Selecting the Right Kind of PE Partner for your Life Science Firm: Part 3 – Mezzanine Debt Funds

29 Jan

By Danielle Silva, Director of Research, LSN

For life science firms, choosing the right kind of private equity fund to partner with can be a difficult task, especially if the business owner does not wish to give up a great amount of their firm’s equity. This issue can be exacerbated if the firm needs further capital in order to grow the business, or possibly finance an acquisition. Last week, we looked at one source of expansion financing, which were private equity groups that use a “growth capital” strategy. This week, we will explore another source of growth financing – mezzanine debt funds.

Mezzanine debt is usually considered a kind of hybrid financing – financing which lays somewhere between debt and equity in a firm’s capital structure. Therefore, mezzanine debt has some characteristics of equity, and some characteristics of debt, falling between senior debt and equity. Some forms of mezzanine debt are convertible debt (meaning the debt issuer has the right to convert the debt into equity), and senior subordinated debt; mezzanine debt is accordingly more junior debt, which means that mezzanine debt issuers are paid back after senior debt holders. Mezzanine debt, however, is senior to equity.

Mezzanine debt is an attractive form of financing for life science firms because it allows business owners the opportunity to access more debt, and thus finance growth or expansion activities without having to give up a good amount of equity. In many cases, business owners will not have to relinquish any equity at all.

Because mezzanine debt is subordinated, however, it has a higher interest rate than senior debt. This is because it is perceived as riskier than senior debt; mezzanine lenders are paid back after senior debt holders. Senior debt holders are essentially the first group to get repaid in the case of liquidation, followed by senior subordinated debt holders (mezzanine lenders), then preferred stock holders, and finally the remainder of the equity stakeholders. Because mezzanine lenders are thus essentially second in line for repayment; there is a higher default risk for mezzanine debt.

One important fact about mezzanine debt is that it is only issued to firms that are cash-flow positive – meaning that mezzanine private equity groups would not issue debt to a pre-revenue company, such as a biotech therapeutics company in pre-clinical development. Mezzanine firms would, however, issue debt to a therapeutics company that, for example, has a couple of products on the market and was seeking to acquire a smaller biotech therapeutics company in order to grow market share.

There are many advantages to using mezzanine debt over other forms of financing; the first, as aforementioned, is that firms have less equity dilution with mezzanine financing than with other forms of private equity – even less so than with growth equity groups who typically do not take a controlling equity stake. Generally, mezzanine lenders will take an observer position (non-voting) on the firm’s board of directors, whereas growth equity funds typically are more operationally focused, and will take an active board seat.

Another advantage is that mezzanine loans are typically longer-term than other forms of debt, and require interest-only payments until their maturity date. Some of the downsides of mezzanine funding are that it is a lot more expensive than other forms of debt, with higher interest rates than other forms of financing.

Furthermore, mezzanine funds may sometimes require firms to give up a portion of their equity upside in order for the fund to achieve their desired rate of return on the debt instrument. Thus for life science firms who are seeking an alternative form of debt to senior debt, and are looking for a form of funding that requires little to no equity dilution, a mezzanine lender may be the solution.

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