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Thursday, 19 April 2012 15:46

Mezzanine financing: Not just for large companies

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GRAND RAPIDS — Mezzanine financing is becoming a viable option for small businesses, according to a pair of veteran financiers who spoke to the West Michigan chapter of the Association for Corporate Growth on Wednesday. 

Mezzanine debt can be thought of as a hybrid between traditional bank financing and equity, said Frank Galioto, partner at McNally Capital. Traditionally, it had been reserved for larger companies, but as the market changes, more mezzanine funds have started to look at different size companies, including lower to middle market firms, he said.

The presentation at Kent Country Club by Galioto and Ward McNally, managing partner of McNally Capital, focused on educating attendees about what the mezzanine market looks for in companies and how deals are structured, as well as the funds’ expectations in mezzanine deals.

In the hierarchy of debt, mezzanine debt falls between secured senior debt and equity capital. Mezzanine debt is typically unsecured and is more expensive than traditional debt, but cheaper and less dilutive than private equity.

Investors typically favor the risk-return profile of mezzanine, which tends to provide better returns compared with equity. For owners, if used properly, mezzanine debt can lower a company’s total cost of capital, Galioto said.

Mezzanine has characteristics of both debt and equity and offers borrowers more flexibility than bank debt, he said. The deals are usually structured to provide business owners a short-term flow of capital, but allow the investors private equity-like conditions to observe and help the company.

Businesses with an enterprise value between $10 million and $50 million that can utilize mezzanine financing typically seek investments of $2 million to $10 million. In that lower middle market sector, there is about $6.4 billion in mezzanine funds available, according to figures cited by Galioto.

However not every company needs to or should employ mezzanine financing. Galioto said companies that are good candidates for mezzanine financing fall into certain situations and are almost always a non-permanent need. Those situations include:

  • Private equity buyouts
  • Buying out a partner
  • Management buyout of the company owner
  • Acquisition financing.

Galioto said mezzanine funds look at several characteristics when evaluating companies:

  • The business must have strong, recurring cash flows. Companies are rarely in distress at the time of a mezzanine investment.
  • The business serves a purpose or “needs to exist.” It is unique in the market and even in the case of a downturn, would be still likely to be acquired.
  • Low customer concentration
  • Good margins
  • The owners have “skin in the game” behind the mezzanine fund
  • Quality of management team or PE group

Mezzanine lenders also take stock of the amount of senior debt in front of mezzanine and the amount of equity behind mezzanine.

Galiato said that mezzanine finance has often been labeled as a more risky strategy, but he noted that loss rates have been fairly predictable across economic cycles.

Loss rates are typically between 5 percent and 10 percent and that between 80 percent and 90 percent of portfolio companies perform as planned, he said.

In the event of a problem or default, there are a number of covenants worked into deals, often set at conservative targets to encourage early dialogue about potential problems. Often mezzanine lenders are usually more flexible in their ability to work through situations with companies. Galiato said mezzanine lenders only take control of a company as a last resort, often letting the management team work out any issues.

To view the presentation, click here or visit the website of the Association for Corporate Growth Western Michigan Chapter. 

Read 2855 times Last modified on Thursday, 09 August 2012 16:11

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