Seldom have I seen a financial topic so irrelevant among today’s pro dealers seeking capital yet discussed so frequently as mezzanine debt. The allure of mezzanine debt (also called “mezz debt” or “sub debt”) is high: Additional capital without the ownership dilution associated with equity capital. But when most pro dealers discuss their interest in mezz debt, I can’t help but think of how much better their time would be spent pursuing more feasible capital alternatives.

For most businesses in liquidity crises that have maxed out bank/senior debt availability, mezz debt looks like a desert oasis. But it’s usually a mirage. Mezz debt is relevant for financing acquisitions or expansion of substantially profitable businesses. Companies with negative to mildly positive EBITDA (earnings before interest, taxes, depreciation, and amortization), or with significant existing leverage ultimately learn that mezz debt is only an option for today’s profit-privileged few.

What is Mezz Debt? Mezz loans are cash flow-based loans, secured by junior claims on a borrowing company’s assets. They rank below the bank’s senior claims, thus the “sub” in “sub debt.” Mezz loans are provided by independent mezzanine lenders, as well as finance entities owned by banks, pension funds, hedge funds, and private equity firms. Mezz loans provide borrowings beyond what senior loans will support. In acquisitions, they fill a gap between senior debt and equity to boost acquirers’ potential equity returns. For growing companies, mezz debt can provide capital beyond what’s available from senior debt.

What Does it Cost? Like all debt, sub debt’s greatest unspoken cost is the risk associated with leverage. For lenders, mezz loans carry more risk than bank debt because of their junior lien position and often more highly leveraged borrowers. Hence, mezzanine debt is more expensive—figure 12% to 18% annually in today’s market. Mezz loans charge interest via cash or “pay-in-kind” (accruing non-cash) interest. Mezzanine lenders also often want minority equity warrants—usually less than 5% of your business—or require the ability to co-invest equity along with the sub debt, both to boost their returns. Like other forms of loans, mezz lenders charge closing and annual fees.

Other Terms Mezz debt’s loan covenants focus on cash flow rather than assets, with expense ratios such as debt to EBITDA or EBITDA to interest expense. Today’s mezz lenders typically will fund amounts up to 3.5 times the ratio of total debt (senior plus mezzanine debt) to EBITDA, though a few will go to 4 times. Loan terms are typically three to seven years with “bullet” amortization, meaning no principal is due until maturity. Loan sizes typically start at $3 million. Mezz loans usually have liquidation priority to all non-secured liabilities such as trade creditors but are junior to any bank/senior secured debt. Mezz lenders are passive investors (so long as your loan is performing), but sometimes require a board seat.

Mezz loans can be a fit for buyers or owners of EBITDA-positive companies that have senior debt balances far below 3.5 times EBITDA. They’re good for growing businesses that have significant profitability but are bumping up against senior debt availability, and can stomach additional leverage; or acquirers who want to boost their equity returns via additional leverage. It’s not a fit for companies that are unprofitable or mildly profitable.

Few pro dealers utilize mezz loans today for an obvious reason–the collective lack of profitability among pro dealers. But for a few profit-privileged pro dealers, and for pro dealers in better times ahead, mezz loans can be a relevant part of the capital discussion.

Matt Ogden is managing principal of Building Industry Partners LLC, a building products-focused private equity investment and M&A/debt advisory firm that is a co-founding equity sponsor of US LBM Holdings. E-mail: 214.550.0405