In architecture, a mezzanine floor is an intermediate level that bridges the gap between two separate floors. That same sense holds for mezzanine financing, which enables companies to reach levels of capital raising that might not otherwise have seemed possible.
DealRoom regularly helps its clients prepare for an efficient process of raising capital, allowing us to look at mezzanine financing in detail and take you through everything from how it works to when you should look for it.
Mezzanine financing is a hybrid form of financing, which combines features of debt and equity. Because of its hybrid form, mezzanine financing is sometimes considered a middle ground between debt and equity, enabling the company to benefit from both, and in doing so, raise higher levels of capital.
One of the principal drawbacks of mezzanine financing - discussed in more detail below - is that it involves a higher level of risk than traditional debt financing.
Mezzanine financing is a creative means of raising capital for companies which have maximized their capacity for senior debt, a point usually considered to be at around 80% of a company’s capital structure, but still want to pursue growth opportunities that require large amounts of capital such as acquisitions.
In these scenarios, mezzanine debt is often preferred to equity financing.
As you might have guessed, the hybrid nature of mezzanine financing means it contains elements of the risk and return inherent in both debt and equity financing. It is higher risk than debt financing, but also promises higher returns.
On the other hand, it is lower risk than equity financing, but similarly promises lower returns. In terms of priority of repayment, mezzanine financing ranks behind senior debt (which it why it sometimes termed ‘subordinated debt’) but before equity capital (i.e. repaying stockholders).
Usually but but not always, the mezzanine financing has warrants embedded, which state that if the company cannot repay its debt, the lender can convert the outstanding debt into an equity stake in the company - sometimes referred to as the ‘equity kicker’.
As mentioned at the outset, the equity component of mezzanine financing gives it a higher risk profile than senior debt, with mezzanine financing annual interest typically coming in at close to 20%.
This higher risk component means that mezzanine debt rarely constitutes more than 15-20% of a company’s capital structure.
Mezzanine financing provides companies with a more aggressive means of achieving growth than senior debt allows. Mezzanine financing is usually unsecured, with a longer dated maturity than traditional senior debt, and is interest only.
This combination of characteristics makes it an attractive form of financing for companies which are making relatively low risk investments in large capital projects (for example, a highly undervalued acquisition that promises to generate huge value).
The origin of the word Mezzanine is the original Italian word for medium, mezzanino - itself coming from the latin word, mediano (which gave us the economic term, median).
The sense for mezzanine financing is that it’s a middle ground between debt and equity. A point some way between the two forms of traditional financing. Mezzanine financing is thought to be a relatively new form of financing, with origins in the 1980s.
In the opening description of mezzanine financing, we noted that it is a ‘creative’ form of capital raising. This creativity is reflected in the different forms that mezzanine financing takes. These forms include, but are not limited to:
When mezzanine finance combines with senior debt and equity capital, it can optimize a company’s capital structure, minimize its cost of capital, and generate significant growth. The structures employed by mezzanine finance borrowers depend primarily on the objective of the transaction, the existing capital structure in place, and expected cash flows (in-flows from the project, and out-flows from the interest payments).
On the other side of the equation, the mezzanine lenders look at the benefits they’ll receive from providing the funds, look for a target rate of return that can be earned through a combination of current and deferred payments.
With some negotiation, the two sides arrive at a structure that works for both. These structures typically look like some of the following:
A key advantage over other instruments is that mezzanine financing allows many variations of the transaction structure. This allows to use mezzanine in virtually all types of transactions.
The numerous structures of mezzanine financing make it a versatile financing option for several corporate finance operations. Perhaps the one caveat is that the higher risk inherent in borrowing mezzanine financing means that returns have to be commensurate.
The list of transactions that companies can use mezzanine financing for, includes:
Mezzanine financing provides a viable solution to companies that want to acquire a target business, but require a large amount of debt to do so (a common occurrence in the case where the target company’s stockholders have no interest in obtaining the buyer’s stock). In this case, the buyer would turn to a mezzanine finance provider who could provide mezzanine debt, facilitating the transaction.
