Filling a Financing Shortfall With Mezzanine Capital: Mezzanine lenders have capital available for private-company acquirers that have tapped their banks to the max.

Mezzanine lenders have plenty of cash on hand for private companies. The capital they offer a hybrid of debt and equity is especially useful to a company whose bank borrowings have exceeded its bank’s comfort zone yet the firm still has sufficient cash flow to service more debt. This article explains how these transactions work. Suppose you run a company that needs $3 million to acquire another company, expand your plant, generate working capital, or retire some outstanding shares. Your bank is willing to put up $2 million but it balks at lending the rest because you lack sufficient collateral. Where can you round up the needed funds? From mezzanine lenders, who base their loans on a company’s ability to generate cash flow, not on its existing asset base. These lenders fill the financing gap with unsecured loans starting as low as $500,000 and going as high as $20 million. In return for their increased risks, they get both interest on the loan and an equity kicker, typically in the form of warrants to buy common stock. In recent years, mezzanine lenders have raised a significant amount of capital from financial investors indeed there aren’t enough deals to go around. Independent mezzanine funds, formed strictly to make these loans, have some $6 billion available for investment. On top of that, many insurance companies, large banks, and commercial finance companies have mezzanine funds of their own. Despite its recent proliferation, mezzanine debt is frequently a misunderstood term in corporate finance. In part that is because subordinated debt comes in all shapes and sizes and some people tend to put all subordinated securities in a capital structure under the mezzanine umbrella. The structure of the deal is limited only by the people involved. Nonetheless, these points are clear in defining the parameters of mezzanine finance: * It is an unsecured loan, and junior to the capital of secured creditors in the event of bankruptcy. * The payback on the loan typically starts in the fifth to sixth year, with final payment due in the eighth to tenth year. * Mezzanine lenders today both will invest in subordinated debt and take a minority equity position in the borrowing company. * The borrower must pay interest and use stock warrants or another mechanism to give the lender a stake in the company’s upside potential. When the lender exercises the warrants, the borrower is required to buy back the stock and cash the lender out of the deal. Coming to Terms Generally, mezzanine lenders are more flexible than banks in setting the terms of a loan and its current interest rate. Unlike banks, which want a fast return of the principal, mezzanine lenders focus on the deal’s overall yield. From a bank’s perspective, in fact, this subordinated unsecured debt looks like equity, and most senior lenders consider a company to have strengthened its balance sheet by adding capital that is junior to their loans. On the flip side, a subordinated lender will expect to be considered an equity partner. That means it may take a seat with full voting rights on your board of directors. The mezzanine lender’s involvement in the oversight role varies greatly, of course, and any financier will get more involved when a company is faltering than when it’s successful. But it also may benefit your company to have an outside director with sophisticated financial skills. Mezzanine loans are, to be sure, more expensive than bank debt, given the longer maturity period and unsecured nature of the financing. Today, the current interest rate on mezzanine debt ranges from 10% to 12%. The equity kicker, such as warrants, brings the total cost to 18% to 22%, depending on the size of the loan and its inherent risk. Remember, however, that everything in financing is relative; bank debt is your cheapest source of capital, but mezzanine capital is still cheaper than straight equity investment because of the high returns required by private equity providers. Like any investor or lender supplying a big chunk of capital, a mezzanine lender also will attach some restrictions to the deal. For example, you may need the lender’s approval to take on additional debt especially if it’s senior to the mezzanine tranche make acquisitions, change the management team, issue new stock, or pay out dividends. Given the recent trend of roll-ups, most mezzanine investors are supportive of borrowers that acquire other businesses under the following general guidelines: * The borrower is performing according to its forecast, or close to it; * The borrower has previously discussed its acquisition strategy with its mezzanine investor; * The target is in a similar business and provides some synergies; * The combined senior and mezzanine debt levels can be supported by the combined company’s profits on a pro forma basis; and * The target is profitable. What are the criteria for supporting the debt levels on a pro forma basis? For example, if a mezzanine investor has a leverage covenant of 4:1 for all acquisitions, that allows the borrower to buy another company as long as the total debt-to-EBIT-DA (earnings before interest, taxes, depreciation, and amortization) ratio on a pro forma basis is less than 4:1. Sometimes a mezzanine investor might not approve an acquisition even if the target company