Mezzanine Finance

Mezzanine debt can be an option for companies not having enough assets or
current cash flow to qualify for senior debt, and where re-capitalisation
through equity is not possible or wanted (e.g. conflicting with existing
shareholders). Basically, mezzanine debt serves as a complement to stretch
senior debt structures, especially during difficult high yield market
conditions. It is used as a funding tool, especially in the following cases of
LBOs/MBOs, acquisitions or organic expansions, re-capitalisation or restructuring.
Mezzanine debt can be negotiated and structured individually to
match exactly the financial requirements of a company. Due to this
customised approach, transactions are non-registered and of relatively small
size. It is normally used as a part of a broader financing package.


Definition

Mezzanine debt provides an additional layer of financing between senior secured
debt and equity. More precisely, it is a hybrid finance product incorporating
equity-based options/warrants with a second priority debt. Due to its flexible
nature a mezzanine investor is thus able to benefit from the capital preservation
and current-pay features of a loan and, at the same time, seek significant upside on its investment through the equity participation.

It is typically secured with the same assets as the senior secured debt, albeit on a
junior basis. Covenants and the definition of default events are also very similar to
the senior debt. In most cases mezzanine debt is structurally equal to senior debt,
only contractually subordinated through an ‘inter-creditor agreement’.

The subordination of loans creates a risk that will not be compensated solely by the coupon of the debt. Additional ‘equity kickers’ give investors a stake in the
company’s upside potential and makes mezzanine performance dependent on the
company’s ability to generate current and future cash flows. Therefore, mezzanine
debt is often considered as ‘quasi-equity investment’.

The equity component usually comes in two forms:

• Warrants. Typically, warrants are detachable and, thus, liquid instruments.
As the exercise price of an attached warrant usually is substantially below the
market value of the company’s stock, it will have a value at least equal to the
difference between the market value of the stock and the exercise price. These
warrants will typically have a ten-year term. Mezzanine lenders may also
require a put option on the warrant (and on any stock purchased with the
warrant) in order to secure the initial value.

• Payment-in-Kind (PIK). PIK is used in mezzanine financing as a way to earn
or generate interest at a time when the company does not generate the cash
flow necessary to pay interest on the senior debt and mezzanine debt. With
PIK financing, interest continues to accrue and is compounded with additional
interest. At some point, PIK interest is converted into cash paid interest or the
debt matures or is refinanced.


The Mezzanine Loan Market

Historically, the European mezzanine market evolved primarily in smaller buyouts
to provide a means of stretching leverage using subordinated debt. The macro
trend in the LBO market has been towards larger buy-out sizes, which has driven
the growth of a high yield market in Europe since 1997/8. Mezzanine-like bridges
have been used to bridge to a high yield or securitised take-out in several larger
structures, but the development of permanent mezzanine financings of size (i.e.
>$100m) has been slower.

There are two influential factors impacting the development of the European mezzanine market:

• The emergence of an investor base focused explicitly on larger-ticket
mezzanine deals should drive a movement towards the use of mezzanine
funding, as an alternative to high yield financing in larger buy-outs. At the
same time, the core base of providers of small-ticket mezzanine funding to
smaller buy-outs should remain stable.

• The other macro driver is the state of the LBO market, which is dependent on
the cash position of private equity funds, level of valuation of the public
equity market and restructuring of large industrial companies.

A new trend is to more variety in the composition of the mezzanine product. Some
banks are marketing a "fixed rate" mezzanine product (i.e. return is cash pay and
PIK, but no equity warrants). Although the classic European mezzanine product is
still in the LIBOR+12% area with the margin divided roughly equally into cashpay,
PIK and warrants.