Making sense of mezzanine financing

Financial Executive
By John Sinnenberg

December 1, 2005

At critical points in a company’s existence, it will need to raisecapital–whether to make a strategic acquisition, invest in facilities and technology, create employee stock incentives or provide liquidity for shareholders. Financial executives will look at a range of options from bank debt to equity deals, and everything in between.

In today’s market, with institutions and providers ranging from commercial banks to hedge funds competing for business, finding the right source can be as important as finding the right form of financing.It is critical to select a provider whose interests, culture and commitment align with the company’s.

Mezzanine capital can fit this critical need, especially for middle-market companies looking for strategic partnership and expertise, without a loss of ownership control. Like debt, mezzanine capital earns an interest rate, can be secured by the assets of the company (generally on a second-lien basis) and has a loan agreement that looks similar to that of bank debt. Like equity, which is longer in term, mezzanine capital has minimal or no scheduled principal payments until the due date and, in some cases, has equity participation.

Uses and Calculations. As the name suggests, mezzanine capital fills the gap between what the senior bank is willing to lend, the available equity and the total need for the transaction.

The amount of mezzanine available for each deal is more an art than science. To determine the maximum debt capacity of a company, issuers and investors will consider a ratio of total funded debt to earnings before interest, taxes, depreciation and amortization (EBITDA) of 4.0 as a reasonable starting point. But, one must not look at this ratio in a vacuum. The industry, amount of recurring capital expenditures for the business, strength and depth of management team and other factors all play into determining the amount of debt a particular company can handle.

Pricing trends now work to the advantage of the business owners. The typical current interest rate–or pay rate–can range from 10 percent to 14 percent, plus a 1 percent to 5 percent payment-in-kind (PIK) rate that accrues but does not have to be paid in cash.

Equity participation, also known as the warrant, allows the mezzanine provider to share in the equity creation of the business. The amount of the warrant is dependent on the projections and subjective assessment by the mezzanine provider as to the achievability of projections. To provide a formula: the return to the mezzanine provider = current pay + PIK + warrant = 14 percent-18 percent.

Mezzanine or subordinated debt is inherently a debt product, with a governing loan agreement and norms that govern the underlying security. The term of subordinated debt is longer than conventional bank financing, with maturities ranging from five to 10 years with minimal amortization during the early periods and larger or bullet payments near or at the maturity date.

Inter-creditor Issues. Given that bank financing and mezzanine areboth debt instruments, the two groups must have a legal agreement that specifies the working arrangement. The two most common legal documents are the inter-creditor agreement and the subordination agreement.

The inter-creditor agreement describes the handling of major itemssuch as: a) cross-acceleration; b) blockage of the subordinated debtinterest; c) subrogation; and d) bankruptcy rights. The subordination agreement simply states that it is “junior” to the senior debt. While mezzanine providers weight the importance of each item differently, the basic concept of repayment of senior debt first and then subordinated debt second holds true.

Types of Mezzanine Providers. Not all mezzanine providers are created equal. Most firms fall into the category “sponsored mezzanine,” when a company is being acquired by a private equity group that utilizes mezzanine financing to round out the capital structure.

There are a few groups that focus on “sponsorless mezzanine,” in which the mezzanine provider invests directly into a situation where the stakeholders are not professional investors, typically a privatelyheld or family held business.

When considering a sponsorless transaction, the stakeholders should interview the mezzanine provider about its investment philosophy and conduct reference checks with existing and previous portfolio companies–including even those that have not performed well–to understand how a mezzanine provider reacts when times get tough.

John Sinnenberg is Managing Partner of Key Principal Partners, a private equity firm based in Cleveland. He can be reached at 216.828.8125.

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