meets the criteria noted above. Some reasons for a possible rejection include: * The target is not as profitable as the borrower; * The target has more business risk than the borrower, e.g., a high degree of customer concentration or a highly cyclical market; or * Target management may not be as capable as the borrower’s or intends to resign, thus leaving the acquirer with a management team that is stretched too thin. When a deal makes the grade with mezzanine backing it can be quite rewarding. Take the case of Superior Candy Co., a 45-year-old candy manufacturer that wanted to acquire a competitor of the same size, Great Candy Co. Great Candy agreed to sell to Superior for $12 million. Superior was highly leveraged but had a good relationship with its senior lender. However, on a combined basis, Superior would not have had the collateral base to support an additional $12 million in debt. Superior considered raising money by selling common stock to several equity funds, but the owners would have incurred significant dilution to their ownership positions. Superior ultimately acquired Great Candy, financing the deal by borrowing $3 million of subordinated debt from a mezzanine fund, which also bought $1.3 million in redeemable preferred stock, and obtaining $7.7. million from its senior lender. The owners of Superior invested no new cash in the acquisition, diversified the company’s customer base, doubled the revenues of its existing business, added a well-known product line, and gave the mezzanine investor warrants for less than 20% of the combined business. Bear in mind, however, that raising more debt means that you will have to deal with another creditor trying to protect its capital. Consequently, you may have to negotiate some difficult issues among your company, the unsecured lender, and the bank. Some trouble spots include: Size of the Warrant Position and Exercise Price Generally the size of a lender’s warrant position is inversely related to the interest rate. The higher the interest rate, the fewer the warrants a subordinated lender will require. For the most part, mezzanine lenders end up with warrants representing a 5% to 20% interest in the borrower. The warrant price will be either a pre-set multiple of operating income or an amount that might be paid for a peer public company in a similar business. Life of the Warrants Another sticking point: how long the warrants last. You probably will want the lender to exercise its warrants five to 10 years down the road, thus delaying your obligation to buy back the stock. The lender will want the option of exercising the warrants as soon as possible, so it can cash out fairly quickly. One solution is to agree to an early exercise date but spread the payments over three years in case you will lack enough cash to pay for a one-shot repurchase. Going-Public Potential The lender will want the right to register the warrants and sell the underlying shares should the borrowing company go public. Covenants and Inter-Creditor Issues The lender will attach a variety of covenants to your loan that spell out the conditions and financial ratios you must meet to prevent a default. Some are strictly between the borrower and lender but others involve negotiations between creditors. For example, the company, to protect its best interests, will negotiate directly with the mezzanine lender on issues such as its cash flow level and its debt-to-cash-flow ratio, i.e., the relationship of interest-bearing debt to earnings before interest, taxes, depreciation, and amortization (EBIT-DA). But senior and subordinated lenders will negotiate separately to hammer out such issues as their relative collateral positions and to define their respective remedies in the event of a default. If your company’s debt-servicing capacity exceeds a bank’s comfort zone, a mezzanine loan might help you avoid a more costly equity investment. Rounding Up The FundsIf your company’s borrowing capacity exceeds your bank’s comfort zone, a mezzanine loan can help you finance a deal while avoiding a morecostly equity investment. Mezzanine loans aren’tcheap, but they offer many advantages toacquiring companies that need extra capital tofund deals. Some of the benefits are better cash flow, due to lengthening the maturity of debt repayment, and an improved balance sheet, due to reduced leverage. On the flip side, mezzanine is more expensive than senior debt, and company ownersmust give up some equity to the lender. Careful weighing of the pros and cons of a mezzanineloan will help you decide whether this type offinancing makes sense in your deal. Weighing the Mezzanine DealPros Improves cash flow by lengthening the maturity of debt repayment Helps improve the balance sheet by reducing leverage, because senior lenders may consider subordinated debt quasi-equity A professional investor on the board helps build long-term cash flow and company valueAn outside director adds a fresh perspective to strategic planningMezzanine debt is cheaper and less dilutive to ownership than an equity investment cont’d Cons The company owner(s) must give up some equity to an outside group The owner(s) may have to reduce their compensation to the same level as a non-owner manager with similar duties Dividend payments may be reduced Mezzanine is more expensive than senior debt Mezzanine is not a permanent source of capital, since most institutional lenders require liquidity within nine to 10 years<\TBL>