I recently discussed with my client Keith, the CEO and 50 percent owner of a recycling company, the options for buying out his partner, Bob, who owns the other half of the company. Bob, who put up the initial capital to start the company about 15 years ago, has never been actively involved in the business and views it simply as an investment.
Now that Bob is spending most of his time on his boat in Florida, he wants to cash in on his investments in operating businesses and invest the proceeds into real estate so all he has to worry about is tornados and whether or not the fish are biting. Keith is agreeable to Bob cashing out, particularly as he sees some opportunities to grow the business, which he can’t pursue as long as he has a partner who insists that all available cash be distributed each year.
I explained that the most efficient way to achieve both parties’ objectives would be to raise mezzanine financing, but neither of the owners was familiar with the concept.
In a nutshell, mezzanine debt is a form of capital that is between equity and debt, as its name implies. Mezzanine debt has some of the qualities of debt (it has to be repaid and it carries an interest charge) and certain qualities of equity (generally options or warrants to purchase stock are granted to the lender.) Mezzanine debt is an appropriate financing option when a company has borrowed all the traditional debt that banks will lend and they still need additional capital to expand their operations, make acquisitions or cash out a partner.
I valued Keith and Bob’s company at about $10 million; therefore, Keith would need to come up with $5 million to buy out his partner. The company generates about $2 million in cash flow each year, which means that in today’s tight credit markets it could only borrow about $4 million from a bank and it already had about $1 million in operating debt. Consequently, Keith needed to come up with an additional $2 million. When I explained to Keith that he would not be able to borrow the entire $5 million needed from his bank, he responded: “Then we will have to go to another bank to get the difference.” Unfortunately, it doesn’t work that way.
While banks come in many shapes and sizes, they all generally approach lending from one of two perspectives. The amount they will lend is either: 1.) a percentage of the hard assets you own, or 2.) a multiple of your annual cash flow. In today’s market, cash flow lenders (which have become virtually extinct since 2001) are generally extending credit equal to about two times annual cash flow. In the headier days of the stock market bubble, that multiple was nearly twice what it is today.
So, if you want to borrow more than twice your annual cash flow now, you most likely will have to turn to a mezzanine lender.
The benefit of using mezzanine debt is that it allows you to raise capital beyond what banks will lend, without relinquishing the same percentage of ownership you would have to if you simply sold stock in your company. However, it comes at a price; the interest rate is substantially higher than bank debt. According to Brent Burgess, of Triangle Capital Partners, the interest rate associated with mezzanine debt generally ranges from 10 percent to 14 percent; plus the lender generally retains an ownership interest after the debt is repaid.
Typically, according to Burgess, the lender will receive warrants to purchase stock in the company, for virtually nothing, that they can exercise from the time the loan is repaid until up to 10 years from the initial funding. For example, in the case of my client looking to cash out his partner, if he had to sell stock to raise $2 million to bridge the gap between what he could borrow and the price he had to pay for his partner’s interest, he would have to give up about 20 percent of the company. If he instead borrowed mezzanine debt, he might give up only 5 percent of the stock.
Mezzanine debt is typically paid back over a five- to seven-year period. If it is paid back more quickly, the number of options or warrants is typically reduced and, if it takes longer to pay it back, the number of shares the lender can purchase are increased.
With traditional banks tightening the reins on lending, more and more companies have considered mezzanine financing for the first time in recent years. Not surprisingly, a lot of capital has poured into the mezzanine market since 2001, attracting some of the major players on a national basis who had never before focused on this market, such as Goldman Sachs and The Carlyle Group.
One fund that has been active in Atlanta is CapitalSouth Partners out of Charlotte, NC. Joe Alala, president of Capital South, says he visits Atlanta monthly and views it as one of the most attractive markets in the south. CapitalSouth invested $1 million to help the management team from Alpharetta-based Staircase and Millwork acquire the company from its prior owner. Alala’s fund also invested $5 million to help fund the buyout of Atlanta-based Canterbury Engineering, a supplier of engineered plastic parts.
Capital South is looking to invest about $100 million in chunks of $3 million to $8 million. Locally, a new mezzanine fund, Chatham Capital, has recently been formed in Atlanta.The reason the rates on mezzanine debt are so high is that the risk associated with subordinated debt are much greater than for traditional senior bank debt, which is often secured by the assets of the company.
According to Burgess, for investments in companies with annual cash flow less than $5 million, a mezzanine investor is looking for a total return of about 20 percent to 25 percent a year. because most companies can’t handle an interest burden that onerous, the lenders achieve their returns by attaching options or warrants to the loan.
While most business owners recoil at the notion of paying this level of return, the cost of mezzanine debt is still less than what venture capitalists or private equity investors seek — typically in the 30 percent to 40 percent range. Equity investors who strictly buy stock may not charge a current yield on the funds they invest, which reduces the burden on cash flow; however, they get their returns by taking a larger chunk of the company and demanding greater rights to control the business.
With the reduced availability of private equity and bank financing in recent years, mezzanine lenders have evolved from fringe players in the capital markets to mainstream sources of capital. Of course, whenever that happens, as Burgess notes, a lot more money gets poured into the sector and it becomes much more competitive. Moreover, both private equity and bank financing are starting to flow a bit more freely these days, all of which bodes well for the business owner seeking to grow or transition the ownership of their business.
Michael Jacobs, Author
Michael Jacobs is the CEO of Jacobs Capital and Professor of the Practice of Finance at The University of North Carolina at Chapel Hill. He's the author of several books and a certified speaker.
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