What Is Mezzanine Debt?
What Is Mezzanine Financing, and When Should A Middle Market Business Use It?
Most middle-market business owners are familiar with the two primary forms of capital —debt and equity. You raise equity from investors and you borrow debt from lenders. Eventually, you can sell all or a piece of your company’s equity to a single buyer or a group of buyers.
What many owners don't readily comprehend is that there is a myriad of other debt and equity options available in the U.S. private capital marketplace. There are also hybrid options that can combine debt and equity. One of the most common alternatives is a layer of debt that sits between bank debt (aka Senior debt) and the company’s equity. The additional layer sitting between those two is commonly called Mezzanine Debt or Mezz Debt. Mezzanine debt is junior capital that can dramatically expand your access to capital without forcing you to give up meaningful ownership. Most importantly, the mezzanine debt market is robust and active and largely unique to the U.S. capital markets. Business owners should investigate the pros and cons of mezzanine debt when considering their capital structure options.
History of Mezzanine Debt
Looking back to the 1970’s, commercial banks dominated the commercial credit markets in the U.S. The era of non-bank finance or Private Credit had not begun and most companies received financing from a traditional bank.
Another key factor present at the time was the reality that most of the U.S. economy in the 1970’s was still driven by manufacturers and industrial companies. The rise of the service sector in the 1980’s and beyond has had massive implications of the commercial finance industry.
Service sector companies including software companies and business services firms have healthy profit margins and substantial enterprise value. However, they do not have fixed assets, big factories and large warehouses of inventory. Some of them don’t even have accounts receivable. Therefore, to lenders, there isn’t a lot of collateral and no verifiable secondary source of repayment for loans.
So how does a company borrow money for growth if it has no collateral to leverage? If there are no fixed assets to pledge as collateral, how does a company borrow money to buy out a partner or a family member? Is the only answer that the company has to sell part of its equity and dilute its ownership?
Enter the innovative genius of the U.S. capital markets to solve these dilemmas. Several new products were created. One of the most effective products was a new type of debt that was structurally subordinate to the Senior lender but still secured by the assets of the company and therefore ahead of the equity holders in the priority or waterfall. This was the dawn of the Mezzanine Debt era in the 1980’s and early 1990’s. The Mezzanine Debt industry has since grown to be one of the largest and most prolific asset classes in the U.S. private credit market.
Centered primarily in Chicago and New York, but branching out to Los Angeles, San Francisco, Boston and other cities, the Mezzanine Debt market continued to grow and expand throughout the 1990’s, 2000’s, 2010’s and is still growing today at approximately $250 billion. Mezzanine debt has become a reliable source of capital for companies and a reliable investment class for institutional investors.
Here is how Mezzanine Debt works, and when it makes sense for a middle market company
Where Mezzanine Resides In The Capital Stack Of A Company
To understand Mezzanine financing, you first need to understand the capital stack. Think of your company's financing as a building. The foundation or the safest, most secure layer is senior secured debt. This is your traditional bank loan or direct lending facility. It gets paid first if something goes wrong. Because it carries the least risk, it also carries the lowest interest rate.
At the top of the building is equity, the ownership stake. Equity investors take the most risk because they get paid last. In return, they expect the highest return.
Mezzanine financing sits in the middle. It is subordinated debt, meaning it gets paid after senior lenders but before equity holders in a liquidation. Because it takes more risk than senior debt, it carries a higher interest rate, typically in the 11% to 14% range. In many cases, it also includes a warrant or equity kicker, a small ownership component that gives the mezz lender upside participation.
What Mezzanine Debt Looks Like In A Middle Market Deal
Here is a concrete example. A business has $5.0M in EBITDA. A senior lender might get comfortable at 2.0x - 3.0x leverage, giving you somewhere between $10.0M and $15.0M in senior debt. But you need up to $20.0M to complete a recapitalization, make a strategic acquisition or buy out a family member.
That funding gap of $5.0M to $10.0M is where mezzanine comes in. A mezz lender steps in behind the senior lender and provides the remaining capital at a higher rate. You now have your full $22.0M without selling additional equity to get there.
The math matters here. If your business is worth $30.0M and you fund that gap with mezz debt instead of equity, you have preserved ownership that could be worth millions at exit. There is definitely a higher cost of capital associated with Mezzanine Debt. However, that higher cost of capital in the form of 11%-13% interest rate and possibly a minimal amount of equity warrants should be compared against the cost of equity, not the cost of bank debt. For a growing business, to make an attractive acquisition or to avoid disruption from bringing in new equity investors, paying the cost of Mezzanine Debt is almost always cheaper than giving up equity at a low valuation.
When Mezzanine Financing Makes Sense
Mezzanine Debt is not the right tool for every situation, but it is nearly always worth considering as an option. Mezz Debt is most commonly used in four scenarios in the middle market:
· Acquisitions, when a buyer needs more capital than senior debt alone, will provide the necessary capital to close a deal.
· Dividend Recapitalizations, when a founder wants to take chips off the table without selling a controlling stake.
· Growth capital when a business needs capital to expand and does not want to dilute existing ownership.
· Management buyouts when a management team is buying out an owner and needs to bridge the gap between senior debt and their own equity contribution.
If your business has stable, predictable cash flow and the ability to service a higher cost of capital, mezzanine is worth understanding as a tool in your financing arsenal.
What this means if you are preparing for a transaction
If you are contemplating a capital raise, an acquisition, or a recapitalization in the near future, understanding where mezzanine debt fits in your capital structure could meaningfully change your outcome. Mezzanine lenders are in business to help middle market businesses grow and achieve their goals. It is absolutely free to start building relationships today with Mezz lenders and explore possibilities and brainstorm your growth ideas and future plans.
Sometimes business owners do not explore the Mezzanine market because they assume that it is too expensive or they fear that the lenders might have sharp elbows or even could be predatory. In fact, the opposite is true. Mezzanine lenders are inherently relationship-oriented, the market is highly competitive and Mezz lenders are usually quite cooperative in distressed situations. Mezz lenders are structurally incented to work with both Senior lender and ownership during a downside scenario with a company. Mezz lenders have tremendous reputation risk given the large amount of competition and financing alternatives. They simply can’t be anything but courteous and professional if they expect to compete and survive long-term.
"Mezzanine financing is often a misunderstood tool in the middle market. Used correctly, it lets business owners access the capital they need to grow without giving up the equity they have spent years building. And Mezzanine Lenders tend to be some of the most cooperative and professional lenders in the Middle Market."
Phil Kain, CFA, is the Managing Partner of Rush Street Capital, a boutique middle market investment bank headquartered in Chicago, IL, and Phoenix, AZ.
Rush Street Capital advises middle market companies on M&A, debt and equity capital raises, special situations, and valuations. Rush Street Capital has completed 100+ transactions across a range of industries. If you are preparing for a capital raise or sale process and want to understand how mezzanine or other debt structures could work for your business, connect with our team.
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