From Buyouts To Small Biz

Mezzanine funds, big players in the mega-mergers of the 1980s, now cast their net in search of smaller growth firms.
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Medport LLC was poised to take its biggest step ever. The Providence, R.I., manufacturer of medical devices had just signed a licensing agreement with watch manufacturer Timex to design and market digital thermometers carrying the Timex brand. Now, CEO Jeff Jacober -- who founded the company in 1996 with bank loans and his own savings and nurtured it into a business that does $15 million a year in revenue -- needed cash to build up enough inventory to service the big pharmacy chains. "We needed money to make the leap forward," Jacober says. "We really wanted external capital."

What Jacober didn't want was a new investor second guessing his decisions. That ruled out venture capitalists, as well as most other equity investors. Taking on more bank debt wasn't an option either, as bankers would have balked at the amount of debt already on Medport's balance sheet. So Jacober turned to a so-called mezzanine lender, Ironwood Capital Advisors LLC, based in Avon, Conn. Within weeks, Medport had an agreement in principle for $1.5 million.

Few entrepreneurs think about mezzanine financing -- and it's little wonder why. Such funds came of age in the 1980s, when they played an integral role in financing that era's multibillion-dollar leveraged buyouts. Such deals, of course, haven't exactly been commonplace in recent years, which has mezzanine funds searching for alternative investments. Increasingly, that means privately held, small and medium-size businesses that exhibit promise but have trouble obtaining adequate bank credit or venture capital. "The goal is to find an established business with a good growth plan," such as an acquisition, or the development of a new product, says Dan Gardenswartz, principal of Sage Group LLC, a Los Angeles - based investment bank.

As the name implies, mezzanine funds sit roughly in the middle of the corporate finance scale, between the least risky (senior bank debt) and the most risky (equity or venture capital investments) -- just as the mezzanine section of a theater is sandwiched in between the orchestra seats and the balcony. Their investments are typically hybrids, involving subordinated debt with an equity component. In most cases, the debt is repayable in a single "bullet" payment in five years' time and carries an annual interest rate of 12% to 14%.

That may seem high, but it reflects the higher degree of risk mezzanine lenders are willing to assume. Besides, equity investors often seek returns of 30% or more. What's more, while equity investors typically demand a say in running the company, mezzanine funds tend to be more passive, just slightly more meddling than your average bank. Deal size can range from $1 million to $150 million, bankers and financiers say. "Next to bank debt, ours is the cheapest source of capital," says Marc Reich, president of Ironwood Capital Advisors.

For Jacober, Ironwood was a perfect partner. Not only does Ironwood believe in his plan, the fund has experience investing in companies in the wholesale distribution business. "If we get some kind of unexpected hiccup in the business plan, they won't panic," Jacober says. He used the $1.5 million to finance the Timex expansion and pay down bank debt -- which will allow him to use bank debt for any future financings. In exchange, he will pay 12% a year in interest for the next five years and has given Ironwood warrants to acquire about 5% of the company's stock.

Such warrants, which are part of most mezzanine deals, are designed to give lenders some additional upside potential. But in most cases, entrepreneurs don't have to worry that their lender will suddenly become a fellow shareholder. "The last thing I want to do is convert those warrants into stock," says Ironwood's Reich. Instead, he sees the warrants as a way to earn another 8% or so on his investment. That's because at the end of the five-year lifespan of the funding, the borrower usually buys back the warrants at a valuation adjusted to reflect any improvement in fundamentals.

Most large cities have a number of mezzanine lenders on the lookout for deals. Unaffiliated with any single leveraged buyout firm or any one venture capital firm, these players are casting a wide net in search of companies to back. But be warned: Mezzanine financing isn't for everyone. Young companies with unreliable cash flow, for example, could have trouble making the high interest payments. The same goes for highly cyclical businesses. In the case of default, mezzanine funds may be more likely than other investors to liquidate what's left, rather than attempt to restructure and rebuild. The funds simply are not inclined to become hands-on owners of failed investments. But under the right circumstances, it can be just the ticket. Six months after completing their financing deal, Reich and Jacober are both happy with their pact. Jacober is forging ahead and making his interest payments to Ironwood on schedule. "We're actually ahead of plan," he says.

Last updated: Aug 1, 2003




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