Is a mezzanine recapitalization right for your business
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Owners of middle market companies still in a growth mode face a variety of challenges and options in terms of raising capital needed to fund their continued growth. Likewise, owners of these companies may also be searching for optimal ways to exit their business, when the time is right.
In both these instances there are a variety of options available to finance growth or provide shareholder liquidity, including:
- Senior secured debt (first lien). In this option pricing tends to increase with leverage, is dependent on availability of collateral and is typically in the London Interbank Offered Rate (LIBOR) plus 3 to 5 percent range.
- Stretch, second lien debt. Pricing is typically in the LIBOR plus 8 to 12 percent range.
- Subordinated, mezzanine debt. Pricing is typically in the 12 to 15 percent range, with 11 to 13 percent being cash and the remainder payment in kind (PIK). This option may include warrants.
- Preferred equity. Pricing is typically in the 8 to 14 percent range, mostly PIK. This option may also include warrants but is less dilutive than common equity.
- Common equity. This option includes 35 to 40 percent of total capitalization, with a target internal rate of return of 18 to 25 percent.
In addition to the above alternatives, shareholders have other options to grow and achieve liquidity, including:
- Selling to a strategic buyer
- Selling to a private equity group (PE)
- Launching an initial public offering (typically uncommon for middle market companies outside of the technology and health care industries)
While the sale to a strategic buyer usually will offer the highest valuation multiple, it comes at a price as it usually means for the selling company a loss of control, replacement of management, sometimes a loss of jobs and in many cases, a different company culture from the legacy business. A sale to a PE group will usually come with a slightly lower valuation multiple than a sale to a strategic buyer, but could have many of the disruptions and disadvantages as a sale to a strategic buyer.
A mezzanine recapitalization will generally yield the lowest valuation multiple, but ownership will often maintain control and can capture future business upside potential. It’s important to note, however, a mezzanine recapitalization is generally only accessible to businesses with strong free cash flow and a strong second layer of management.
Mezzanine recapitalization: A closer look
The following is an example of how a mezzanine recapitalization might work if the conditions are right.
While a mezzanine recapitalization is not for every business or shareholder group, consider the following when looking at this option for your company:
- You will be operating in a leveraged environment, still owning your own problems, but now have additional ramiﬁcations and shareholders. You will now be working with an institutional partner with corresponding governance and covenants, and the expectation that more robust ﬁnancial reporting may be required.
- You will have the ability to execute on a management plan, driving growth in rollover equity value.
- You will have the ability to possibly increase your growth efforts and surpass growth projections.
- You must plan for future balance sheet reﬁnancing or a complete exit.
Questions? Contact us at RSM's Center for Business Transition.