We recently wrote about the refinancing wall that is now rapidly approaching, and the fact that it may spark the “mezz debt” market. We thought we should talk more about the latter.
Mezzanine is a traditionally stable asset class, with a desired IRR of 15 – 25%, cheaper than equity and more accessible than bank debt. As its architectural moniker implies, it is the space in a capital structure between the top (secured debt) and bottom (equity), bridging the gap as a hybrid of the two, advantageously used during management buyouts and for growth investments and acquisitions. Mezzanine is especially attractive to both borrowers and lenders in times of prolonged equity price volatility. It can be structured purely as debt with both cash interest and PIK components, or as a blend of both forms of interest plus warrants awarding a future equity stake.
So what makes a company a viable mezzanine borrower? It depends who you ask.
Lenders invariably like to see companies poised for market share growth, run by strong, seasoned management teams, and typically like to check the following three boxes before providing a mezzanine loan, and a fourth depending on investor strategy:
1. Tangible Assets
“You want to stay away from ‘asset-lite’ companies,” an anonymous source at an unnamed white shoe bank told me over the phone. “The thing with ‘mez’ is that it usually gets flushed in a bankruptcy. In that case there’s more residual value in a hard asset than in a bunch of patents. A transportation company can always sell some trucks, but a tech company is stuck with intangibles.”
Mezzanine has a very low recovery rate in case of bankruptcy, and a relatively high probability of bankruptcy to begin with, so lenders prefer some kind of tangible collateral as a backstop.
2. Cash Flow
Like most debt securities, mezzanine viability requires strong cash flows able to at least cover the interest expense. Since PIK interest is usually a component of mezzanine, cash flows must exceed cash interest comfortably so there is sufficient liquidity by the time the principal must be repaid at the end of the term.
3. High Expense Ratios (Low Operating Margins)
This one may be a bit counter-intuitive, but our banker friend said he likes to see companies that have a high operating cost-to-revenue ratio, depending on what the high costs stem from. “Look to see what’s going on under the hood and if there’s anything you can fix, like wages in non-union companies. Or maybe a printing press uses high quality paper and ink that just doesn’t make sense anymore. You can get in there and strip that out to increase cash flow.” He used another example of a logistics company that doesn’t use the same technology as a FedEx or UPS, making it less efficient and ripe for overhaul. Or maybe the accounting systems are outdated. “If you’re a specialist in a field and know exactly the type of systems to implement, that’s an easy way to augment efficiency.”
Margin preferences will vary among investors with different goals. He speaks from the vantage point of a distressed lender, especially interested in the low-hanging cost fruit. Yet mezzanine growth lenders, valuing the security more like equity, prefer high, stable margins.
4. Potential Ownership
The way a lender looks at this depends on his investment horizon and risk profile (whether your needle points closer to traditional lender or venture capitalist). “Non-ownership should be a selling point of a borrower in the sense that they can pay higher interest now in lieu of future ownership,” said a principal of a Manhattan hedge fund. Contrarily, by weighting the investment more highly on the equity component, an investor acts more like a venture capitalist and places a bet on future growth rather than collects a fixed return.
Although it may be easier in the short run to offer equity in your business, doing so will cost you the most in the long run, as equity is the most expensive form of capital. Keep this in mind if you’re confident in your growth prospects.
Mezzanine financing can be the bridge between solvency and growth, and stagnation and bankruptcy, offering cheap capital to business owners and high returns to investors, and could proliferate in such current uncertain economic times.