Mezzanine Capital

During a period of rapid expansion, manufacturing companies invest heavily in machinery, equipment, receivables and inventory. Leverage increases quickly as debt (versus profits) is used to expand. Mezzanine financing allows management to execute a relatively aggressive expansion plan without impairing its normal working lines of credit. It is particularly useful in the manufacturing environment due to the relatively high capital requirements of the industry. Acquisitions can also cause higher leverage and financial risk, and mezzanine financing is designed to mitigate this risk. What is Mezzanine Financing? “Mezzanine” refers to the priority level of capital on the balance sheet. It is the middle level between senior debt and common equity. Mezzanine capital usually takes the form of subordinated debt, which senior debt holders (usually banks) view as equity. Mezzanine financing is primarily used to fund rapid expansion or acquisitions. In either case, subordinated debt is used to reduce the balance sheet leverage from the senior debt holder’s perspective. Banks will not permit their borrowing customers to become too leveraged. Thus, mezzanine financing fills the gap between the need for more common equity and less senior debt in the execution of a strategic business expansion or acquisition plan. Mezzanine lending has been a scarce form of capital in the past five years. There were many mezzanine lending sources in the 1980s as merger and acquisition mania peaked. These lenders disappeared as the recession and credit crunch made deals scarce and expensive. As American manufacturing restructures itself in the 1990s, mezzanine lenders are returning in large numbers with strong capital backing. After all, the capital markets love a vacuum. Increased Rates of Return Because mezzanine capital has a higher degree of risk than bank financing, the lender will require a much higher rate of return, usually above 25 percent and frequently as high as 40 percent, depending on the level of risk involved. Mezzanine lenders are generally compensated in two ways. First, they receive an interest rate approximating current “junk” bond rates (as much as 14 percent in today’s economy). Second, they require a “piece of the action,” typically in the form of warrants to purchase common stock of the company at a future date (usually three to five years out). The current and expected future values of the company drive the percentage of equity that can be controlled by the future conversion of warrants to common stock. Why would a company pay such high rates of return to a lender? Answer: It allows management to achieve strategic goals (expansion/acquisition) that banks would never allow them to pursue with pure debt alone. The basic premise is that the owners of the company will be more than sufficiently enriched by the increase in the value of their company. Mezzanine financing is an extremely flexible form of debt/equity that can be structured to fit the needs of the company and its strategic plan. For example, repayment of the debt portion can be delayed for several years while an acquisition is being assimilated and then “termed out” over another period of years. For public companies, issuing additional common stock at later and greater values is a common method of repaying subordinated debt. Sometimes, the issuance of additional debt is sufficient to retire the stock warrants. In some cases, they may not be repurchased at all. For privately held companies, subordinated debt often serves to finance the rapid growth preceding an initial public offering. Almost all mezzanine financing is issued by professional investors, and obtaining their confidence eases the transition to Wall Street. Not all companies that use mezzanine debt financing go public. Management’s strategy may be to sell the company to another buyer after achieving the strategic goal of increasing the shareholders’ value.

© 2009 Principa. All Rights Reserved.

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Mezzanine Capital (Cont’d)
Requirements of Mezzanine Lenders Four primary requirements must be met in order for mezzanine lenders to consider an investment: 1. 2. First and foremost, the company must have an experienced management team with depth at all levels. The management team and owners must have a strategic plan/vision that is easily understandable and readily achievable given the company’s capabilities and resources. The company must have a demonstrated history of predictable cash flow indicating that interest payments will be made on the subordinated debt. There must be a projected substantial increase in the value of the company as a result of the execution of management’s plan.

3. 4.

The fourth requirement is the reward for the higher risk assumed by the mezzanine lender. At the outset, the company is professionally valued. Management’s projections are then taken into account and a future value is forecast. The value of the company at the end of the proposed financing term, usually three to five years out, determines the ultimate return to the mezzanine lender. As an example, a compound rate of return of 25 percent per year would triple the value of the company within five years. Because mezzanine financing involves both debt and equity, the company will be required to comply with loan covenants and management covenants. Loan covenants are usually the same or slightly less restrictive than senior debt covenants (although there may be more of them). Management covenants may include board representation, adherence to the business plan, and future remedies should the company falter. The mezzanine lender often provides professional financial advice leading to an increase in shareholder value. Therefore, it is important that the manager/owner work very closely with the lender/investor. Finding Mezzanine Financing There are hundreds of issuers of mezzanine financing in the United States. Most are Leveraged Buyout (LBO) and Equity Funds. With the changes in the Small Business Investment Corporation (SBIC) programs, these funds can now be a source for smaller amounts of subordinated debt financing. Almost every major bank has a subsidiary that specializes in the placement of debt/equity funds. Often, several banks will team together if the investment is large enough. Conclusion With economic expansion and the recent end of the credit crunch, a brisk new market for expansion and acquisition is forming. Mezzanine financing is a proven method for owners looking to take advantage of the restructuring marketplace, without incurring higher leverage and financial risk. Manufacturers are especially well suited to take advantage of this financing vehicle because of their higher shareholder values and suitability for public offerings. 39 © 2009 Principa. All Rights Reserved.

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