Mezzanine debt takes center stage for small business

By Deborah L. Cohen
October 14, 2008

CHICAGO (Reuters) – In the middle of the credit crisis, privately held dairy product maker Kan–Pak needed $15 million in capital, and quickly.

Higher energy and commodity prices had prompted its food–service customers, which include Burger King and Chick–fil–A, to demand more of the company’s shelf–stable products. The Wichita–based company knew it had to jump on the trend, but needed funds to build another costly manufacturing facility and to assist with expansion efforts in China and Mexico, where its customers were building out developing fast–food markets.

When financing from traditional bank sources proved difficult due to the frozen U.S. credit markets, Kan–Pak shifted its efforts toward wooing mezzanine funds — increasingly popular investment vehicles that provide longer–term, unsecured debt capital in companies with bright prospects for long–term growth.

“We talked to a lot of banks, a lot of non–bank funding institutions – AIG, CIT – and you could sense they weren’t as adventurous as they had been in the past five years,” said Dennis Cohlmia, Kan–Pak’s founder, who began looking in April. “We needed to get some growth capital.”

Surprisingly, the company’s financial team found some 30 mezzanine funds willing to hear Kan–Pak’s story. After an extensive screening process, Kan–Pak ultimately found funding from Key Principal Partners, an affiliate of Cleveland–based KeyBank that manages about $1 billion.

“We work directly with privately held companies,” says John Sinnenberg, Key Principal Partners’ CEO, whose firm has taken stakes in private companies ranging from a maker of telephone networks for prisons to a cleaning service for big retailers like Target.

“We invest in really good businesses,” he said. “We find them through senior lenders, accounting firms, law firms, business brokers and small regional investment boutiques.”

These days Sinnenberg and other mezzanine fund managers are getting a lot more calls. Their money has become an increasingly popular financing alternative for small to mid–sized companies, which are often harder pressed to prove their worthiness to lenders than larger companies with higher profiles and more established credit histories.

Companies and buyout firms have raised some $24 billion in mezzanine financing in the first half of 2008, up from $2 billion in the first half of 2007, according to data from Dow Jones.

“If you look at really the last six months, the deal flow from companies has gone up noticeably,” says Michael Kane, managing director for Los Angeles–base Caltius Mezzanine, which manages $1.1 billion. “There is less bank debt out there – we’re getting higher up in the capital structure.”

Leading providers of senior debt have essentially closed their doors to middle market companies in recent weeks, according to banking sources familiar with the situation, as major U.S. banks look to government bailouts for their survival and the world financial markets continue to post record sell–offs.

The sharp increase in mezzanine loans, which are frequently backed in commitments from institutional investors such as pension funds, began late last year as banks struggled with billions in leveraged loans and tightened lending.

Mezzanine derives its name from “middle”; in a company’s capital structure, mezzanine debt is typically positioned below traditional secured bank loans but above equity financing. The debt tends to be longer term, with typical maturities of five to seven years. Because it is not backed by collateral, the financing carries higher interest rates than senior bank debt; investors will also frequently take a smaller, coordinating equity position in the form of warrants, coupons or some related device that gives them the right to some ownership.

But unlike private equity firms, which mezzanine firms often team up with to provide a comprehensive financing package for a company, mezzanine investors typically aren’t looking for control. That’s often very appealing for smaller companies that want to reap the highest returns for their entrepreneurial efforts.

“Private equity is expensive,” says Steve Miller, chief executive for Bulk Handling Systems, a Eugene, Oregon–based maker of equipment that sorts glass, plastic and other recyclables from municipal solid waste. The company recently refinanced its capital structure, largely with mezzanine debt from Caltius. “They’re going to want equity in exchange for their cash.”

“When we go to private equity, really at that moment we’re ready to sell the company and reduce our position,” he adds. “We’re a growing company – it’s just not the time to sell in our minds.”

Just because they’re lending when other institutions aren’t doesn’t mean that mezzanine funds are pushovers. Because they make a long–term commitment, mezzanine investors typically spent lots of time evaluating potential investments through a lengthy due diligence process. Once they commit, they closely monitor the company’s financials staying in close contact with management.

And in recent months, the time it take to close a deal has gotten a lot longer, as fund managers sort through the glut of prospects in search of the best candidates.

“Over the last month or two there’s been some urgent calls placed to us: ‘Can you help solve this or that problem?'” says Ed Ross, managing partner for Fidus Capital, a Chicago–based mezzanine firm with more than $200 million under management. “We are being extremely cautious.”

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About Key Principal Partners

Key Principal Partners (KPP) is a $1 billion private investment firm that provides expansion capital to profitable middle-market companies with at least $30 million in revenue. The firm has the flexibility to provide any combination of subordinated debt, preferred equity and/or common equity in either non-control (minority ownership) or control (majority ownership) positions. KPP can invest between $10 million and $40 million to facilitate the growth, acquisition, refinancing, deleveraging or liquidity needs of private company owners and their management teams. Affiliated with KeyCorp, KPP is headquartered in Cleveland, and has additional offices in Greenwich, and San Francisco.

About KeyCorp

Cleveland–based KeyCorp is one of the nation’s largest bank–based financial services companies, with assets of approximately $97 billion. Key companies provide investment management, retail and commercial banking, consumer finance, and investment banking products and services to individuals and companies throughout the United States and, for certain businesses, internationally. For more information, visit www.Key.com.