Cash Flow From Assets Is Also Known As The Firm Mezzanine Finance – Viable Financing During Tough Times

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Mezzanine Finance – Viable Financing During Tough Times

The economic outlook for 2008 remains uncertain, as the turbulent conditions affecting financial markets have created a turbulent business climate for middle-market companies, which is likely to continue unabated in 2009. Commercial and investment banks have recently become industry leaders. financial services pariah in less than a year.

Adversity creates opportunity, however, and many companies have actually been successful in obtaining financing during the collapse of the credit markets. Mid-market companies looking to grow and need capital to do so need not panic as banks withdraw funding and credit tightens. Money is still available for companies with good business prospects – you just have to know where to find it and how to get it.

Bridge financing can play an important role in financing the growth of private “middle market” companies in good times and bad. However, this type of debt financing is not understood by many outside the industry.

Mezzanine debt, often referred to as subordinated debt, is often considered virtual equity. As such, it is a hybrid of debt and equity financing that is often used to finance acquisitions, product development, plant expansions, and new equipment purchases. Business owners also use it to diversify or invest in other opportunities.

Lenders who provide mezzanine financing generally lend based on the company’s cash flow rather than the company’s assets. Since there is little or no collateral for the loan, the price of this type of financing is significantly higher than secured bank debt. Bridging financing is advantageous because it is treated as equity on the company’s balance sheet and can make it easier to obtain standard bank financing. It is also very attractive to the business owner as it reduces the amount of equity dilution, which increases the expected return on equity.

Bridging finance has many of the debt features associated with traditional debt, including interest payments, covenants and, in some cases, amortization. But it also has an advantage in the form of an ownership stake. Mezzanine debt is usually secured by the company’s equity rather than its tangible assets and is subordinated to 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. Debt holders receive a higher interest rate than senior debt, as well as a virtual equity stake in the company as compensation for the increased risk. It is a much cheaper source of capital than equity financing; perhaps more importantly, existing equity owners are subject to significantly less dilution.

In the balance sheet, mezzanine debt is located between senior debt and equity. In payment, the subordinate has priority over the senior’s debt, but it has priority over the common stock if the company is liquidated. It can be in the form of convertible debt, senior subordinated debt or warrant debt.

In the middle market, mezzanine lenders are looking for a fixed current coupon rate of 11% to 15%, which equates to a spread of 5% to 9% over the prime rate, plus an additional return from an equity stake in the company. This compares with a rate of 1% to 4% above the prime rate for long-term loans from older lenders.

While most equity investors aim for returns between 30 and 45 percent, mezzanine investors seek annual returns between 20 and 30 percent. Lenders tend to be flexible in adjusting the structure of the investment to meet the borrower’s business and cash flow needs, making mezzanine debt a useful form of financing.

Most mezzanine loans last from five to seven years with early repayment options. Unlike bank debt, which usually requires amortization, interim repayments are often not required until maturity. This allows the business owner to reinvest cash flow into growth opportunities instead of paying down older debt.

Because their returns are largely dependent on equity growth, mezzanine lenders are more accommodating in tough business conditions. Although the business owner may lose some independence, he rarely loses direct control of the business or its management. Owners usually do not encounter much interference from the mezzanine lender as long as the business continues to grow and prosper. The amounts raised through mezzanine financing can be substantial. The company can leverage its cash flow and obtain senior debt between 2x and 3.5x cash flow. With mezzanine debt, it can increase total debt to 4 to 5 times cash flow, depending on risk appetite in the debt markets.

Mezzanine lenders are usually repaid by recapitalizing the company with cheaper senior debt or with accumulated profits generated by the company’s growth. For years, mezzanine debt has proven to be a successful source of growth capital to finance privately held middle-market companies whether the economy is going full steam or when it’s in the tank.

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