Executive Summaries Jan 22, 2019
A Flexible Tool to Support a Company’s Growth: Mezzanine Debt
Given the complexity and vast number of tools available for corporate financing, it is not always easy to understand the relevance and benefits of each one of them. Mezzanine debt is one of these underrated tools.
A Highly Flexible Financing Tool
Also known as “subordinated debt”, mezzanine debt is defined as being debt that is payable after the preferred debts are settled (we are speaking here of the debt, not the security that guarantees it). Subordinated debt must not be associated with the rank of the security that guarantees the debts. Subordinated debt requires higher rate of interest because the lender’s risk is also higher. It is an intermediate financing tool, between equity and senior debt (debt owing to a bank), and may or may not be convertible into shares.
Mezzanine debt can be useful, and used, to buy out shareholders to finance a business succession, for an acquisition, an expansion project or for any company growth.
Why Turn to Mezzanine Debt?
For a company, mezzanine debt holds many advantages, including no, or minimal, dilution for the shareholders and the optimization of the capital that has already been invested by possibly permitting an increase in the capital gain that would be necessary upon an acquisition.
Mezzanine or subordinated debt has a longer term than conventional debt, which gives the company flexibility and stimulus.
Repayment is often based on cash flow, which has a leveraging effect during the company’s growth period before the subordinated debt matures. It is also possible to negotiate moratoria on capital repayment, which will enhance the leveraging effect. The combined effect of the aforementioned advantages is to create significant financial flexibility.
In terms of accounting, mezzanine debt is considered to be quasi-equity and is favourable in the context of the financial ratios demanded by both senior and subordinated lenders, as well as other corporate investors who, in some circumstances, may also offer their expertise to the company either as directors, observers, or simply consultants. Mezzanine debt is usually granted without being secured by the company’s assets, which represents a significant advantage if the senior credit facilities are secured by all the existing assets.
One disadvantage of mezzanine debt is its rate of interest, which is higher than a conventional credit facility. However, this drawback is mitigated by the deductibility of interest on the company’s income. The lender may also insist on warrants upon the occurrence of certain events or growth steps of the company, considering the cycles that the financing will have allowed the company to achieve.
In conclusion, mezzanine debt can be seen as a financing step in the growth of the company’s life. It is proving to be a useful tool and an alternative to be considered compared to conventional financing or an equity injection. It allows the existing shareholders to ensure the company’s growth without diluting their investment, thus obtaining a better return on their initial investment at key subsequent steps.
To learn more about the various financing tools, sign up for our Strategic Forum on Corporate Financing, which will be held on Tuesday, February 19, 2019 in Montreal and Quebec City.