Mezzanine in an SME context, and when the gap means something else

The gap, and what it is really telling you

The structure is always the same. The senior lender will advance a certain amount against the business's rebuilt earnings. The deal costs more than that. The buyer either cannot or will not put in the difference, and does not want to sell shares. Something has to fill the space.

Subordinated debt, which everyone calls mezzanine, is the instrument that does it. What it is, how it is priced, how rolled-up interest and warrants work and what the intercreditor deed decides are covered in mezzanine finance. This page is about a narrower question: whether it belongs in a deal of the size most buyers in these sectors are doing, and what a gap usually means at that scale.

The honest starting point is that a gap is a symptom, not a diagnosis. It can mean the deal is sound and the buyer is simply short of capital, which is what mezzanine exists for. It can also mean the price is too high, the earnings are weaker than the accounts suggest, or the buyer's contribution has been overstated. Filling the gap with expensive money solves the first case and buries the other three.

Why the economics work against it at this size

Most of the arguments against mezzanine in an SME deal are not about the interest rate. They are about fixed costs that do not scale down.

• Two lenders means two diligence processes. Two sets of questions, two credit committees, two sets of legal fees paid by the borrower, and two timetables that have to converge.
• The intercreditor deed is the same document either way. It takes the same negotiation and roughly the same legal cost on a modest deal as on a large one, and it is paid for out of a much smaller transaction.
• Providers have minimum facility sizes. Below a certain amount the work of underwriting and monitoring the facility is not worth doing, and a buyer can spend weeks discovering that.
• The timetable stretches. Every additional party adds time, and a seller who has agreed a completion date does not always wait patiently while a second lender is found.

Set against the cost of the money itself, which is materially higher than senior debt precisely because it ranks behind, and the total cost of closing a modest gap this way can be out of proportion to what is being solved.

The four things worth exhausting first

More from the seller. Money left in by the seller occupies almost the same position in the structure, usually costs a great deal less, and a senior lender frequently views it more kindly than a commercial subordinated facility because it signals the seller's confidence. It is also a conversation with somebody who already wants the deal to happen. How it has to be ranked to count in the buyer's favour is in vendor finance.

More from the buyer. Contribution is the cheapest money in any structure because it has no coupon. Where it exists and has simply not been counted, it is worth checking what a lender will and will not recognise, which is set out in equity contribution.

Assets that are not working. A business with equipment, vehicles or a substantial debtor book may be able to release funding against them separately, which reduces what the main facility has to cover and closes the gap without adding a layer. Asset-based lending is the route, and it ranks against specific assets rather than sitting in the general queue.

The price. The least popular option and often the correct one. If the gap exists because the price was negotiated on a headline number rather than on what the business earns after somebody is paid to do the work, then filling it means paying for years for a valuation that was wrong. What the rebuild does to a price is set out in valuation basics.

When it is genuinely the right answer

None of the above means the instrument is useless. It works, and there are recognisable situations where it is the best available option.

Where the business generates strong, growing and genuinely predictable cash and the gap is the only obstacle to a transaction that will not come round again. Where the buyer would otherwise have to give away ownership, and doing the arithmetic properly shows that paying a high coupon for a defined period costs less than selling a permanent share of the business. Where a management team is credible and the alternative is losing the deal to a trade buyer. Where the transaction is large enough that the fixed costs stop being the dominant consideration.

The pattern shows up most often where a business has genuinely contracted, long-dated income and the acquisition is competitive, which in these markets usually means facilities management or a contract book that a trade buyer also wants. Predictable income is what makes a subordinated facility serviceable, and competition is what makes paying for it rational.

The comparison that decides it is not mezzanine against senior debt, which mezzanine always loses. It is mezzanine against equity, against losing the deal, and against a smaller deal on different terms.

What it does to the rest of the structure

Three effects are worth planning for rather than discovering.

The senior lender has to consent, because almost every senior facility restricts additional borrowing. That consent is not automatic and it is easiest to obtain before the senior facility is signed rather than after.

The covenant headroom shrinks. A cover test is usually defined against everything the business has to pay, so adding a subordinated layer consumes headroom in the existing test rather than creating a separate one. How the layers interact is covered in stacking facilities.

The real cost may be invisible until the exit. Where the facility carries warrants or a share of value on a sale, that element is paid out of the sale proceeds rather than out of trading, so it does not appear in any monthly figure. A buyer who models only the cash cost of the facility has modelled part of it.

Being told the gap should be closed another way

A provider whose business is filling gaps has little commercial reason to suggest that this particular gap should not be filled, or that the seller should be asked to defer more instead. That conversation has to come from somewhere with no facility to sell.

We know this market and we know the people who fund both layers of it, which is why the useful thing we can do is tell you what the whole structure is likely to look like before you commit to the expensive part of it.

Tell us where the gap is, what the senior position is, and how the business trades. We come back to you having spoken to the right people, including where the answer is that something cheaper closes it first.

We introduce buyers who are acquiring through a limited company or a NewCo. If you are buying personally, as a sole trader or as a partnership, we will point you to an authorised firm directly instead.