CDFA Spotlight: Mezzanine Financing

Overview
Mezzanine financing is a gap financing measure that can be used for growth-oriented small businesses that may not entirely qualify for loans or investments through traditional lending institutions.

Just as the mezzanine is the mid-level of a theater or auditorium, mezzanine funds occupy the middle of the business finance scale – less risky than equity or venture capital, and more risky than senior bank debt.

Mezzanine funds were first popular in the 1980s, taking an important role in financing multibillion-dollar leveraged buyouts. With deals like this no longer prevalent, mezzanine funds have turned to different types of investments.

Today mezzanine financing is more commonly used for companies that have moved beyond the startup stage but do not yet have the footing attractive to more traditional lenders. Still, borrowers are required to demonstrate a proven cash flow, solid management and operations, expanding market scope, and an established business plan.

General Uses and Terms
Small businesses may use mezzanine financing to overcome working capital constraints caused by fast growth; higher-than-acceptable leverage under traditional underwriting criteria; as a means to preserve capital and gain a longer repayment term; and to address credit issues that do not meet bank thresholds.

In addition to business uses such as real estate loans, term equipment loans, and expansion, mezzanine funds may support the development of affordable housing and community facilities.

The applicable terms and rates depend on the use of funds, with working capital and equipment costs on the short end (5-7 years) and real estate extending to 15 years or more. Debt is repayable at the end of the term and carries an annual interest rate between 10 and 15 percent. Amounts vary from community development ($50,000 to $500,000) financing to larger business financing into the millions of dollars.

Sources of mezzanine financing include community development financial institutions (CDFIs), development corporations, insurance companies, mutual and pension funds, and other private investors.

Advantages and Disadvantages
A commonly cited advantage of mezzanine financing is that it is cheaper than equity financing and does not require the company to give up equity. In addition, businesses have more flexibility in meeting their specific cash flow needs; receive long-term commitments from investors; gain new business insights and strategies from lending entities; and receive a source of capital to expand into new markets or products.

Disadvantages include ceding some independence to the lender, which may be unattractive for some who have run their companies entirely independently up to this point. This includes items like a vote on the board of directors for the lender and the ability to hold the borrower accountable for missed projections. Companies may also be steered into spending money in certain areas, according to restrictions on the financing.

Applications for Community Economic Development
While it comprises a smaller portion of the market, mezzanine financing can be of particular help in community development, where community-oriented financial institutions and development corporations have used the tool to bring financing to companies located in low and moderate- income communities that have typically had limited access to financing.

Mezzanine funds in California have been developed to support housing for the middle income workforce, such as teachers, nurses and firefighters; and funds are also in the works to address the urban housing shortage and expenses at-large. In Texas, a mezzanine fund is facilitating the development and expansion of minority-owned small businesses. The following details how the Texas mezzanine fund works and how it is being applied.

Texas Mezzanine Fund, Inc. (Dallas-Ft Worth)
Web address: www.tmfund.com

The Texas Mezzanine Fund, Inc. (TMF) is a statewide Community Development Financial Institution (CDFI) that provides financing for businesses located in distressed areas, minority-owned businesses, and small businesses that create jobs for low and moderate-income people.

TMF also provides financing to for-profit and non-profit developers of single-and multifamily affordable housing for families, senior citizens and households with special needs. Further, TMF provides loans to neighborhood-serving community facilities. A consortium of financial institutions in Texas capitalized the fund.

To qualify for a TMF loan, a business must be located in a distressed and under-served community; or provide more than 50 percent of their jobs to low- to moderate-income workers; or be a minority or woman-owned business.

Investors in the Texas Mezzanine Fund include: Guaranty Bank, $8.8 million; Washington Mutual, $1 million; MBNA Community Development Corporation, $1 million; Wells Fargo Bank, $1 million; Regions Bank, $200,000; First National Bank of Granbury, $250,000; Comerica Bank, $50,000; First State Bank & Trust, $50,000; U.S. Trust Company of Texas, $50,000; Wachovia Bank, $25,000; Southern Dallas Development Corporation $1,000; and ACCION Texas, $1,000.

Example #1 – TMF
The Texas Mezzanine Fund has helped a number of businesses expand or jumpstart operations. TMF assisted a start-up manufacturer of engineered stone locate in rural community that is in a low- to moderate-income census tract. The plant required a total capitalization of $8.5 million. With a $2.5 million capital injection by the company, the plant needed a $6 million loan.

This project posed many challenges, including the start-up nature, introducing a new product to the U.S. market, and the need for start-up working capital until the company could meet threshold for bank asset-based line of credit.

The company was able to qualify based on its equity injection (29%); a solid business plan resulting from extensive research, endorsed by a third party feasibility study engaged by the bank; and a strong and seasoned management with direct industry experience.

The deal proceeded according to these terms: