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Reprint Perspectives on the Capital Markets W I N T E R 2 0 0 4 REPRINT PERSPECTIVES ON THE CAPITAL MARKETS W I N T E R 2 0 0 4 Mezzanine Financing An intermediate stage of capital, mezzanine is typically employed by middle-market companies to fill a shortfall in financing. by Michael T. Newsome ezzanine is a tier of higher-risk capi- The two primary situations where mezzanine tal almost exclusively geared toward ......... is typically employed are: Mprivately held companies with spe- Mezzanine financing is Funding a capital investment as part of a cific event-driven financing requirements. major plant expansion or an acquisition that This capital combines the characteristics of commonly an event-driven is intended to provide significant growth; or debt and equity, and is often referred to as transitional source of funding, Re-engineering the capital structure in subordinated debt. Like the architectural providing funding for high- order to buyout one or more shareholders, or term from which it is derived, mezzanine pay out a special dividend. financing represents an intermediate stage rate-of-return investment In the former case, the new investment is of capital, squeezed between senior secured opportunities for mature, expected to be the catalyst for a significant loans and equity financing. developed companies. increase in corporate value. The latter situ- Mezzanine is the private equivalent of ation is designed to maximize equity returns public high-yield debt. Issuances usually It makes sense in circum- through the application of financial leverage. range in size from $3 million to $25 million, stances where the investment The most suitable mezzanine candidates but can be as large as $150 million. In most will earn a return that are mature businesses with stable or grow- cases, public high-yield debt is a more attrac- ing margins, defensible market positions, tive alternative for financings in excess of creates incremental value well-defined strategies, and competent man- $100 million. for the equity holders. agement teams. It is not a high-risk capital APPLICABLE SITUATIONS ......... source that will step up when the bank balks Mezzanine capital is typically employed because of performance problems. Likewise, by middle-market companies (revenue of $20MM to $500MM) to fill a shortfall in -fi nancing imposed by limitations on secured SENIOR SECURED JUNIOR SECURED HIGH YIELD MEZZANINE PRIVATE EQUITY borrowings, because of either insufficient Rank Senior Structural Contractual Structural/ Junior to all debt Subordinate Subordinate Contractual collateral or excessive financial leverage (the Subordinate ratio of debt to cash flow).These two vari- Security 1st liens 2nd liens Unsecured Unsecured/ N/A ables, which are key determinants of senior secured debt capacity, tend to move up and down, depending on the appetite of bankers for Term 5-7 years 5-7 years 10 years 5-8 years N/A new business. Coupon Cash Pay Cash Pay (fixed) Cash Pay (fixed) Cash Pay & Dividends Mezzanine is commonly an event-driven (floating) PIK (fixed) transitional financing source, providing fund- Pricing ing for high-rate-of-return investment op- Upfront Fees 1-2% 1-2% None 2-3% Varies Interest Rate L+200-300bp 11-13% 11-14% 12-14% N/A portunities for mature, developed companies. PIK N/A N/A N/A 4-6% N/A It makes sense in circumstances where the in- Warrants N/A N/A N/A Almost Always N/A vestment will earn a return that creates incre- All-in Pricing L+350-500bp 12-14% 9-10% 15-22% 25%+ mental value for the equity holders. In other Covenants Comprehensive Comparable to Incurrence tests Financial None words, if an investment is realistically antici- Sr. Debt Maintenance pated to provide a 12% return on capital, it Tests; cross makes little sense to fund it with subordinated default with senior lender debt that requires an 18% return. Companies tend to use mezzanine as bridge financing Prepayment Generally Generally Expensive call Expensive call N/A permitted w/o permitted w/o premiums premiums in the for events of this type. Once the anticipated premium premium first 2-3 years cash flow benefits begin to be realized from an Capital Providers Banks and Asset Specialized Institutional Banks, Insurance Private Equity acquisition or a major capital investment and Based Lenders Asset Based Investors via Companies, Firms senior debt capacity expands, the relatively Lending Firms Public Offering Mezz Funds and high cost of mezzanine capital provides a Private Equity strong economic incentive to replace it. Firms (continued p.2) 1 INSIGHT REPRINT WINTER 2004 it is not suitable for early-stage, emerging- attracted to mezzanine for several reasons. as a method to tie the lender’s return to the technology, or turnaround situations. Flexibility and patience – relative to incremental value of the business that their TYPICAL TERms senior debt, mezzanine is typically structured capital helped create. The lender’s funda- Mezzanine investments are