The recent economic downturn has been financially challenging for many businesses. Existing credit lines have been reduced, new loans from commercial lenders are more difficult to obtain, and accessing the public capital markets is likely not an option. So in this difficult market climate, where does a middle-market company turn for financing? The answer may be mezzanine capital.
What is Mezzanine Capital?
Mezzanine capital is broadly defined as the layer of financing between a company’s senior debt and equity. Typically, mezzanine is issued in the form of subordinated debt or preferred stock with equity provided by a warrant, conversion feature, or the outright purchase of common stock.
Mezzanine Capital Structure
Who are the Mezzanine Lenders?
Many different institutions provide mezzanine capital to middle market companies across numerous industries. These lenders include traditional commercial banks, specialty mezzanine firms, private equity firms and more recently, hedge funds.
The Cost of Mezzanine
Mezzanine capital, given its place in the capital structure above common equity but below senior debt, is generally priced accordingly. Thus, without significant collateral protection, mezzanine capital providers typically seek “all-in” annualized returns in the range of 15% to 25%. Mezzanine lenders seek their returns from three primary sources: cash interest payments; payable in kind interest (PIK); and equity ownership provided by a warrant or the outright purchase of common or preferred stock.In addition, mezzanine debt securities usually have a maturity of between five and eight years, with little or no amortization (principal paid at maturity).
Middle market companies often have unique requirements with specific financing needs and given its hybrid structure of debt and equity features, mezzanine capital is extremely flexible. In addition, no active market exists to trade mezzanine securities, creating a negotiated process between the borrower and lender that produces a highly customized security. This combination along with favorable amortization terms often results in mezzanine capital being a favorable solution for growing middle market companies since the bulk of a company’s cash flow can continue to be reinvested in the existing business. Typically, mezzanine capital is used for buyouts; acquisition financings; recapitalizations; capital expenditures; shareholder liquidity; and ESOPs.
Can Mezzanine Fill in the Gap?
Some recent trends may suggest growing opportunities for mezzanine financing.Given the weak economic environment and credit market issues of the past 12+ months, many commercial banks have tightened their lending standards considerably, resulting in a sharp decline in the leveraged loan market.
Leveraged Loan Market
($ in billions)
As a result, the use of mezzanine capital to fill this gap for middle market companies is expected to increase. In fact, many institutional mezzanine investors began preparing to take advantage of this growing financing gap as funds investing in mezzanine securities raised more than $40 billion in 2008, a 350% increase over the prior year.
Mezzanine Capital Raised
($ in billions)
In summary, the recent economic challenges and dramatic pullback in lending sources, from commercial lenders to capital markets, for middle market companies translates into a significant capital gap needing to be filled. As discussed in the prior sections, mezzanine capital is well suited to fill this capital gap given the $70 billion raised by institutional mezzanine funds since 2006 and the flexibility offered by mezzanine capital’s hybrid debt and equity structure.