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Sources of Capital: Mezzanine Funds

Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser et al


The base content of this section is adapted from "Mezzanine Capital Financing for Small and Midsize Businesses," written by Donald Tyson, PNC Bank.

Mezzanine funds are typically subordinated debt lenders and seek businesses that have high potential for growth and earnings but are currently unable to obtain from a bank all of the funds necessary to achieve their goals. This may be because of a lack of collateral, higher balance sheet leverage, shorter operating history, or a variety of other, transitional reasons. As risk lenders, mezzanine investors consider investment opportunities outside conventional commercial bank parameters. Ideally, mezzanine investors prefer companies that, in a three-to-five-year period, can exit mezzanine financing through additional debt from a senior lender, an initial public offering, or an acquisition. In addition to these financial criteria, a critical consideration is the quality of the people involved. Strong management is important, and mezzanine investors look closely at an entrepreneur's hands-on operating achievements and proven management ability. The track record of a company's management team is a valuable indicator of its ability to achieve future success.

The typical borrowing profile of a company funded by a mezzanine fund is:

  • Strong management.
  • Strong cash flow.
  • Insufficient senior financing.
  • Insufficient collateral.
  • High leverage.

Mezzanine funds typically provide financing for:

Businesses and situations usually not of interest to mezzanine investors include:
  • Start-ups.
  • Seed capital.
  • Prerevenue or development stage companies.
  • Non-owner-occupied real estate investment.
  • Any business unable to support additional debt service from its cash flow.
  • Turnaround situations.

An interested company should contact a mezzanine investor for a preliminary screening to determine whether mezzanine financing is appropriate for its situation. The company then works closely with its bank and the mezzanine investor to structure a complete financing package. Alternatively, a bank unable to fully satisfy the financing needs of a growing company may suggest a mezzanine investor.

Mezzanine Financing/Subordinated Debt

Mezzanine is a term used to describe financing that fits on the balance sheet between commercial bank debt and traditional shareholder's equity. While this type of financing is a form of debt (typically a subordinated loan), it is often referred to as an investment.

Mezzanine financing is not generally used by firms to cover day-to-day operations; rather, it is used during transitional periods in the life of a company when extra financing is required. Mezzanine loans are used for longterm or permanent working capital, equipment purchases, management buyouts, strategic acquisitions, recapitalizations, acquisitions of commercial real estate, and other worthwhile business purposes. Typically, a business will be in a situation where its commercial bank is unable to fully meet its credit needs. In these situations, the business owners have two options: (1) raise additional capital through the sale of equity in the business, or (2) raise additional debt by borrowing from a mezzanine lender. If you have a successful company and need a substantial investment, but do not want to give up large amounts of equity or control, mezzanine financing may be for you.

Equity versus Mezzanine Debt

Equity investment may be attractive to some businesses because it does not require interest payments or principal amortization. However, equity financing may also involve higher long-term costs, the inability to exit, and management control issues. An equity investor will look to earn, at a minimum, a 25 percent to 35 percent return on the investment as compensation for the risks taken. Equity investors want to have some input into the management of the business in order to protect their investments, and have to be bought out to terminate the relationship.

By contrast, mezzanine financing may offer the advantages of a lower cost, no management control, and a predefined exit arrangement. Mezzanine investors usually seek a 15 percent to 30 percent return on investment, some of which can be generated through fees or stock warrants. When the mezzanine investor earns much of its return through fees tied directly to the performance of the company (instead of through stock ownership), the investor participates in the success or failure of the company, and these fees are limited to the life of the financing arrangement. In this way, mezzanine financing can eliminate the outside ownership and management control issues that often concern entrepreneurs, and it does not dilute the equity of the shareholders.

