Is Mezzanine Right for Your Mid-Market Company?
Mid-Market Lending Insights
Mezzanine financing is a form of borrowing that sits between senior debt and equity that has both debt and equity features.
The Investopedia definition refers to mezzanine financing as the hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally after venture capital companies and other senior lenders are paid.
Due to its subordinated and unsecured nature, mezzanine debt has an interest rate between 12% and 18%, much more expensive than senior debt, but it is usually much cheaper than equity.
Mezzanine financing often requires lenders to receive some upside for providing such funding in the form of equity participation either through warrants, straight equity shares, or the ability to co-invest in the equity alongside the loan. Borrowers often use Mezzanine financing to increase their total debt amount or simply to get financing when senior lenders aren’t able to lend.
Who qualifies for mezzanine financing?
This high-risk, high-return type of financing is not for all middle-market businesses. Mezzanine financing works well for companies that have high growth profiles with top-line revenue growing at 15% or more and healthy, consistent cash flows of at least $2.5MM of EBITDA or more.
Generally, private equity funds or small business investment companies (SBICs) are the typical mezzanine lenders. Mezzanine funds are most comfortable providing mezzanine financing to companies of $5MM of EBITDA or more, but each mezzanine fund has its own profile. If you are a startup with growth potential, you might qualify for such debt.
What are the advantages of mezzanine financing?
A mezzanine loan can be an excellent option for business owners who want to take their company to the next level but lack the working capital to make it happen.
Mezzanine debt provides more flexibility than traditional banks loans. Borrowers’ typically gain 4x or more in cash flow leverage especially at the initial outset of the term of the loan.
The credit facilities are generally structured as interest-only term loans. Interest for a mezzanine loan can often include payment-in-kind (PIK), meaning the investment might allow a portion of the interest payments to be accrued over the life of the loan and paid along with the principal at maturity. PIK further helps remove strain on cash flows.
On the lenders’ side, issuing mezzanine debt allows them to participate in equity upside through warrants or otherwise, which increases the lender’s interest in the success of the company. As a result, lenders are likely to be more flexible as new financing needs or covenant challenges arise.
What are the drawbacks to mezzanine financing?
As good as it can be, let’s not forget about the high interest associated with mezzanine finance. PIK accumulates on the principal and therefore is subject to compounding interest costs. The longer borrowers are using the mezzanine debt instead of converting it to a lower-interest debt, the more interest the borrowers will be paying at the end.
Also, mezzanine term loans come with substantial prepayment penalties, meaning that if the borrowers pay it off early, they might need to pay out all the interest that would have been due to the lender.
Most importantly, borrowers risk losing a particular portion of their company regarding equity and control if default on loan.
Is mezzanine financing right for you?
Cerebro’s experienced transactions team works with a variety of lenders including senior debt lenders, mezzanine lenders, and more. Our Credit Explorer service works to get the borrower the best deal for their needs. Instead of talking to one lender who will try to convince you that their loan products make the most sense, talk with an unbiased industry expert. Get a free consultation with Cerebro Capital to find out if mezzanine finance might be the best option for your growth needs.
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