The economic outlook for 2008 remains suspect as the tumultuous conditions afflicting the financial markets have created a turbulent business climate for middle market companies that is likely to continue unabated well into 2009. Commercial banks and Investment banks recently the paragon of the financial services industry have become pariahs in less than a year.
Adversity, however, creates opportunity and indeed many companies have been successful in obtaining financing amid the melt down of the credit markets. Middle market companies looking to grow and needing capital to do so need not panic as banks pull back on financing and credit tightens. Money is still available for companies with solid business prospects – you just need to know where to find it and how to get it.
Mezzanine finance can play an important role in funding the growth of privately owned “middle market” companies in good times and bad. This type of debt financing, however, isn’t really understood by many outside of the industry.
Often called subordinated debt, mezzanine debt is often viewed as quasi equity. As such it is a hybrid of debt and equity financing that is often used to finance acquisitions, product development, plant expansion and new equipment purchases. Company owners also use it to diversify or invest in other opportunities.
Lenders that provide mezzanine financing, for the most part, lend based upon a company’s cash flow rather than a business’ assets. Since there is little or no collateral to support the borrowing, this type of financing is priced significantly higher than secured bank debt. Mezzanine financing is advantageous because it is treated like equity on a company’s balance sheet and may make it easier to obtain standard bank financing. It is also very attractive to a business owner as it reduces the amount of equity dilution, which increases the equity’s expected return.
Mezzanine financing has many of the debt features associated with traditional term debt including interest payments, covenants, and in some cases amortization. But it also has an upside in the form of an equity interest. Mezzanine debt is typically secured by the equity of the company rather than its tangible assets and is subordinated to the debt provided by banks and commercial finance companies.
Mezzanine debt is more expensive than secured debt or senior debt because of the increased credit risk assumed by the subordinated lender. The debt holders receive a higher interest rate than senior debt as well as a quasi-equity stake in the company to compensate for the increased risk. It is a much less expensive source of capital than equity financing; perhaps more important, existing equity holders are subject to significantly less dilution.