Loan Structure

Mezzanine loans are structured to accommodate the financing needs of growing companies. The mezzanine investor predicates the investment decision on the firm's cash flow and projected growth rather than on collateral. Typically, mezzanine loans are unsecured; the mezzanine investor presumes that there will be little or no recovery of principal from a liquidation, and the investment is priced accordingly. However, the investor may require a subordinate claim on corporate assets, second to the senior lender. The terms of a mezzanine deal are usually flexible, generally involving five-to-seven-year maturities with no amortization. Repayment of principal is usually due at maturity or deferred until later in the loan term and is scheduled to fit the borrower's needs and cash flow projections. Creativity in structuring loans is a strength of the mezzanine investor.

Loan Size

Mezzanine investors fill a niche in the financing market, and some provide funding for smaller businesses and in smaller amounts than most other investors. While mezzanine investments are available in all amounts, the smallest investments ranging from $100,000 to $750,000, most deals today are $1,000,000 plus in size. Larger investments are made by many mezzanine funds with loans that range from $10 million to $50 million, or more.

Price

Mezzanine financing presents a greater degree of risk to the investor, so it is considerably more expensive for the business than borrowing from a bank. The price of mezzanine debt typically includes a base interest or coupon rate on the loan with an additional pricing vehicle to ensure that the investor participates in the success (or failure) of the business. This vehicle can take the form of a stock warrant or a royalty, often called a success fee or revenue participation fee, that is based on the growth of the business. The pricing is structured to fit the unique characteristics of the business and the deal. In some instances, a success fee will have variable terms to protect the lender from nonperformance of the company; you may hear the term ratchet used in this context. Typically, mezzanine investors seek overall returns of 15 percent to 20 percent or more on investments. In addition, expect to pay an application fee of 0.5 percent to 2 percent plus a commitment fee of 1 percent to 3 percent, both amounts as a percent of the total transaction value.

The portion of the pricing that rewards the investor based on the firm's success should be carefully considered. A warrant or any other financial vehicle that ties into the equity of the company may have disadvantages and costs similar to those of a straight equity investment. Mezzanine investors that do not use these types of vehicles usually have a lower cost, no management control, and an easier exit strategy. Instead of using an equity based vehicle, these investors base a portion of the pricing on the firm's measurable financial success during the loan term, using a fee based on a formula tied to the firm's income statement. The simplest of these success fees works much like a royalty: The firm pays the investor a periodic fee equal to a small percentage of that period's gross revenues. Therefore, as sales increase or decrease, so goes the return to the mezzanine investor.

If the company wishes to exit the mezzanine investment prematurely, there may be some costs to doing so. These costs may include a prepayment penalty or a yield maintenance calculation to ensure that the investor is guaranteed a minimum return on the investment. These costs should be defined up front to ensure a smooth exit strategy.

Pricing questions to ask a mezzanine investor include:

  • What is the interest or coupon rate of the loan?
  • What are the other pricing components?
  • Is there an equity component to the price?
  • What are the costs to exit the relationship and pay off the loan?

Prepayment or Early Exit Usually subordinated debt can be prepaid; however, there are terms in the transaction documents (negotiable) that will provide what is in effect a prepayment fee. A couple of examples are the sum of the average remaining success fees or the discounted NPV of the remaining success fees. Alternatively, the firm may continue to pay the remaining success fees through the original maturity date of the loan.

Practically Speaking

Mezzanine financing is typically not available to early stage or venture capital-backed companies until the business has demonstrated significant commercial success and consistent growth. While mezzanine players may not have significant collateral positions as required by commercial banks, they are debt players and typically have restrictive financial covenants to protect their debt. Mezzanine players are often found in leveraged management buyouts where the company's cash flow justifies greater leverage than the company's asset coverage. The companies financed by mezzanine lenders generally have a proven financial history and cash flows that justify additional leverage.

Remember that lenders in liquidation must be repaid before the equity holders; thus if events cause the company to go sideways or take a turn downward, the company's management may not be able to change course without the lender's permission because of restrictive covenants. This often leads to raising additional equity to pay off debt at precisely the wrong time to price the new stock. Thus, significant shareholder dilution can result. If all goes well, dilution is avoided and everyone wins.

The above material is adapted from The Handbook of Financing Growth: Strategies and Capital Structure by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser. Copyright ©2005.This material is used by permission of John Wiley & Sons, Inc.