Financing options Featured

8:00pm EDT July 26, 2007

Stringent disclosure requirements and rising interest rates have many businesses looking for alternatives to traditional securities and bank loan funding options. Mezzanine financing is helping fill the gap, especially for transactions under $50 million. Buyout and mezzanine funds raised $102.9 billion in 2006, their highest year ever, according to tracking firm Thomson Venture Economics.

Mezzanine financing offers more flexibility than bank loans and has less regulation than securities. These advantages come at a price, including the possible transfer of some equity.

Smart Business spoke with Mike Revord of mezzanine investment firm Aldine Capital Partners to learn about mezzanine financing and when it is a good option for businesses. Aldine Capital has partnered with MB Financial Bank to provide mezza-nine financing to its middle-market customers.

What sets mezzanine financing apart from other capital options?

It’s really a hybrid between debt and equity financing. There is debt — the company issues a note with a coupon, but the investor typically wants to take an equity position or some other form of upside. It’s a great source of low-cost capital when compared to common equity.

Mezzanine financing is almost always used with a bank loan and is typically used in leveraged buyouts or any other type of ownership change where the amount of debt the company needs to take on is more than it can get a bank loan for. Banks typically will lend a company two to three times its Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), while mezzanine can go for three to four-and-a-half times EBITDA, sometimes even higher, depending on the business.

What types and sizes of businesses are suited for mezzanine financing?

Companies with less than $10 million in sales and less than $1.5 million in EBITDA are less attractive to mezzanine lenders, and once deal sizes get into the $60 million range and higher, mezzanine tends to be more like a private placement. Company type is more important. There are several types of businesses where mezzanine financing doesn’t work well, such as fad companies or those in very cyclical industries. Fad companies include toy companies and software companies where the product might be very hot for a short time. Highly seasonal and cyclical businesses don’t appeal to mezzanine finance companies because of the requirement for a consistent earnings performance. In fact, to get mezzanine financing, a company has to show consistent performance for a fairly long time, usually at least three years.

What are some key terms and negotiating points?

One thing that is commonly misconstrued in mezzanine financing is the role the coupon rate plays in the cost of capital. In deals where warrants are included, the coupon is not the only cost to the borrower. Warrants are typically for common stock and dilute the borrower’s ownership in the company. It’s important to understand the overall yield. I recommend that companies focus on the overall cost of their capital, not just the coupon rate.

The coupon rate is negotiable, and so is the length of the deal and other terms. Mezzanine deals are typically no shorter than five years, and five to eight years is standard. The investor looks at it as a long-term opportunity.

How does the financing process compare to traditional bank loans?

There are many similarities, and a few differences, with the commercial lending process. The timing of the processes is very similar. So is a lot of the information the lenders want, but that’s where bank and mezzanine financing start to diverge. Mezzanine financiers tend to look more long term than banks. They’ll look more at the company’s value-creation capabilities and more in depth at the market and the competition. They’ll also spend more time on strategic and board-level issues. In that regard, they’re more like a buyer than a lender. After the deal is complete, the mezzanine financier won’t be involved in the day-to-day operations but will have board-level involvement, which can continue for years.

Mezzanine financing is a lower-cost source of capital than issuing equity but is more expensive than borrowing from a bank. Mezzanine is more patient than a bank because it doesn’t demand regular principal payments.

Mezzanine financing is a young market, and it’s maturing quickly. There’s a lot more competition than there used to be, which has made more capital available. It’s also led to the development of a more standardized approach for getting mezzanine financing, which is another positive development for borrowers.

MIKE REVORD is managing partner of mezzanine investment firm Aldine Capital Partners. Reach him at (312) 346-3950 or Mrevord@aldinecapital.com.