What to Expect When You’re Raising Mezzanine Capital

The process for completing a mezzanine financing transaction may seem daunting, but will leave companies better off in the long run.

Companies seeking to grow quickly, either organically or through acquisitions, or complete other objectives beyond the capacity of available senior financing, such as a recapitalization or shareholder buyout, may utilize mezzanine financing. The process for completing a mezzanine financing transaction might seem overwhelming at first, but mezzanine financing is a useful capital raising alternative that is well-suited for a variety of situations. Additionally, working with an institutional mezzanine provider can help companies leapfrog to a new level of sophistication, with better governance, financial systems and capital structure flexibility, leaving them in a better position than they were before.

Mezzanine financing is a type of junior capital that bridges the gap between senior debt financing and equity. With mezzanine, companies can access capital beyond what they otherwise may be able to raise on a senior debt-only basis.

"Before committing to mezzanine financing, a company should be certain it is the right type of capital to meet its need"

Understanding Uses for Capital

Before committing to mezzanine financing, a company should be certain it is the right type of capital to meet its need. Typically, mezzanine is not used as permanent capital, but instead used as solution-oriented capital, that performs a definitive purpose and can be replaced over the medium-term with a more conservative, less expensive type of financing.

Additionally, mezzanine is a patient source of financing that enables businesses to accomplish their goals for growth, whether it is building a larger production facility or accomplishing an acquisition that cannot be completed with only senior financing. Mezzanine financing provides incremental leverage to facilitate a wide variety of growth or shareholder activities, including the following:

Who are the Potential Partners?

To complete a successful mezzanine financing transaction, a company will need to surround itself with a few key players to facilitate the process:

• The Investor — The mezzanine financing provider should act as a partner, and spend the time required to fully understand the business as well as structure the financing in a manner that best fits the needs and goals of the business, its owners and management team. Typical mezzanine providers include mezzanine funds and large institutional investors. It is important to ensure that the transaction opportunity fits within the investment mandate for the investor, such as investment size, business profile as well as investment horizon, and that the investor is aligned with the business owners on supporting the direction and objectives of the business.
• Consultants — Mezzanine investors typically hire third-party consultants to assist them in conducting due diligence; this may include reviewing the historical financial results and long-term prospects of the company as well as performing a commercial assessment of the company and its market position. It could also include utilizing a specialist firm to examine specifics of a business, such as its technology position. Ultimately, the scope of this third party due diligence is determined by the nature of the mezzanine investment, and will be mutually agreed upon between the investor and the company. A company, management team or ownership group may also hire third-party consultants to help them assess capital structure alternatives as well as provide advice on the financing structure and terms.  
• Auditors — If a company does not already have audited financials, investors will require annual audits on a ‘go-forward’ basis.
• Attorneys — Both the company and investor will select legal partners to draft documentation. To facilitate a faster and smoother process, it would be in a company’s interest to choose a legal partner that has experience with mezzanine transaction documentation.

"The process for completing a mezzanine financing transaction can vary depending on the type of transaction and needs of the company, but it generally takes 6-10 weeks"

The Process for a Mezzanine Financing Transaction

The process for completing a mezzanine financing transaction can vary depending on the type of transaction and needs of the company, but it generally takes 6-10 weeks and unfolds as follows:

• Initial Due Diligence — During this stage, the investor learns as much as they can about the business via discussions and Q&A with the company’s management team, company presentations and data/information requests. This information is used by the investor to determine if the company fits within their investment mandate, to assess the risk level associated with providing capital to the company, to hold preliminary internal discussions on the investment opportunity as well as prepare preliminary feedback to share with the company.
• Preliminary Feedback — The investor shares verbal feedback on their investment appetite and potential structure with the company to determine if it fits within the company’s goals, objectives and expectations. This stage enables both parties to decide if there is a ‘meeting of the minds’ on the potential financing, in which case, this feedback can be formalized and expanded upon in the next stage.
• Indicative Terms — Typically, the investor requires a meeting with their investment committee to formally discuss the opportunity before providing a term sheet. Afterwards, the investor sends a term sheet to the company to add further detail to the preliminary feedback provided in the prior stage. The term sheet specifies the economic terms and, structure as well as the investor’s rights and requirements associated with providing capital; it also delineates the relationship between the different participants in the company’s capital structure, including the provider of the senior debt, mezzanine investor and equity owners. The term sheet generally begins as a ‘high-level’ or preliminary document, with additional detail and refinement provided over time, as the investor completes further due diligence, and the company and investor negotiate a transaction structure.

"While the primary purpose of the third-party due diligence is for the investor, the company will often take advantage of this opportunity to further ‘professionalize’ their business"

• Confirmatory Due Diligence (Business Documentation) — Once a general agreement has been reached on the transaction terms, and the company confirms that they would like to proceed with the proposed financing, the investor finalizes their due diligence process; this typically involves the use of third-party consultants, as previously mentioned, to help assess the financial, operational and commercial position of the company. While the primary purpose of the third-party due diligence is for the investor, the company will often take advantage of this opportunity to further ‘professionalize’ their business, and to ensure that the findings of the consultants are useful to the management team.
  
  Following completion of Confirmatory Due Diligence, the investor presents all findings to their investment committee.

• Commitment Letter — After receiving the investment committee’s approval on the financing, the investor provides a commitment letter to the company, confirming the economic terms of the financing agreement.  The term sheet is finalized at this stage.
• Legal Documentation — Legal partners for both the company and the investor are selected, and the transaction legal documentation is completed. During this stage, any remaining business terms are negotiated. If mezzanine financing needs to be expedited, legal documentation can begin at the same time as the Confirmatory Due Diligence stage.
• Funding — Once legal documentation is finalized and the transaction documents have been signed by all parties, the investor transfers capital to the company.

While the process for evaluating and completing a mezzanine financing transaction may appear to be daunting, working with an experienced investor will help simplify this process as well as ensure efficient transaction execution, providing companies with the capital resources needed to grow their business and accomplish their goals. If you’re interested in mezzanine financing, Prudential Private Capital is here to help guide you through each step.