Mezzanine debt is capital layer below senior debt and above equity. Its use in an M&A transaction provides flexibility in the capital structure, increases debt capacity and reduces the amount of equity that is needed to close the deal. These are distinct advantages for both the lender as well as the borrower.
In terms of composition and pricing, subordinated debt in the middle market usually has two main components: (a) coupon debt which tends to be priced at 12% to 14% depending on market conditions and (b) an equity component in the form of warrants with an associated “put” option to provide liquidity to investors. When taken together, these two elements provide the lender a targeted all-in return of about 21% to 25%.
Generally, the most common range for mezzanine financing is $5m to $10m representing about 1x the company’s latest-twelve-month EBITDA. Its uses range from acquisition financing and re-capitalizations to growth financing and management buyouts. The average loan term tends to be 4-5 years.
It is important to note that not all companies are good candidates for subordinated debt. The preferred candidates for this type of financing involve companies with stable earnings and cash flow such as manufacturing companies and low- to medium-tech retail and distribution firms. Other important factors considered by investors include the breadth and depth of the management team, an established product line and a defensible market niche. Mezzanine debt is not appropriate when a company is in an early stage, lacks consistent cash flow or when there is too much debt already on the balance sheet.
On the legal side, there are three important issues that companies seeking subordinated debt financing will face:
- Default provisions
- Warrant terms connected with the debt
- Subordination with other capital layers
Borrowers should carefully examine the loan covenants associated with the subordinated debt and seek a meaningful period to “cure” a default on these covenants. It is not uncommon for a company to trigger a “technical” default which in turn would trigger a violation under a senior’s lender loan arrangement. Some of the common covenants included by mezzanine lenders include restrictions associated with the sale of any assets, acquisition of other companies or product lines and/or repurchase of their own stock. Additionally, it is common for sub-debt lenders to ask for a board seat or board visitation rights.
As previously stated, warrants are typically issued to the lenders in conjunction with the subordinated debt. It is critically important to examine the conditions under which the lender can “put” the warrants to the company, the right of the company to “call” the warrants, how the warrants will be valued and whether or nor there is an upside “cap” on the value of the warrants.
Lastly, to ensure their rights in relation to other lenders, there is often an intercreditor agreement associated with the subordinated debt. It typically involves negotiations between the subordinated and senior lenders as well as the borrower. The objective is to adequately secure the lenders’ rights regarding their loan positions.
Overall, mezzanine debt is an important tool in corporate finance as it can greatly facilitate closing a financing gap in M&A transactions that otherwise would not be possible to execute. However, it is important for companies seeking subordinated debt to insure that they have an appropriate debt load and the operational stability to service it.
About Enrique Brito
Enrique Brito is a senior financial executive and a principal at Kaizen Consulting Group. He is a national instructor and lecturer on M&A, business valuation and negotiation topics. Learn more about him here and connect with him on Twitter.
Copyright © 2012 Kaizen Consulting Group, LLC, All Rights Reserved
On Value 