Bridge Your Financing Gap with a Mezzanine Loan

Although a strengthening economy made bank loans easier to come by in 2015, many companies still struggle to finance acquisitions. If an acquisition is part of your 2016 plans, but you foresee a gap between the financing you’ve lined up and the financing you’ll need, you might want to look at a mezzanine loan. These instruments, also known as junior liens and second liens, can bridge financing shortfalls — so long as you meet certain qualifications and can accept possible risks.

Debt/equity hybrid

Mezzanine financing works by layering a junior loan on top of a senior (or primary) loan. It combines aspects of senior secured debt from a bank and equity obtained from direct investors. Sources of mezzanine financing can include private equity groups, mutual funds, insurance companies and buyout firms.

Unlike bank loans, mezzanine debt typically is unsecured by the borrower’s assets or has liens subordinate to other lenders, so the cost of obtaining financing is higher than that of a senior loan. However, the cost generally is lower than what’s required for an equity investment. To compensate investors for increased risk, companies generally must offer the potential for higher gains. Mezzanine debt may even convert to equity if the borrower doesn’t repay it on time. 

This means that established, higher-growth companies are more likely to be successful finding a lender. Be prepared to prove you have good cash flow, a solid earnings history and competent management.

Common characteristics

The primary advantage of mezzanine financing is that it can provide capital when you can’t obtain it elsewhere. So if you’ve struck out with primary lenders — or they’re willing to give you only a portion of the amount you need — mezzanine debt is another option. 

That doesn’t mean it’s an option of last resort, though. Many companies prefer it because it offers flexible structures. If, for example, you’re uncomfortable giving up any equity interest (and partial control of your company), you can choose to pay a higher interest rate instead. Mezzanine loan rates typically range between 10% and 20%. That may sound high, but it’s important to remember that loan interest is tax deductible.

Structures vary, but most mezzanine instruments share several characteristics, including a term of between five and 10 years. Repayment of principal typically is deferred, based on your financing needs and cash flow projections. So you repay only interest during the loan’s term, and may even be able to defer this interest by rolling it into your principal.

Most mezzanine instruments also enable the lender to participate in your company’s success — or failure. Generally, the lower your interest rate, the more equity you must offer. Your lender’s participation will likely take the form of warrants, which enables the lender to buy a certain amount of equity ownership at a relatively low price. At the end of the loan term, you may be required to repurchase the lender’s stock. 

Possible drawbacks

In addition to having higher rates, mezzanine financing has a few other potential disadvantages. Loan covenants can be restrictive. For example, a covenant may restrict how much you spend on executive compensation or impose stricter guidelines on the financial ratios you must maintain. And though some lenders are relatively hands-off, they retain the right to a significant say in company operations — particularly if you don’t repay the loan in a timely manner. 

What’s more, mezzanine financing can make an M&A deal more complicated. It introduces an extra interested party to the negotiation table and can make an already tricky deal that much harder.

Rare but possible 

If your company qualifies for mezzanine financing, it might help you close a deal that otherwise wouldn’t be feasible. To ensure you make the best financing decisions, consider all of your options — including traditional loans, seller financing and equity investments.

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