Mezzanine Finance Can Be Critical Capital
by Marc A. Reich
Reprinted with permission. Originally published in the November, 2002 edition of The Monitor industry newsletter
Mezzanine finance has long been a component in creating the optimal capital structure for middle-market companies, but its importance has increased dramatically within the last few years. Because underwriting criteria applied by banks have tightened due to the softening economy and pressure from bank regulators, demand for mezzanine finance has increased significantly. In fact, mezzanine finance is now often the difference between successfully bridging the gap between equity and senior debt funding and having a deal fail to close. This article is intended to provide the ownership and management of companies, and their bankers, attorneys and other professionals with a working understanding of mezzanine finance and how it is applied in meeting the financing needs of middle-market companies.
Mezzanine finance occupies a location on the balance sheet of a company between senior debt and equity. Like the architectural feature from which it derives its name, it sits above the main floor of equity capital and below the upper floors consisting of senior debt. Like most mezzanine floors, it is smaller than the floors above and below it; thus, the dollar amount of mezzanine finance is generally less than either the equity base or senior debt of a company. Mezzanine finance can be viewed as a hybrid form of capital, combining elements of both debt and equity. It most commonly takes the form of subordinated debt coupled with warrants that enable the investor to purchase shares in a company at a predetermined price. Mezzanine finance is not a control investment and is normally not used to take an ownership position in a company.
The subordinated debt, or “sub debt,” has all the characteristics of other debt instruments, but is structurally junior in priority of payment and its claim on collateral to senior debt. Because of this subordinate position, sub debt presents a greater risk profile to the lender; and thus, warrants a higher rate of return. The total internal rate of return, or IRR, that a mezzanine investor would seek in a mezzanine investment in a privately held middle market company ranges from the high-teens to the mid-20s. In today’s market, subordinated debt for a middle market company typically has an interest rate of between 10 and 12 percent, payable on a current basis. It is the current-pay aspect of mezzanine finance that makes it generally unavailable to early-stage companies that are typically cash constrained, preferring to use cash in their business rather than to service debt. The sub debt would typically have a maturity ranging from five to seven years, call for modest amortization over its term, and have a large balloon payment at maturity. The remainder of the expected return over and above the interest rate charged on the sub debt must come from the equity-linked aspect of the mezzanine investment, most often in the form of warrants.
The warrant position that accompanies the subordinated debt is known as the “equity kicker” and is structured to provide another 10 to 12 percent of IRR to the investor. Unlike the debt component, this portion of the total return to investors does not come in the form of periodic payments of interest, but through the projected increase in the equity value of a company. The company is valued at the inception of the transaction and the warrants carry a price based upon this initial valuation. It is important to note that the intent of the equity kicker is to enable the mezzanine investor to achieve its targeted return on the investment, not to take an ownership position in the company. The equity-related portion of the total return on the investment is realized by the investor selling the warrants upon an “exit event” or “put back” to the company at some agreed upon date based upon a formula established at the initial closing of the deal. Some typical exit events are a sale or change in control of the company or a recapitalization.
A mezzanine investment is typically made in a company that is facing some sort of growth opportunity, e.g., the acquisition of another company, the acquisition of the company itself by new management, the establishment of a new product line or distribution channel or merely internal growth. This growth opportunity is expected to create top line revenue growth, bottom line growth in earnings, and most importantly, increased cash flow; which ultimately, increases the value of the company. The resulting increase in equity value translates into an increase in value of the warrants. Mezzanine capital is most commonly used in situations where the equity component of a company’s capital structure is insufficient to satisfy senior lenders. Senior lenders seek to have a sufficient amount of capital subordinate to them, normally in the form of equity or mezzanine, to shield them from loss of any of the capital they lend to a company. Senior lenders, typically banks and finance companies, are generally indifferent to the form of the subordinate capital below them in the capital structure, provided it will be there beyond the term of their loan, not place undue demands on the cash flow of the company, and not possess rights greater than theirs.
This lender indifference makes mezzanine finance attractive to companies since the all-in cost of mezzanine is considerably lower than the 35 to 45 percent required by equity investors, causing mezzanine to look like “cheap equity” to a company, thus a cost effective alternative. Furthermore, mezzanine finance, since it is primarily debt with only enough warrants to enhance the overall yield to an acceptable level, is less dilutive, requiring the owners to give up less of the company than an equivalent amount of pure equity would require. The primary measure utilized by investors and lenders in all levels of a company’s capital structure to both determine the value of the company and the amount they are willing to invest/lend is cash flow analysis. Cash flow is normally measured on the basis of earnings before interest, taxes, depreciation and amortization, or EBITDA. Generally, various multiples are applied to a company’s EBITDA to determine the enterprise value of the company (normally ranging from 4x to 6x) and how much senior debt a bank will lend to the company (normally 2.0x to 2.5x, depending upon the company’s underlying asset coverage). In today’s investment environment, the average company is being valued at an EBITDA multiple of 4.0x to 5.0x. With the banks lending at 2.0x EBITDA (sometimes a bit more, provided there is strong collateral coverage) and sub debt lenders generally providing another 1.0x to 1.5x turns in EBITDA, companies are now required to have the equivalent of 1.0x to 1.5x EBITDA in private equity.
As the economy, a company’s industry, and the performance of the company ebbs and flows, the current market-level multiples for that company may vary. A stronger overall situation commands higher multiples, while lower multiples prevail in down or uncertain times as we are now experiencing. Prior to 2001, as banks were pushed by competitive pressures to lend at higher multiples of EBITDA, they were effectively becoming mezzanine investors by assuming higher levels of risk while receiving little or no additional yield for that risk. Two years ago, deals were routinely done at valuation multiples of as much as 6x (sometimes even higher), with banks lending 3.5x or more, much of it done without asset coverage, i.e. “air ball” financing. Thus with senior lenders providing an additional l.0x to 1.5x of “air ball” financing together with mezzanine lenders providing another l.0x to 1.5x in funding, it was common to see minimal equity levels of 1x EBITDA or less. Those transactions resulted in the high volume of highly leveraged transactions, HLTs, presently in bank portfolios. Many of those HLTs are now seeking additional equity and/or mezzanine finance to strengthen their overall capital structure, often at the insistence of their banks.
Whether used in conjunction with a management buyout, overall recapitalization or as a stand alone transaction, mezzanine finance serves a vital purpose in crafting the capital structure of a company. It is the least expensive form of junior capital, normally the least intrusive into the management of a company, and is the least dilutive. With banks lending fewer dollars to companies on an EBITDA multiple basis and purchase/valuation multiples having declined under the current economic conditions, the demand for mezzanine has increased significantly. While the current-pay requirement of the debt component of mezzanine finance makes it unattractive to and generally unattainable for early stage companies, it is an achievable and attractive alternative to equity for latter stage companies with positive cash flow.