Mezzanine capital

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Mezzanine capital
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Mezzanine capital - is the layer of company financing that sits between senior debt and common equity: it is subordinate in priority of payment to senior debt, but ranks ahead of common stock. In practice it takes the form of subordinated debt, convertible debt or privately placed securities such as debt with warrants or preferred equity[1].

The name comes from architecture. A mezzanine is the floor squeezed in between two main storeys, and mezzanine money is squeezed in between the bank's loan and the owners' cash. It behaves like debt most of the time (fixed interest, a maturity date, covenants) and like equity at the very end, when the lender collects a share of the value the company has created. That double nature is why the instrument is classed as a hybrid instrument. Lenders accept a weaker claim than the bank. In exchange they want a much higher return.

Position in the capital structure

A company's financing can be pictured as a stack. Claims at the top get paid first in a liquidation and carry the lowest price; claims at the bottom are paid last, absorb the first losses and expect the highest return. Mezzanine is the last layer that still looks like a loan. In a typical leveraged buyout, debt covers 60 to 90 percent of the purchase price, and the debt "almost always" includes a senior secured loan, often joined by a junior, unsecured portion financed by high-yield bonds or mezzanine debt[2].

Rank in liquidation Layer Typical security Who usually provides it
1 Senior secured debt (first lien term loans, revolving credit facilities) First-ranking charge over assets and shares Banks, institutional loan investors
2 Second lien loans; unitranche (one blended facility combining senior and junior tranches) Second-ranking charge on the same collateral (unitranche: one security package) Direct lenders, credit funds
3 Mezzanine (senior subordinated and junior subordinated notes) Unsecured or junior security, subordinated by contract Mezzanine funds, insurers, specialist lenders
4 Preferred equity None; priority over common shareholders only Mezzanine and private equity funds
5 Common equity None; residual claim Owners, private equity sponsors, management

Rank 2 deserves a short comment. Second lien loans and unitranche facilities are younger products than classic mezzanine, and in many deals they now compete with it. They are secured, so a lender recovers more in a default. Mezzanine is usually not secured, or holds only a junior claim. A secured creditor sitting above it gets paid out of the collateral first.

Bond Capital, a Canadian mezzanine lender, summarised the differences in a simple grid. Senior debt is secured, has tight covenants and a floating coupon, and its recovery rate is high. Mezzanine is subordinated, has flexible covenants, a fixed coupon and warrants as its equity kicker, and its recovery rate is low. Equity has no security and no covenants at all[3].

Instruments and features

Mezzanine isn't one product. It's a family of contracts that lenders and borrowers mix and match. The usual building blocks are:

  • Subordinated notes - the core of most deals. A subordination clause or a separate agreement makes the notes junior to the senior loan in payment and in bankruptcy. "Senior subordinated" notes rank above any other subordinated debt the company may have; "junior subordinated" notes rank below it.
  • Cash interest - a fixed coupon paid quarterly or semi-annually. Bond Capital describes cash-pay rates of 12 to 18 percent on the debt portion[4].
  • PIK interest (payment in kind) - interest that isn't paid in cash but added to the principal, so the next period's interest is charged on a larger balance. PIK keeps cash in the company during the years when the senior loan is being amortised. The cost is simply pushed to maturity, and it compounds.
  • Equity kicker - the part that makes the deal "mezzanine" rather than just expensive debt. It usually takes the form of warrants to buy common shares at a nominal or fixed price, or a conversion right. The remainder of the lender's target return, above the cash coupon, comes from warrants or from PIK interest[4]. Warrants are measured as a percentage of fully diluted shares.
  • Preferred equity - used where the borrower can't take more debt, or where the senior lender forbids it. Preferred shares carry a fixed dividend, often cumulative, and a liquidation preference over common equity. Unlike interest, preferred dividends are normally not deductible for tax.
  • Intercreditor agreement - the contract between senior and mezzanine lenders. It sets payment blockages (mezzanine interest can be stopped if the senior loan is in default), standstill periods during which the mezzanine holder may not enforce its claim, and rules on how the senior loan can be amended or refinanced.
  • Covenants - mezzanine lenders usually mirror the bank's covenant package with looser thresholds. Bond Capital gives an example: if a bank caps total debt at 3.5 times EBITDA, the mezzanine lender would accept something closer to four or five times[5].
  • Bullet repayment - principal (plus accrued PIK) is repaid in one amount at maturity, after the senior loan, rather than in instalments.
  • Tenor and call protection - maturities of five to seven years, with the right for the borrower to repay earlier[4]. Early repayment usually triggers a prepayment premium in the first years, so that the lender still earns a minimum return.

