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Mezzanine Finance

My last post on acquisition financing covered senior debt. This post will cover Mezzanine debt. Specifically, I would like to talk about how mezzanine debt is structured and what the implications are for small businesses that use it.

The word mezzanine is defined as the “partial story between two main stories of a building”. In this case, the two main “finance stories” of a company are senior debt and equity. Mezzanine debt then is the middle level or “mezzanine” between senior debt and equity. From a borrower’s perspective, mezzanine finance is more expensive than senior debt and less expensive than equity. Mezzanine debt is more expensive than senior debt because 1) it is subordinate to senior debt (meaning in a liquidation the senior debt lender will be paid in full before the mezzanine lenders sees a dollar) and 2) it typically does not require any principal payment until the end of the term loan. This structure obviously creates more risk for the mezzanine lenders and as a result they charge higher interest rates.

Mezzanine loans are typically priced anywhere between 15–20%. There are three main components off mezzanine debt: 1) current interest 2) PIK Interest and 3) Warrants. As mentioned, Mezzanine loans are typically interest only with the principal due at the end of a five or seven year term. Current interest payments are typically due monthly or quarterly. For example, a $3 million 15% current pay interest mezzanine loan with a 5 year term would look something like this:

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In some cases mezzanine lenders will PIK (Payment-in-Kind) a portion of the interest payment and add it to the principal payment of the loan. In this case, there will be two buckets of interest: current cash interest and PIK interest. Here is what it would look like if a mezzanine lender offered a $3 million with 14% current cash interest and 2% PIK interest:

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Mezzanine debt can also frequently include warrants, which are very similar to equity options. Warrants give lenders equity upside when the borrower performs well. Warrants typically represent 1–5% of the fully diluted ownership of the company.

Due to the high interest rates associated with mezzanine debt, we work with management to pay it off sooner rather than later. If a company is performing well and has plenty of cash, we will use some cash to pay down the mezzanine debt. We typically use 1x–1.5x EBITDA (or cash flow) of mezzanine debt in an acquisition. So if we buy a company for 5x EBITDA, a typical capital structure might be 2x senior debt, 1x mezzanine debt and 2x equity. We feel 3x total leverage (2x senior + 1x mezzanine) is an appropriate amount of debt for a small company.