts and is prevalent in both operating company situations as well as certain real estate development scenarios.

 

While Mezzanine financing can be structured in any number of different ways, the common elements of mezzanine financing are as follows:

 

1.     Cash interest – Regular interest paid on a periodic basis similar to paying term debt;

 

2.     PIK (Payment in Kind) Interest – A stated amount of periodic interest that is actually added to the principal amount of a loan which is usually paid back as a bullet payment at the end of the term.

 

3.     Ownership – The lender will receive an option or warrant to convert to equity. Generally, in private company situations, the equity is repurchased by the owner(s) over time.

 

Since the target total annualized return for mezzanine lenders ranges from 18-21%, it should be noted that mezzanine lenders usually work with the primary bank in structuring their deals to ensure that the cash interest portion charged on the financing is not prohibitive to the business, thus allowing greater flexibility in the overall capital structure. It should also be pointed out that it is possible to achieve an 85%-90% loan to cost ratio with mezzanine financing. In addition, mezzanine financing is usually treated as equity by senior lenders for purposes of financial covenants.

 

In today’s lending environment, it is common to see senior term debt issued at 3.5 times EBITDA (Earnings Before Interest Tax Depreciation and Amortization) with mezzanine debt adding another 1 times EBITDA for total financing of 4.5 turns of EBITDA.  As an example, it is conceivable that a strong cash flow company with $2M of cash flow (EBITDA) could borrow $7M of senior debt and another $2M of mezzanine debt for $9M of total financing. Given the strong emphasis placed on cash flow, lenders are very meticulous in their due diligence process.

 

In the United States, there are hundreds of lenders directly involved mezzanine financing. In Canada, the number of credible lenders is much smaller. The organizations involved in mezzanine financing include private investors, insurance companies, mutual funds, pension funds, certain government crown corporations, and chartered banks.

 

Business owners should consider the advantages of mezzanine financing prior to raising equity in the private or public markets.

 
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  1. 1 Comment
  2. Laura Johnson
    -
    Feb 22, 2016 at 4:41 pm

    You provide very concise, yet still very informative of mez financing.

    As you mention, there is a great number of mezzanine lenders active in North America. What might be interesting for you, is that we’ve compiled a list (for sure not complete, but still most up-to-date out of all existing on the internet) of mezzanine funds. You can find it on our page: getmezzaninefinancing.com under “mezzanine funds” tab.

    We’d be interesting to hear from you if you find it useful.

     
 
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