Most mezzanine positions are taken out by a sale of the company or by a recapitalisation that replaces them with cheaper senior debt. The IPO exit, the "home run", is rare. A typical transaction runs for 5 to 8 years, with the possibility of an earlier exit[4].

Typical uses

Who borrows this way? Mostly companies that are already cash-flow positive. Start-ups without revenue go to venture capital instead, because mezzanine lenders need cash to pay their coupon from day one. The main situations are:

  • Leveraged and management buyouts - the classic use. Mezzanine fills the gap between what the bank will lend against cash flow and what the sponsor wants to put in as equity. When SunGard Data Systems was bought in 2005 for $11.9 billion, the $8 billion of debt was split into $5 billion of senior secured debt and $3 billion of subordinated debt, with $3.6 billion of equity on top[2].
  • Growth financing - a new plant, a new product line or a new distribution channel, where the owners don't want to sell a large equity stake[1].
  • Recapitalisation - owners take money out of the business, for example through a dividend recapitalization or a partial buy-out of a retiring shareholder; this also covers refinancing of existing debt.
  • Acquisitions - the buyer funds part of the price with mezzanine as part of an acquisition financing package in mergers and acquisitions. Bond Capital gives a worked case: a $20 million purchase where the bank lends only $7.5 million alone, but agrees to $10 million once a $5 million mezzanine tranche is added, cutting the owner's equity from $12.5 million to $5 million[3].
  • Real estate mezzanine - here the loan is usually not secured on the building at all. The mortgage lender holds the property; the mezzanine lender takes a pledge of the shares or partnership interests of the company that owns the property. If the borrower defaults, the mezzanine lender can take over that company (and the building with it) subject to the mortgage, which is why an intercreditor agreement with the mortgage lender is standard.
  • Project finance - occasionally, as a layer between project debt and sponsor equity.

Cost and return

Mezzanine is cheaper than equity and dearer than bank debt. That's the whole proposition. The pricing quoted in practitioner literature is reported as ranges, not single numbers.

Bond Capital's 2006 paper shows a typical private-equity structure: senior debt and asset-based lending making up 30 to 60 percent of assets, with expected returns of 5 to 12 percent; mezzanine at 20 to 30 percent of assets, with 13 to 25 percent; and equity at 20 to 30 percent, expecting 25 percent or more[6]. In the same paper, mezzanine investors are described as "looking for between 15 and 25 percent IRR" compared with 25 to 50 percent for equity investors; a chart based on Fleet Securities data for 1998-2001 puts the median targeted return at about 20 percent[5]. Those are targets. Realised returns depend on defaults and on what the warrants turn out to be worth.

Markets differ. A 2019 study of Russian practice reports mezzanine current rates of 18-20 percent with a target return of 25 percent, allowed debt of 4-6 times EBITDA (against 2-3 times for a bank loan) and terms of 2 to 5 years[7].