Recapitalizations involve changing the capital structure of a company - shifting the debt to equity balance. In certain scenarios, stockholders may want liquidity but not a full sale of their business. In these cases, private equity firms may opt to give them a mezzanine financing solution that provides an optimal combination of liquidity and retained ownership.
A refinancing could be used by a company for extra liquidity required for various business operations (working capital, for example) or simply to pay off existing debt with higher interest.
Following the same logic as using mezzanine financing for an acquisition, LBOs frequently use mezzanine financing to maximize their leverage before making the acquisition attempt. This is equally true of Management Buyouts (MBOs), where the goal is to maximize borrowing capacity, and mezzanine financing can facilitate that.
In certain situations, a majority shareholder will seek to obtain further (or full) control over the company stock by buying out other stockholders. The buyer may choose mezzanine financing as a means of achieving this, bringing enough liquidity to the business to buy out the other shareholder’s interests in the company.
When considering how mezzanine financing compares to other types of capital, it’s useful to consider a few different factors, specifically cost of capital (which is directly related to investors’ growth expectations), and liquidity.
The following chart provides an easy-to-understand overview of the differences between each form of capital:
Any company or investor seeking liquidity for a well-defined strategic purpose may do well to consider mezzanine financing. The high interest payments mean that there has to be a solid motive (and business plan) behind the bid to obtain the financing. Without it, a company which already lacks liquidity may find itself in an even worse position.
Those seeking mezzanine financing typically fall into one of a few categories:
Sensing its opportunity to capitalize on diminished credit access for lower-rated transactions, Goldman Sachs in September announced that it was raising a $15 billion mezzanine finance fund, which it would use to gain access to attractive private credit opportunities brought about by the combination of rising interest rates, inflation, and oil prices.
The thinking is that these companies, unable to access the credit lines that had fueled their growth until now, will now turn to Goldman Sachs to access mezzanine finance at a higher rate of interest, thereby pushing up Goldman Sachs’ own return on investment.
A frequently asked question is: Do banks provide mezzanine financing?
Yes and no. Usually, banks - specifically investment banks - only provide mezzanine financing to large corporate clients with annual revenues running into the hundreds of millions.
At the lower end, in the middle and lower middle markets, mezzanine financing can be provided by special private debt providers, private equity companies, or even funds looking to diversify their cash flows.
What should you expect when you’re raising mezzanine financing?
Any company looking to raise mezzanine financing should expect something similar to the standard debt raising process, with the caveats that mezzanine financing tend to take longer, and anecdotally at least, there are far less participants willing to offer it as an alternative.
That being said, the mezzanine financing process will include the following steps:
Whoever is providing the plan will want to see evidence that the debt will be repaid. Whatever the purpose of the debt - an M&A transaction, a recapitalization, etc. - it’s better to be armed with a business plan.
As with all capital raising transactions, the attractiveness of your business will determine to a great extent which partners are open to working with you. If you’re business isn’t particularly attractive, the selection process may be a short one.
As mentioned, the terms can be stringent. In the current market (where Goldman Sachs has entered), we can be sure that the terms are beginning to favor lenders at the expense of borrowers. To learn more about term sheet negotiation, check out How Atlassian Negotiates a Term Sheet
This can be one of the most challenging and time consuming parts of mezzanine financing. The list of documents demands extensive due diligence on behalf of the borrower and by extension, a good data room tool.
Documents may include:
The complexity of mezzanine financing means the right partnerships can add significant value to the process. In particular, these include:
There are estimated to be over 1,000 mezzanine finance lenders in the United States, so there is scope for a wide range of different terms for a company’s mezzanine finance requirements.
In reality, once industry specializations and company size restrictions are removed, there may be be only a relatively small fraction of these mezzanine finance providers which are still relevant. Suppose the number of applicable providers is 200. Assuming there’s good demand to provide a company with mezzanine finance, how should its executives decide on a suitable lender?
Mezzanine finance is a creative alternative for companies which already have significant levels of senior debt on their balance sheet to raise capital.
It also tends to be a far more complex method of raising capital than more regular methods. Prepare well, bring in partners, and use technology to reduce the complexity and diminish the learning curve.
Talk to DealRoom today about how our project management tool for capital raising can assist your company in this endeavour.