The economic outlook for 2008 remains suspect as the tumultuous conditions afflicting the financial markets have created a turbulent business climate for middle market companies that is likely to continue unabated well into 2009. Commercial banks and Investment banks recently the paragon of the financial services industry have become pariahs in less than a year.
Adversity, however, creates opportunity and indeed many companies have been successful in obtaining financing amid the melt down of the credit markets. Middle market companies looking to grow and needing capital to do so need not panic as banks pull back on financing and credit tightens. Money is still available for companies with solid business prospects - you just need to know where to find it and how to get it.
Mezzanine finance can play an important role in funding the growth of privately owned "middle market" companies in good times and bad. This type of debt financing, however, isn't really understood by many outside of the industry.
Often called subordinated debt, mezzanine debt is often viewed as quasi equity. As such it is a hybrid of debt and equity financing that is often used to finance acquisitions, product development, plant expansion and new equipment purchases. Company owners also use it to diversify or invest in other opportunities.
Lenders that provide mezzanine financing, for the most part, lend based upon a company's cash flow rather than a business' assets. Since there is little or no collateral to support the borrowing, this type of financing is priced significantly higher than secured bank debt. Mezzanine financing is advantageous because it is treated like equity on a company's balance sheet and may make it easier to obtain standard bank financing. It is also very attractive to a business owner as it reduces the amount of equity dilution, which increases the equity's expected return.
Mezzanine financing has many of the debt features associated with traditional term debt including interest payments, covenants, and in some cases amortization. But it also has an upside in the form of an equity interest. Mezzanine debt is typically secured by the equity of the company rather than its tangible assets and is subordinated to the debt provided by banks and commercial finance companies.
Mezzanine debt is more expensive than secured debt or senior debt because of the increased credit risk assumed by the subordinated lender. The debt holders receive a higher interest rate than senior debt as well as a quasi-equity stake in the company to compensate for the increased risk. It is a much less expensive source of capital than equity financing; perhaps more important, existing equity holders are subject to significantly less dilution.
On a balance sheet mezzanine debt is found between the senior debt and equity. It is subordinate in priority of payment to senior debt, but senior in preference to common stock if a company is liquidated. It can take the form of convertible debt, senior subordinated debt or debt with warrants.
In the middle market, mezzanine lenders look for a fixed current coupon rate of 11% to 15%, which equates to a spread of 5% to 9% above the prime rate, plus the additional return from the equity stake in the company. This compares to a rate of 1% to 4% above the prime rate for term loans from senior debt lenders.
While most equity investors look for returns of between 30 to 45 percent, mezzanine investors look for annual returns of between 20 and 30 percent. Lenders tend to be flexible in tailoring the structure of the investment to meet the borrower's operating and cash flow needs, which makes mezzanine debt a useful form of financing.
Most mezzanine loans last from five to seven years with the possibility of early repayment. Unlike bank debt, which usually requires amortization, mezzanine repayments are often not required until maturity. This allows a business owner to reinvest cash flow in growth opportunities rather than paying back senior debt.
Because their return is largely driven by their equity upside, mezzanine lenders are more accommodating during difficult business conditions. While a business owner may lose some independence, he rarely loses outright control of the company or its direction. Owners don't usually encounter much interference from a mezzanine lender as long as the company continues to grow and prosper. Amounts raised through mezzanine financing can be substantial. A company can leverage its cash flow and obtain senior debt between 2 and 3.5 times cash flow. With mezzanine debt, it can raise total debt to 4 to 5 times cash flow depending on the risk appetite in the debt markets.
Mezzanine lenders are usually paid off through a recapitalization of the business with less expensive senior debt or through the accumulated profits generated by the growth of the business. For years, mezzanine debt has proven to be a viable source of growth capital to finance privately owned "middle market" companies whether the economy is going full bore as well as when it is in the tank.