For the borrower, the relevant figure is the all-in cost after tax. Cash and PIK interest on subordinated debt is usually deductible, subject to local limits on interest deductibility and thin capitalization rules. The warrant cost is non-cash but real: it is paid by existing shareholders through dilution. The lender's view is captured by the required rate of return on the whole package:

\[-P_0 + \sum_{t=1}^{n} \frac{C_t}{(1+IRR)^t} + \frac{B_n + W_n}{(1+IRR)^n} = 0\]

where:

  • P0 - amount lent,
  • Ct - cash interest received in year t,
  • Bn - outstanding balance repaid at maturity (principal plus capitalised PIK),
  • Wn - proceeds from the warrants at exit,
  • IRR - the lender's internal rate of return.

With PIK compounding annually, the balance at the end of year t is:

\[B_t = P_0 \times (1 + r_{PIK})^t\]

Example of mezzanine capital

The figures below are hypothetical. A mid-sized manufacturer is bought by a private equity fund. On top of the bank loan, it raises 10 m of mezzanine notes for 5 years on these terms:

  • cash interest 10% a year, charged on the outstanding balance (including capitalised PIK),
  • PIK interest 2% a year, added to the balance and compounded annually,
  • bullet repayment of the whole balance at the end of year 5,
  • warrants for 4% of the fully diluted equity, with a nominal exercise price.
Year Opening balance (m) Cash interest 10% (m) PIK accrued 2% (m) Closing balance (m)
1 10.000 1.000 0.200 10.200
2 10.200 1.020 0.204 10.404
3 10.404 1.040 0.208 10.612
4 10.612 1.061 0.212 10.824
5 10.824 1.082 0.216 11.041

Over five years the lender receives 5.204 m in cash interest. PIK adds 1.041 m to the debt, so the repayment at maturity is 11.041 m (10 m × 1.025). Without the warrants, the notes yield exactly 12% a year, because both coupons are charged on the same growing balance (10% cash + 2% PIK).

Now the kicker. At the end of year 5 the fund sells the company with an equity value of 75 m. The warrants for 4% are worth 3.0 m. Year 5 cash flow to the lender is therefore 1.082 + 11.041 + 3.000 = 15.123 m, and total receipts over the life of the deal are 19.245 m on 10 m lent. Solving the IRR equation for the flows (-10; 1.000; 1.020; 1.040; 1.061; 15.123) gives about 16.2%, which is inside the 15-25% range quoted above[5]. If the exit value were only 45 m, the warrants would bring 1.8 m and the IRR would drop to about 14.6%. If the company failed, the warrants would be worthless and recovery on the notes would depend on what was left after the senior lenders were paid.

For the company, the cash burden is 1.0-1.08 m a year, rather than the 1.2 m that a 12% all-cash coupon would demand from year one. That gap is the point of PIK. It lets the business put more of its early cash flow toward the senior loan and the debt service coverage ratio the bank is watching.

Advantages of mezzanine capital

For the issuer:

  • less equity is needed, so owners keep control and suffer less dilution than in a straight equity raise[6],
  • cheaper than new equity on a risk-adjusted basis, and interest is usually tax deductible, which can lower the overall cost of capital (see optimal capital structure),
  • flexible structure: PIK interest, bullet repayment and looser covenants fit companies with lumpy cash flows,
  • banks may lend more once a mezzanine layer sits below them, since it acts as a cushion[3],
  • faster and more private than a public bond issue; terms are negotiated with one or a few lenders.

For the investor:

  • contractual cash income plus equity upside through the kicker,
  • call protection and prepayment premiums guard the minimum return,
  • covenants and information rights give earlier warning than a shareholder would get,
  • higher expected returns than senior loans, with a prior claim over common equity[6].

