Through conversations with owners, investment bankers and business brokers, we often get asked about lending and financing solutions.
Typically, these conversations always focus around traditional banks and their lending programs. However, we are big proponents of mezzanine debt financing solutions.
While mezzanine debt comes with a meaningfully higher cost of capital, it provides significantly more flexibility to the business owner and often comes with a lending team focused on supporting business growth rather than debt paydown.
This article will discuss how mezzanine debt compares to traditional bank financing, cost of capital, and other benefits of working with a mezzanine financing company.
How Does Mezzanine Debt Compare with Traditional Bank Financing?
First and foremost, it is important to understand why traditional banks are typically called “senior” lenders and mezzanine financing companies are called “junior” lenders.
Senior means that a bank or creditor is taking the highest position in the capital structure, typically accompanied by a first lien on all assets. In the event of a bankruptcy or other bad scenario, banks get paid back first.
Junior means that a lender or creditor is taking a subordinated position to another lender or does not require a formal first lien on assets, providing more flexibility for the business.
Traditional bank lenders are focused on several key qualifications when making lending decisions:
- Value of physical fixed assets, inventory, and accounts receivable owned by a company
- Ability to pay back debt on a traditional amortization schedule
- Potentially personal guarantees backing the financing
- A more robust set of financial covenants
For many businesses that are “asset light”, there is a lack of collateral to support a loan. Beyond that, many traditional senior lenders do not offer cash flow loans to smaller companies. Cash flow loans are another way of saying that the bank lender only focuses on the company’s profit in making a credit decision rather than relying on asset collateral.
In situations where traditional bank debt may be more difficult to find or a company seeks more operational flexibility, mezzanine lenders can fill the void. Mezzanine lenders offer the following in comparison to traditional bank financing:
- Less focused on collateral and more focused on understanding the underlying business and its growth potential
- Charge a higher interest rate but do not expect much, if any, amortization payments during the term of the loan (more to come on this point)
- Are not as likely, if at all, to require personal guarantees and rely solely on the business to pay for the debt
How Does This Translate to Cost of Capital Differences?
As the saying goes, “there is no such thing as a free lunch.” In exchange for more flexibility, no amortization, and less overall collateral / guarantees, mezzanine lenders do charge higher interest rates.
Typical bank lenders price debt based on LIBOR or some other standard rate plus a spread. Depending on where LIBOR sits, interest rates on bank debt would be expected in the 4% to 6% range in the current market.
Over the past decade, this has been a bit lower in the 3% to 5% range, but interest rates have moved up in recent months.
Mezzanine lenders, on the other hand, generally charge a fixed interest rate in the 10% to 14% range.
We have had many conversations with owners concerned about what is perceived as a much higher interest rate. However, there is a big difference in amortization and cash out the door to service debt on an annual basis.
We consistently use mezzanine debt in all of our deals because of the flexibility. We are keenly aware that we can find lower interest rates but the flexibility and actual benefit to our annual cash flow outweighs the meaningfully different interest cost in our opinion.
Why is Mezzanine Debt More Flexible?
Cash flow “arbitrage” is the biggest benefit of using mezzanine debt versus traditional bank debt. When looking at how much a company “pays” in any given year to service its debt, you have to combine both interest payments and principal amortization.
In the case of a bank loan, we typically see loans amortize over a 5 or 7 year period. For simplicity, let’s look at a $5 million loan amortizing for 5 years with an interest rate of 5%.
In year 1, the company would owe $250,000 of interest expense and principal amortization of $1 million for a total debt payment of $1,250,000.
For the same $5M mezzanine loan at an interest rate of 12% and no amortization, the company would have to pay $600,000 in interest expense.
As you can see, the company is able to keep $650,000 of cash in the business to invest in growth, hire new employees, buy new equipment, possibly do an acquisition, make investor distributions, etc.
This “arbitrage” of cash going out the door allows the business more flexibility. Alternatively, if the company decides it doesn’t have a use for the extra cash, it can make a payment to pay down the mezzanine loan.
In scenarios where we are buying a business to help it grow, we are big believers in conserving the extra cash to make investments in the business.
Our goal is to help companies double or triple revenue. We can earn a lot more value by investing in growth than we can save in getting a lower interest rate but having to pay down the loan principal.
With that said, the mezzanine loan will come due at some point, typically 5 or 6 years after the original date, so a company must prepare to pay it off or refinance it at some point in the future.
Nonetheless, the initial cash savings provides more flexibility to the company in a growth scenario.
What Are the Other Benefits of Mezzanine Debt?
We mentioned previously that traditional bank lenders typically have more extensive and stringent financial covenant requirements.
Mezzanine lenders are typically less stringent and do not require as many financial covenants. This also maps to the overall philosophy shared by many mezzanine lenders – a focus on growth and value creation versus debt paydown.
Given that typical mezzanine debt isn’t paid off for several years, the lending team is more focused on long-term growth. Additionally, many mezzanine lenders have the ability to also invest in equity ownership, meaning they have real benefit in seeing a company grow and increase its value.
This typically means the lending team will have a seat on the board or be a board observer, wants to provide strategic advice, and acts in many ways similar to a partner in trying to push the growth of the company.
While most owners have “sticker shock” at the interest cost of mezzanine debt, we believe the benefits can far outweigh the costs especially for a company that is focused on growth.
For some businesses looking to remain in a steady state, there may be other considerations, and we understand that. Our goal is to provide context on the potential benefits so as to look beyond the “sticker shock”.
We have many relationships with mezzanine debt financing firms and would be happy to answer any questions or make any introductions for owners considering this type of financing to support their next stage of growth.
Please reach out to Josh Welk (firstname.lastname@example.org) with any questions or comments.