Mezzanine debt may be the right option if the cash infusion means accelerating revenue growth well beyond what you could achieve organically and if … you want to sell it or list it within a few years.

Imagine you can take advantage of a transformative opportunity for your company. You need $10 million to realize your vision, but the bank is only willing to lend you $5 million. Fortunately, private equity firms are willing to provide growth capital in the form of mezzanine debt, growth equity or a hybrid of both. Each entails some cost to owners above what a commercial bank would charge, in exchange for the greater risk these investors are willing to take.

Commercial Lenders

If you have the assets to secure a loan, debt financing may still be the best and least expensive option, even if it does not come from a bank. For instance, many private equity funds have added senior debt options (through what is called unitranche lending) to their lineups. These funds primarily provide leverage for investments by private equity firms.

Non-bank lenders are also willing to extend senior debt beyond a commercial bank's comfort zone. Finance companies such as CIT and GE Capital specialize in underwriting debt for closely held companies, usually at the larger end of the middle market. If you are looking to lease new equipment or if there is a real estate component to your investment and you will have the cash flow to cover a higher debt load, you may be able to fund your growth with non-bank senior debt. This has the advantage of keeping your equity intact, but may require personal guarantees. These non-bank lenders are also less understanding in downturns or "hiccups," which likely means more risk to you. While they do not charge much, if you do not perform, they expect you to fix it since they are not making enough of a return to fix it for you. However, other alternatives are available.

Mezzanine Debt

Mezzanine debt, as the name implies, sits in the middle of the capital structure, between senior debt and equity. Mezzanine lenders are private equity funds that raise money, from institutional investors and others, and they usually look for opportunities within a set specialty—either a group of industries, a geographic region or a certain size company. Mezzanine lenders lend their fund's money in the form of subordinated debt. They also often make equity investments in companies, along with other private equity firms.

In "unsponsored" deals, those without a private equity firm investing, mezzanine lenders seek to invest in profitable companies that can provide a payout within a few years—companies on the verge of a growth opportunity, about to go public or planning to cash out an owner in part. In "sponsored" deals, they work with commercial banks and private equity firms to provide a layer of funding on a specific project or deal.

A typical mezzanine loan will be structured with a five-year term, during which the company will pay "interest only" until maturity, when the principal will be due. The interest rate will typically range from 11 percent to 14 percent,¹ of which 10 percent to 12 percent will be interest payable in cash on a monthly basis and the balance will be interest payable-in-kind, or "PIK" interest. Mezzanine lenders may also charge up-front fees of up to 2 percent of the principal amount of the loan. As part of the agreement, mezzanine lenders generally secure observation rights on the board, and depending on a variety of factors, they may require a seat on your board. In addition, mezzanine deals usually involve an equity kicker in the form of a warrant. Where a bank earns money on interest and services, such as deposits and cash flow management, mezzanine lenders who sit below the senior debt lenders, and are thus in a riskier position, want to participate in the upside that equity investors will enjoy—at least in the medium term.

In an ideal transaction, the mezzanine fund hopes to make a profit through a combination of current interest, the exercise of warrants, the sale of the underlying equity upon a sale of the business or by requiring the company to repurchase the warrants after a period of time. Most mezzanine lenders are not interested in becoming long-term shareholders in your company because they need to make distributions to their own limited partners. Mezzanine lenders do not lend to keep the lights on. Therefore, this is a good option if you need to fund a growth project with a fairly certain payout within a fairly predictable time frame, or even to take some money off the table. If, on the other hand, you are looking for total liquidation of your ownership in the company, or if your company requires rescue capital, mezzanine debt is generally not among the better options.

For a business that is comfortable with the provisions of a traditional bank loan, the terms of a mezzanine debt transaction may initially look aggressive. Is it worth it? Mezzanine debt may be the right option if the cash infusion means accelerating revenue growth well beyond what you could achieve organically or if you believe the investment would help you enhance the valuation of your company because you want to sell it or go public within a few years. The question you need to ask is: Will your business generate a return on the capital in excess of the cost of the capital?

Growth Capital

Taking on an equity partner may be a more attractive solution than taking on debt for a company seeking growth capital, but it is a more expensive alternative. Some private equity firms have funds called "growth capital funds," with which they will make minority or non-control investments in a company. However, the terms may look very similar to what a private equity firm would demand if it were making a control investment. For instance, in exchange for a capital infusion, you may have to give up some ownership of your company and some board control. Keep in mind that while an investment by a growth capital fund is not debt, and therefore does not have to be repaid, private equity firms generally seek to exit an investment in four to six years. To achieve this objective, private equity funds generally make an investment in the form of preferred equity and negotiate a "right of redemption," which enables them to cause the company to replace them in five years or, in some cases, permit them to cause the company to be sold.

The Duane Morris View

David Bernsohn: When we help put together debt financing for transactions involving private equity, it would be illogical to assume that a business owner—or even an active private equity group that doesn't consistently participate in leveraged deals—would have a solid handle on state-of-the-market conditions or sophisticated, sometimes-novel financing types and terms. We make it our business to stay current and conversant and, in so doing, convey competitive advantages to our clients, on either side of a transaction.

Notes

1. Skitch Investment Banking Quarterly Middle Market Report, Spring 2012, page 4.