By Vijay Madyastha – VERCOR Atlanta
In Summary
-Mezzanine financing allows borrowers to obtain unsecured debt financing based on cash flow rather than traditional collateral.
-In deciding on a source for mezzanine financing, businesses should pay attention to the lender’s personnel turnover, commitment to the business, track record and flexibility in structuring.-PROS: The mezzanine financing arrangement is usually flexible taking into account the cash flow.
- CONS: Mezzanine financing requires the business owner to relinquish some measure of control over the lender. Businesses may be forced to accept restrictions in how they spend their money in certain areas.To some, mezzanine financing might sound like a complicated term. With a little insight, however, mezzanine financing may turn out to be just the avenue you need to grow your business to the next level.
What is Mezzanine Financing?
The word “Mezzanine” comes from the Italian word meaning half, in the middle or lower.
Mezzanine financing, also referred to as "mezzanine capital" or "junior capital," allows borrowers to obtain unsecured debt financing based on cash flow rather than traditional collateral. It is a tool that can typically fill the financing gap that often occurs between owners' equity and traditional bank financing. Business owners often use mezzanine financing is most for re-capitalization, financing growth, acquisitions or ownership changes.
Generally speaking, mezzanine funds occupy the middle of the business finance scale making it less risky than equity or venture capital, and more risky than senior bank debt. Companies beyond the startup stage, but without the historical cash flow desired by traditional lenders, typically use it. Still, borrowers are required to demonstrate an established cash flow, strong management and operations, a growing market scope, and a solid business plan. Major sources of mezzanine financing include private equity groups or investors, insurance companies, mutual funds, pension funds, and banks.
How Does It Work?
To utilize mezzanine financing, a business borrows some of the money that it requires to grow their business (either through acquisition, increasing of existing operations, etc.), then raises additional funds by selling stock in the business to the same mezzanine financing lenders. In a mezzanine financing arrangement, the borrower negotiates an arrangement with a lender wherein the necessary capital is secured by combining a loan with a stock purchase to the lender. As a rule, the business only pays interest on the money it borrows for a given period specified by the lender. At the end of the arrangement period, the business can cash out their investors by going public or by recapitalizing their business in a new round of financing.
Here is an example:
ABC Company requires $10million to purchase land and facilities to expand its business operations in two new locations. Traditional lending institutions may offer to loan ABC Company $5 million for the land and facilities acquisition based on the companies current performance as detailed in their existing financial statements (balance sheet, cash flow statement and P&L Statements). ABC Company will need to devise a way of supplementing the $5MM in a traditional loan with additional funding to be able to execute their growth strategy. That is where mezzanine financing comes into play. ABC Company can look to mezzanine lenders to raise the additional $5MM needed to execute their strategy by offering lenders stock or a percentage ownership stake in their existing business of that $5MM value for a term of five or so years. At the end of the term ABC Company has the opportunity to buy back the stock (or cash out) from the Mezzanine lender and the new value of stock, based on the return on the expansion investment.
What is in it for the Mezzanine Lender?
The lender makes their money by earning interest on their loans, and if the value of the business they invested in has increased, they realize capital gains by selling their stock in the business.
Why Go To A Mezzanine Lender?
Business owners go to mezzanine financing because it is seen as a viable financing option for some companies that have moved beyond start-up status, but do not yet have the ability to finance substantial growth moves themselves or via traditional lending arrangements. The amounts raised via mezzanine financing can be sizeable in nature. The domestic commercial and industrial loan market is estimated to be greater than $1 trillion annually, and a conservative estimate of the number of mezzanine funds available today is around 180 separate funds.
What Should You Look for in a Lender?
In deciding on a source for mezzanine financing, businesses should pay attention to the lender’s personnel turnover, commitment to the business, track record and flexibility in structuring. Low turnover and commitment to the business are good indicators for a lender, because businesses rarely perform exactly according to plan, prompting the need for an investor who understands the business and will respond readily and appropriately.
To Whom Do Mezzanine Funds Look To Lend?
Since they are more concerned than senior lenders about their overall yield, mezzanine lenders are very liberal in designing their investment to meet the financial, operating and long-term cash flow needs of the borrower. As so much as the lender's anticipated yield is satisfied, they can be flexible as to the loan and the interest rate. One of the important factors examined by a mezzanine lender is the business's capacity to generate cash flow. In addition to cash flow, lenders also tend to look at ownership flexibility, business history, growth strategy and acquisition targets.
Pros of Selecting Mezzanine Financing
-The business owners usually will not be subject to any management interference from their lender.
-The mezzanine financing arrangement is usually flexible taking into account the cash flow requirements of the business.
-Lenders are usually long-term investors rather than entities looking to make a quick buck.
-Mezzanine lenders can offer valuable strategic assistance.
-Mezzanine financing increases the value of stock held by existing shareholders, though the existing shareholders’ ownership stake becomes diluted.
Cons of Selecting Mezzanine Financing
-Mezzanine financing does require the business owner to relinquish some measure of control over the lender.
-Subordinated debt agreements may include restrictive covenants, including agreements by the lender not to borrow more money, refinance senior debt from traditional loans or create additional security interests in the assets, as well as the various financial ratios that the borrower must meet.
-Businesses may be forced to accept restrictions in how they spend their money in certain areas.
-Mezzanine financing is more expensive than traditional or senior debt arrangements.
-Arranging for mezzanine financing can be a hard and lengthy process. Many mezzanine deals can take at least three months to arrange, and many will take twice that long to complete.
The Outlook of Mezzanine Financing
Many experts believe that the use of mezzanine financing will continue to increase among both small and large companies. Businesses are becoming more in tune with financial restructuring in order to create incentives to increase business value. The growing demand of mezzanine financing from businesses along with a growing supply of mezzanine capital from a varied base of institutional investors, will help ensure that mezzanine financing has a home in future capital agreements.
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