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How Does Mezzanine Debt Exit?

How does mezzanine debt exit?

Typically, in a mezzanine deal, the transaction period is for 5 to 8 years, with the possibility of an early mezzanine debt exit. In most cases, mezzanine investments are taken out either through a change-of-control sale or recapitalization of the company. While an IPO is a rarity in a mezzanine deal, some mezzanine providers may look to invest in companies that represent strong IPO candidates. However, most frequently the mezzanine capital provider is bought out by the initial owner through a recapitalization with inexpensive senior debt, through the accumulated profits generated by the business or through an acquisition of the company by a competitor.

To explain further, a mezzanine lender may exit through any one of the three exit strategies listed below.

  • Refinance Exit
    This is the most common and most preferred exit strategy for mezzanine lenders. