Why Mezzanine Financing?

During the Great Recession, traditional funders lost a lot of their power. In their place a plethora of alternative lenders stepped in to pump money into the economy (and many companies) since the banks no longer could. The diversified investment landscape that grew out of the Recession has allowed alternative lenders to carve themselves into the geography of the industry. Even in the slow-to-change world of private equity (the opposite of traditional funding and arguably just as large and formative in the economy) alternative funding has made its mark. Eric Myers from Diversified Lenders, Inc addresses the changes saying: “The Great Recession changed the mindset of many in the private equity space as traditional bank loans dried up for companies in PE firms’ portfolios. PE companies got educated in alternative lending and benefits of fewer covenants, more liquidity, and approvals for their transactions.” A particularly important type of alternative funding for private equity was mezzanine financing. In fact, three out of four mezzanine funds that Malartu interviewed for this piece admitted to partnering with PE firms at least 90% of the time, some exclusively with PE firms. And while this partnership directs a large portion of mezzanine loans, there’s no doubt that mezzanine funding has affected the wider investment landscape as well.

During the European financial crisis in the early 2000s the popularity of mezzanine financing rose as they came to the rescue of companies needing a quick cash and then fizzled out as the economy recovered. In the U.S., however, mezzanine has found a home in our investment landscape since the Recession. Preqin states that "among private debt strategies, mezzanine funds reached a final close the quickest in 2016, averaging 19 months in market. Mezzanine funds, on average, also had the most fundraising success, closing at 120% of target." Nearly a decade after the Great Recession, mezzanine funding is still on the rise, and it’s not hard to see why.

Bridging Debt and Equity: The Best of Both Worlds

Don Levett from Mergers & Inquisitions says that “Mezzanine falls squarely into that space between equity and debt, and has elements of both investment banking and private equity.” His assessment is spot on - mezz funds are in between traditional debt and equity financing.

Like traditional debt, mezzanine funds lend out money and in return expect a series of payments with added interest sometime in the future. Unlike traditional debt, mezzanine funds will ask for higher interest rates. Why? Well mezzanine funds aren’t investing in the low-risk companies that the banks are investing in; mezzanine funds invest in riskier, more volatile markets and companies and require a higher interest rate to make up for the added risk. Where banks may avoid loaning to middle market companies that need millions upon tens of millions of dollars to grow to an ideal size, mezzanine funds will gladly hand over the money.

Compared to senior securities, mezzanine (a junior security) is much more flexible in the structure, timeline, and terms of a deal. Oftentimes, safeguards will be set in place to protect the fund in case a portfolio company does not meet the required terms. This is where mezzanine funding meets the equity side of the spectrum. For example, should a company not repay a debt in a timely manner, depending on the terms of agreement, a mezzanine lender might acquire equity or a warrant for purchasing equity in the future. Each and every deal is different for mezzanine lenders, but this safeguard is one commonly implemented to ensure timely payments.

Unlike private equity, mezzanine funds don’t typically restructure or manage portfolio companies. Out of our surveys, three out of four mezzanine funds said they restructure portfolio companies about 10% of the time. Where private equity may provide operating partners and industry experts to help guide a company’s growth, mezzanine lenders will only do this in dire situations. This is one of the reasons many mezzanine lenders will partner with private equity firms; there, they know that their investments are being properly managed and aided.

Is Mezzanine For You?

Mezzanine is known for sticking to the middle market. And today, we have one of the fastest growing, most confident middle markets we’ve had in quite a while. According to RSM, “during the next six months, 67 percent of middle market executives anticipate growth in gross revenues, with 67 percent anticipating improved net earnings.” Additionally, middle market growth in areas like the South-Atlantic, Mid-Atlantic, and Southwest are showing a lot of potential for high growth in the coming years (check out our Top Ten Middle Market Metros). Mezzanines are historically attracted to companies with track records of positive growth, and it seems like these days, there are a lot of qualifiers.

If you fall under the “middle-market high-growth” category, then you’re definitely piquing some mezzanine interest. But is it right for your company? Ask yourself how much cash you need to grow at the rate you want, how much interest you’re willing to pay, whether or not you’re willing to give up equity in the company, and whether or not you’re interested in having industry experts and operating partners that you could reference. Study the pros and cons and figure out what you value most. Here’s a nifty pros and cons list I made to get you started:

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A Brief Briefing

Each mezzanine fund is different, and this briefing is just that: a briefing. But hopefully it’s helped you to more fully understand the ins and outs, the pros and cons of mezzanine funding. If you’re interested in learning more about the research we’re doing on mezzanine funds (among others), feel free to reach out to me at audrey@malartu.co.