Limitations and risks of mezzanine capital

  • Cost - all-in cost in the mid-teens or higher is several times the price of senior debt. A business whose returns on new investment fall below that cost destroys value for its owners. Mezzanine raises the company's debt-to-equity ratio and fixed charges.
  • Dilution - warrants or conversion rights hand part of the upside to the lender. Family-owned firms are often reluctant to accept mezzanine for exactly this reason[3].
  • Subordination - the lender is paid only after senior creditors. Payment blockages in the intercreditor agreement can stop cash interest for long periods if the senior loan is in trouble.
  • Low recovery - in a default, unsecured subordinated claims recover far less than secured loans; Bond Capital rates mezzanine recovery as "low" against "high" for senior debt[3]. The real value of a junior claim is set by the liquidation value left after the senior layers.
  • PIK compounding - deferred interest grows the debt. If the business underperforms, the balance at maturity can exceed what the company can refinance.
  • Covenants and control - even looser covenants restrict dividends, acquisitions and new borrowing. Breaches can give the mezzanine holder board seats or other control rights.
  • Refinancing risk - bullet repayment means the company must sell itself or raise new money at maturity, which is hard when credit markets are closed.
  • Illiquidity - for the investor, private mezzanine positions are hard to sell before exit.

History

Mezzanine finance grew up with the American buyout. Leveraged buyouts first became an important phenomenon in the 1980s[8]. In that decade, according to Bond Capital, the mezzanine business was dominated by insurance companies and savings and loan associations; limited partnerships entered in the 1990s, followed later by pension funds, hedge funds and banks with stand-alone mezzanine units[5].

Then came the junk bonds. Kaplan and Stein studied 124 large management buyouts completed between 1980 and 1989 and found that, over the decade, private subordinated debt was replaced by public debt and the use of "strip financing" (where investors held a vertical strip of several layers of the capital structure) declined. Prices paid rose relative to cash flow, and required bank repayments came faster[9]. The investment bank Drexel Burnham Lambert, led in this business by Michael Milken, built the public high-yield market that financed much of that junior debt. The first buyout wave peaked with KKR's purchase of RJR Nabisco in 1988-1989. Shortly after, the junk bond market crashed following Drexel's demise in 1990, many high-profile buyouts ended in default and bankruptcy, and public-to-private deals virtually disappeared by the early 1990s[8].

Leveraged buyouts of private companies and divisions carried on through the 1990s, and so did private mezzanine, now increasingly run by limited partnerships, which suited mid-sized companies too small for the bond market. When public-to-private deals came back in the mid-2000s, large subordinated tranches came back with them, as the SunGard deal shows[2]. Since then, unitranche and second lien loans from direct lenders have taken over part of the ground mezzanine used to hold.

References

Footnotes

  1. ↑ Silbernagel C., Vaitkunas D., Mezzanine Finance, Bond Capital, January 2006, p.2
  2. ↑ Kaplan S.N., Strömberg P., Leveraged Buyouts and Private Equity, NBER Working Paper No. 14207, 2008, p.6-7
  3. ↑ Silbernagel C., Vaitkunas D., Mezzanine Finance, Bond Capital, January 2006, p.4-5
  4. ↑ Silbernagel C., Vaitkunas D., Mezzanine Finance, Bond Capital, January 2006, p.7
  5. ↑ Silbernagel C., Vaitkunas D., Mezzanine Finance, Bond Capital, January 2006, p.6
  6. ↑ Silbernagel C., Vaitkunas D., Mezzanine Finance, Bond Capital, January 2006, p.3
  7. ↑ Cheredov K., Tarkhanova E., Mezentseva O., Mezzanine Financing: Application Practices and Leadership Aspects, Advances in Social Science, Education and Humanities Research, Vol. 386, Atlantis Press, 2019, p.47
  8. ↑ Kaplan S.N., Strömberg P., Leveraged Buyouts and Private Equity, NBER Working Paper No. 14207, 2008, p.2-3
  9. ↑ Kaplan S.N., Stein J.C., The Evolution of Buyout Pricing and Financial Structure in the 1980s, The Quarterly Journal of Economics, Vol. 108, No. 2, 1993, p.313
Mezzanine capital — recommended articles
Hybrid instrument — Acquisition financing — Warrant — Private equity investments — Optimal capital structure — Long-term debt — Dividend recapitalization — Debt-to-equity ratio
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