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DMezzanine loans strengthen borrowers, banks and local economies
by Jean Wojtowicz, President
Cambridge Capital Management Corporation
Every business lender's career includes many instances in which gut instinct conflicts with the obvious need for lender security. These cases occur when a business owner seeks financing without the necessary credit history, something spotty in the owner’s or company's background, or the company’s capital is limited.
In these instances, should you always say "no?" Or should you – as a lender – probe deeper if you have a hunch that the business owner actually has a sound plan and a product or service that the community will support?
Alternative business lending was created for such situations, and a "mezzanine loan" may be the right solution to this problem. The loan's name comes from the Italian word for "half" or "middle," and accurately describes this loan's intent: to provide a level of financing that fits half way between the owner's equity and the senior debt traditionally provided by a financial institution.
Several mezzanine funds exist in Indiana, including at least one is owned by a consortium of banks, called the Indiana Community Business Credit Corporation. The Credit Corp. recently added three new members to its ranks, Charter One, Lake City Bank and First Federal Savings Bank in Huntington. This brings the fund to over $30 million that is provided by 34 financial institutions.
It may help to look at a specific example of how mezzanine funding helped an Indiana company grow quickly and assisted a local bank in developing a strong relationship with that company.
The firm was a three-year old manufacturer of automated machines used to build electric motors. Former employees of a large national corporation that closed its local division started it. The company was growing rapidly and needed to finance $1.5 million of work-in-progress, but it was hampered because the principal owners and employees had placed all the money they could in the company and the local bank's line of credit -- $450,000 – was insufficient to support the company's needs. The bank couldn't go higher because of collateral shortfall and a high leverage ratio. Venture capital and owner financing were not available.
Even though the company was making a profit, its future was in jeopardy.
It was worth a hard second look, though. The local bank was willing to increase its line of credit if it could find additional capital of at least $300,000. It came to the Credit Corp. for the funding, and the deal structure resulted in $600,000 of combined new working capital available to the manufacturer.
The local bank increased the company's line of credit from $450,000 to $750,000, basing its loan on accounts receivable and inventory, and holding a first lien on all corporate assets and the personal guaranty of the principal. It was able to charge prime plus 2.5 percent.
The mezzanine lender's $300,000 was in the form of a three year term loan with a seven year amortization. It held a second lien on the assets and guaranty of the principal. Repayment to the mezzanine lender was structured at prime plus 4.25 percent, plus an annual facility fee of 2.75 percent of the outstanding loan balance. The mezzanine lender anticipated a return of 18 percent. While this rate seemed high – the blended cost of the entire financing package was actually quite reasonable.
The outcome: the mezzanine lender was paid off at the end of three years by the company's refinancing with the local bank; at payoff, the company had increased revenues from $1.8 to over $4 million and net profits were approaching 11 percent; employment had increased by 60 percent to 67 people; and the local bank had developed a new, strong banking relationship with a fully bankable company.
Without mezzanine lending, the company would not have had the opportunity to grow so quickly and the local bank would probably have lost the customer, if the company even survived.
As seen in the example above, mezzanine lenders offer banks a way to stretch further than they can on their own. A mezzanine loan fits between the senior debt and equity portion of the balance sheet. When offered under the right circumstances and at the appropriate time in a company's history, mezzanine financing allows you to make a loan that will build three things: a good business, your community's economic profile, and your bank's portfolio.
Sometimes you can gain the kind of result that brings the governor or the local mayor to the site of your latest economic development success story. And that's good for everyone.
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