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• Institutional capital markets are reeling from the meltdown in the sub-prime mortgage market and its cascading effect
• Banks are increasingly concerned about the strong possibility of a recessionary period and lower interest rate spreads
• Venture capitalists are cautious about funding new ideas and companies
• Private accredited investors (angels) have seen their personal portfolios shrink with the declines in the public equity markets

What’s a middle-market entrepreneur to do as he seeks incremental capital to grow, or to stabilize, his business?
 
Consistent with previous transitional times in the economic cycles, when equity and debt capital become harder to find from traditional sources, more attention seems to be focused on the financing alternative known as mezzanine debt. 
 
What is Mezzanine Financing?
Mezzanine financing is a hybrid blend of debt and equity financing used by businesses of all sizes, in search of capital for rapid growth through acquisition or expansion of existing operations.  Typically structured as a debt instrument and carried on the balance sheet as a liability, the loan carries a market-driven interest rate payable monthly or quarterly, and generally matures in 5-7 years. 
 
One of the major benefits of mezzanine capital is the “equity-like” and friendly principal repayment provision, which generally requires only a single lump-sum repayment of principal at the maturity date in the future. This accommodating repayment schedule allows the company to prudently invest the capital and seeks a return on such investment over the 5-year period of the loan, aligning the needs of the borrower and the mezzanine investor.
 
As a trade-off for the friendly repayment schedule and use of the capital for a longer period of time, the mezzanine investor requires a small amount of equity to increase its yield over the investment time horizon.  This equity component is usually in the form of a stock warrant, giving the investor the right to share in the increased value of the company derived from the use of the mezzanine loan proceeds.
 
Historically, interest coupons on mezzanine debt have ranged from 10-14% and the investor seeks an all-in return in the upper-teens or lower-twenties.  Despite significantly lower interest rates at the shorter-end of the yield curve (under 90 days), the scarcity of capital is causing mezzanine debt rates to push north towards the higher end of the historical range.  We expect this environment to exist for the immediate future, perhaps extending as far as the next 4 quarters.
 
The warrant, usually issued in a form convertible to stock, gives the lender the right to purchase a specific number of shares in the company, generally at a price approximating the current value of the underlying business.   It is this feature that again aligns the expectations of the borrower and the investor, where the investor has the right to share in the future value of the business created with the investment and the business owner retains the majority control of the equity.  The warrant can be exercised into either common or preferred stock, tailored to fit the specific capital requirements of the business, and is exercisable over a period up to 10 years from issuance.  Mezzanine debt can be unsecured, or secured and subordinate to the rights of the company’s senior banking partner. 
   
When is Mezzanine Financing used?
There are three common scenarios when business owners should consider mezzanine financing as an option for growth capital:

• The capital need exceeds what the commercial banking segment is willing to support
• The owner has a strong desire to minimize equity dilution, and maintain control
• The company has historical cash flow to service the incremental interest expense of the new mezzanine investment

While terms can be customized to fit the unique cash flow dynamics of the company, market conditions dictate the amount of capital that can be raised.  Banks and investors do not want to “over-leverage” the business and put too much undue stress on the cash flow.  Although lending multiples on cash flow has crept towards the 6x range, multiples have reduced and most lenders are seeking a more traditional leverage range of 3.5-5x, primarily dependent on the stability and predictability of the cash flow stream.
 
There are a few key advantages for the business owner in considering the value of accepting mezzanine investment.   First and foremost, it is less expensive than traditional equity financing and provides a significant amount of flexibility in structuring the instrument (coupon, repayment, covenants, and warrant coverage).  Almost always, the owner has a strong desire to maintain economic and operating control of his business, but needs external financing over and above what its banking partner is willing to do.
 
Other considerations for the business owner include:

• With a new partner in the business, the owner must make time to keep that partner informed and must be willing to accept new ideas and influences from the new investor
• The new debt inherently increases pressure to generate immediate cash flow to service the incremental interest, and the mezzanine investment must be repaid at the maturity date
• The process to source and close a mezzanine investment may take 3-6 months, and require a significant time commitment of the business owner 

Overall, the appeal to investors is an attractive current rate of return, a company with historical cash flow to repay the loan, the potential for capital appreciation and favorable capital gains tax treatment on the sale of the underlying equity – if the company performs well and increases its value over the life of the investment.  Sources of mezzanine financing include private investors, insurance companies, specialty investment funds and banks.
 
At Penn Valley Group, we work closely with both entrepreneurs seeking capital and investors seeking fundamentally-sound investment opportunities with good companies and management teams.  We help company owners clearly understand their capital requirements, identify potential investors and lenders, structure the investment in a mutually-beneficial way, support the definitive negotiations and documentation, and work with management teams after the close to optimize operations and opportunities.
 
Should you wish to explore this interesting area in more detail, please contact Michael Wilk directly at 610-977-2777 or michael@pennvalleygroup.com .