Mezzanine Finance: a Worked Example

There is often a gap between what a bank will lend against a business and what its owners will put in. Mezzanine lenders fill that gap at a price. They accept being repaid behind the bank in exchange for a higher return, and many also ask for a share of the upside.

A credit desk reads that layer in two ways. On value, every dollar below the bank is a dollar of loss someone else takes first, which helps. On cash, the layer is not equity: it carries interest, has a maturity date and comes with a lender who has rights of its own. Until the terms have been read, a desk cannot say whether it is looking at capital or at a competing creditor.

The mix is negotiated. PIK interest keeps cash in the business today, at the cost of a loan that grows. A warrant lets the lender share in a good outcome and can reduce the interest it asks for. Maturity is commonly set after the senior loan's, so that the bank is repaid first.

The ranking comes from contract and structure rather than from the word mezzanine. The loan may be unsecured, may hold security that ranks behind the bank, or may be lent to a holding company above the bank's borrower, where it is structurally subordinated. In sponsor-backed buyouts it usually sits in the acquisition structure. In New Zealand and Australian property it often means a second-ranking mortgage behind a bank on a development, which is one reason a desk asks which kind it is looking at.

A maker of commercial coffee machines, constructed for this page like every figure in it, is bought by its managers and a small fund for US$60m, six times EBITDA of US$10m. The price is funded by a senior loan of US$30m at 8%, repaying US$3m a year; mezzanine of US$12m paying 7% in cash and 5% PIK, with warrants over 3% of the equity; and US$18m of equity. Cash available for debt service, after tax, capex and working capital, is US$6.5m. These terms are the example's and are not offered as a market norm.

Had the US$12m been equity, the bank would be looking at 1.20 times, with the same US$30m of value beneath it. The cushion is as deep either way, and it is the cash that differs. As mezzanine, the business has US$0.26m left after paying everyone in its first year, with nothing gone wrong. The bank's balance falls by US$3m a year while the layer behind it compounds: 12 × 1.05³ is US$13.89m after three years, and US$15.32m after five.

The cushion is visible on a sale three years in, when the senior loan is down to US$21m. Selling costs are ignored:

Between a value of US$34.89m and US$21m the mezzanine lender takes the fall and the bank loses nothing. If all goes well and the business sells for US$70m in year five, the warrants are worth 3% × (70 − 15 − 15.32), or US$1.19m. With the 7% paid on the growing balance, that lifts the lender's annual return from 12.0% to about 13.4%.

A second-lien loan shares the senior lender's security and ranks behind it, and commonly pays a floating margin with no equity kicker. Mezzanine is more likely to be unsecured or held a level up the group, to run longer, to pay part of its return in PIK and to take warrants. A unitranche replaces both layers with one loan from one lender. The labels are used loosely in all three markets, so a desk reads the document and not the name.

A shareholder loan that has been subordinated is different again: the owner is expected to wait. A mezzanine lender is a return-seeking creditor with its own default rights and its own timetable. Equity, by contrast, can be diluted or wiped out but cannot put the company into default.

DEFINED IN ONE PARAGRAPH → · THE INTERCREDITOR AGREEMENT → · BANK LOAN VS PRIVATE CREDIT →

A senior desk asks for the intercreditor agreement before forming a view, because that document decides how much of the layer is really a cushion. Can the cash coupon be stopped when the senior loan is in default? How long must the junior lender wait before enforcing? Can it block a sale? A coupon that can be stopped behaves more like equity in a downturn. A junior lender free to enforce behaves more like a rival.

The desk also tests the whole cash burden, coupon included, at lower earnings, and asks how the compounded balance gets repaid. In the example, the US$15.32m reached by year five has no cash flow set aside for it and depends on a sale or a new lender, which makes it a refinancing risk that someone will have to carry. And it asks who the lender is, what else that lender holds in the group, and how it has behaved in a downturn. In Australia, ASIC has also pointed out that one manager holding senior, mezzanine and equity in the same borrower can conflict its decisions during distress.