Mezzanine debt is a unique form of capital that brings value to a company’s capital structure. Also known as subordinated debt, mezzanine debt plays a versatile role in balance sheet management. It is capable of funding a variety of corporate needs such as accelerated growth, acquisition or a leveraged buyout. Mezzanine debt is a hybrid form of capital that has the structure of a loan but provides the accretive value of an equity investment such as preferred stock. Like preferred stock, it is unsecured and its future repayment is largely determined by the free cash flow of the borrower. Mezzanine debt and preferred stock are structured off of a borrower’s cash flow value, which is usually a multiple of EBITDA. This approach to valuation is based on free cash flow and theoretical exit value of the firm. Mezzanine debt providers lend up to 85% of the cash flow value of the business.
Mezzanine Debt Position
Mezzanine debt is typically in second position behind secured senior debt in the capital structure. Because it is based on cash flow value as opposed to asset value, it provides a critical middle layer of capital support to a company undergoing a transitional capital need. As a middle layer of capital support, the mezzanine debt is exposed to default risk should the borrower’s free cash flow not increase or the company unwind.
How Mezzanine Debt is Used
Mezzanine debt is used most frequently as a form of acquisition financing by companies seeking to acquire other businesses. It is also used in a buyout scenario wherein a financial buyer is completing a control transaction. In the case of providing business acquisition financing, the mezzanine provider lends directly to the borrower and seeks to build a long term relationship with the borrower’s management team. In this scenario, the mezzanine debt, if structured properly provides all of the capital needed to finance the acquisition. In the case of a leveraged buyout, mezzanine debt is used by private equity sponsors to fill in any gap in the purchase price not provided by the senior secured debt provider or bank. Due to its equity like value, mezzanine debt can often allow a company to take large growth steps with minimal to no share dilution. Often, a company can double or triple its value through prudently employing a mezzanine debt strategy.