typically with a longer term and requires little or no mental objective is to earn a return that is structured as a term note, coupled with an amortization in the first three or four years of commensurate with the business and finan- “equity kicker” in the form of either warrants its tenor. It is common to see subordinated cial risk taken. for the purchase of a minority share of com- debt structured as a five-year bullet loan.The MEZZANINE PROVIDERS mon stock at a nominal cost, or a deferred covenants usually contain less-restrictive fi- Historically, the most active providers fee. Investors/lenders earn their return from nancial tests that focus on maintaining cash of mezzanine capital have been insurance the combination of: flow and limiting financial leverage. companies and dedicated mezzanine limited An upfront commitment fee, Control – although more expensive than partnerships funded by institutional inves- Interest paid on a current basis, ......... tors, such as pension funds and endowments. Accrued interest added to the loan and In recent years, the field of mezzanine provid- paid on a deferred basis (known as payment- The most significant benefit ers has expanded to include leveraged public in-kind or PIK interest), and of mezzanine is that it funds and the captive mezzanine lending Value realized from warrants as the compa- arms of private equity firms, commercial ny’s equity value increases. reduces the amount of banks and investment banks. The private Mezzanine providers customarily target equity that is required to mezzanine market was quite robust during annual, all-in rates of return in the 15% to fund a transaction. the late 1990’s - growing in concert with the 22% range over the life of an investment. ......... overall M&A activity. As leveraged lending Required returns vary based on the degree of cooled and M&A activity sputtered during financial leverage, the size of the company, senior debt, mezzanine does not impose the the past three years, the weak volume af- the strength and stability of the cash flow shareholder dilution and loss of control that fected the demand for mezzanine.With senior and the competition among lenders to pro- is part and parcel of private equity. lenders still showing conservatism, the mar- vide the capital. The table above provides a Leverage – mezzanine is an effective way ket upturn is returning mezzanine to being an comparison of the conventional terms and to expand the total debt capacity of a busi- important component of leveraged finance. cost of mezzanine relative to other tiers of ness beyond the collateral and cash flow CONCLUSION capital. constraints imposed by senior lenders. It is fair When a significant opportunity presents The one area where mezzanine tends to to note that senior lenders tend to view com- itself to increase the value of the business, be decidedly less flexible than senior debt is panies supported by institutional lenders/in- and the bank is unwilling to provide all of the call protection. Mezzanine often carries steep vestors more positively. These firms are often necessary funding, mezzanine can provide prepayment fees designed to keep the capital rewarded with more favorable credit terms. the bridge capital to make that step without in place for as long as possible. A typical call- The most significant benefit of mezzanine suffering significant shareholder dilution. protection provision would require a prepay- is that it reduces the amount of equity that We have been involved as advisors and ment fee of 5% of principal in the first year and is required to fund a transaction. Although placement agents in a number of situations ratchet down by 1% in each succeeding year. mezzanine is expensive relative to senior where clients have used mezzanine to supple- The note can be repaid without any penalty debt, it is substantially cheaper than equity. ment senior debt, in order to fund major stra- by the end of the fifth year. When the interest For owners of closely held businesses, the tegic opportunities. The ability to fund the meter is running at 15% or more per annum, idea of parting with some amount of owner- business strategy with mezzanine propelled it often makes sense to repay the mezzanine in ship can be a major deterrent to the use of these companies to a new level and gener- spite of the high prepayment costs. mezzanine. Nevertheless, mezzanine inves- ated attractive returns to the shareholders. WHY MEZZANINE? tors are not long-term shareholders bent Owners of privately held businesses are on control. The warrants are simply used ABOUT ZACHARY SCOTT Zachary Scott is an investment banking and financial advisory firm founded in 1991 to serve the needs of privately held, middle-market companies. The firm offers a unique combination of in-depth knowledge of the capital markets and industry competitive dynamics, sophisticated analytical capabilities, and proven expertise in structuring and negotiating complex transactions.
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