Mezzanine Financing Deserves A Look

October 12, 2004
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GRAND RAPIDS — There's another source of capital out there that is sometimes overlooked by local middle market companies that it could serve.

Michael Arguelles has covered the West Michigan market for Huntington Capital Markets for 18 months. He said it didn't take him long to realize that there was a void in financing for middle market business.

He said he found that many of the companies in the West Michigan market were using equity to support their capital needs instead of cheaper mezzanine capital.

Arguelles believes mezzanine financing can fill that market void and provide an alternative source of capital to help middle market companies grow.

Historically, insurance companies, pension funds and endowments have been the largest providers of mezzanine capital, but providers now include private equity groups, leveraged public funds, commercial banks and investment banks.

Mezzanine financing fits between traditional bank financing and equity investments. According to Arguelles, it's more expensive than a traditional bank loan but less expensive that an equity investment.

In Arguelles' opinion, there's a local lack of information and understanding about mezzanine financing — partly because so few providers are available in the local market.

Another large bank in the area provides a form of mezzanine financing, he said, but he claims that bank's risk tolerance is a lot lower than Huntington's. 

"It's been a process of educating accountants, attorneys, Huntington's commercial lenders, other banks and companies on what the mezzanine product does," he explained.

"Most transactions that have been done in the past in West Michigan have been done either with someone providing more equity than is necessary or a seller providing some financing."

As its name implies, mezzanine capital refers to the layer of financing between a company's senior debt — or bank debt — and equity.

John Irwin, who's in charge of corporate banking, real estate and treasury management for Huntington in West Michigan, told the Business Journal that, "A lot of times, there is a lack of ability to have pure equity, or stockholder equity, because it's sometimes more expensive.

"So some companies that don't have the ability to attract other shareholders, or don't want to, sometimes turn to folks like Mike to bring in that layer of financing that makes their capital structure balance in order for them to perform well with their clients, financial institutions and suppliers." 

When commercial lenders are looking at their exposure — how much they can lend to a company — they typically look at the client company's cash flow and collateral to figure out how much they can lend the business, Arguelles observed.

"But from a mezzanine standpoint," he explained, "we typically lend only on cash flows; we're typically not secured with collateral. So we're taking a little more risk in that we don't have a collateral position."

Comparatively, a traditional commercial loan can run from a 4.5 percent to 6 percent interest rate.

Mezzanine financing rates can run from 12 percent to 20 percent and equity returns usually run 25 percent to 30 percent, Arguelles pointed out.

He said people look to their senior bank for as much financing as the institution can provide and then fill in the rest of their needs with equity.

"What I see happening a lot of times in this market is that people put too much equity in transactions that is not necessary," Arguelles said.

"What they end up doing is paying 25 or 30 percent for that expensive equity as opposed to putting a strip of mezzanine in there to make it cheaper. They don't need equity. They need mezzanine."

Irwin said a company also could use the mezzanine financing alternative when a shareholder wants to cash out but it can't afford to buy back shares out of its existing cash position. So it secures a layer of mezzanine financing, he said, to avoid the more expensive equity route.

Arguelles cited a hypothetical example: A group of shareholders that is no longer active in the business may decide they want some liquidity in their investment. Or an existing owner may have 100 percent of his net worth in the business and wants to keep running the business but wants to take some money off the table. A piece of mezzanine can help achieve either goal, Arguelles said.

"The management buyout is probably one of the most prevalent reasons we see mezzanine transactions," he said.

Irwin said mezzanine also is a good financing alternative for people who want to buy a business but don't have enough pure equity to make the transaction work. For a $10 million business transaction, for instance, they could come in with $2 million in their own cash, put in $2 million in mezzanine financing and $6 million in senior bank financing to achieve their capital structure, he said.

"Having a team of mezzanine experts like Mike and his group is really a gift to our bankers in western Michigan," Irwin remarked.

"It's really nice for us to be able to have these national resources to be able to do things for our clients that many banks can't do."    

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