Understanding the basics and functions of mezzanine debt can be helpful when a business owner is considering making a major investment, buying out a partner, or planning for the transfer of a family business to the next generation. Mezzanine debt, a combination of typical bank debt and equity, is also known as subordinated debt.
What is Mezzanine?
Mezzanine debt earns an interest rate, can be secured by the assets of the company (generally on a second lien basis) and has a loan agreement that looks similar to that of bank debt. Mezzanine debt has minimal or no scheduled principal payments until the due date (bullet maturity, usually 5 years) and, in some cases, has equity participation via warrants or an equity co-investment.
The Uses of Mezzanine
As the name suggests, mezzanine capital fills the gap or is the “bridge” between a senior bank loan (usually based on collateral availability) and the available equity to fund the total “price” for a transaction. Mezzanine capital is commonly used to finance acquisitions or ownership transitions, but it can also be used to support organic growth opportunities or pay dividends to shareholders.
The amount of mezzanine available for each deal is more of an art than a science. To determine the maximum debt capacity of a company, issuers and investors will consider a ratio of Total Funded Debt to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of up to 4.0x as a reasonable starting point. But, one must not look at this ratio in a vacuum. The industry, amount of recurring capital expenditures for a business, and most importantly, the strength of a management team, all play an important role in determining the amount of mezzanine which could be available for a transaction.
Mezzanine providers usually expect a percent return per investment from 14% to 18% or more depending on the risk profile and size of the transaction.
The typical current interest rate – or pay rate – can range from 12% to 14%, plus a 1% to 5% Payment-In-Kind (“PIK”) rate that accrues but does not have to be paid in cash. Equity participation, via a warrant or a direct equity co-investment, allows the mezzanine provider to share in the equity or “value creation” within the business. The amount of the equity participation is dependent on the projections and subjective assessment by the mezzanine provider.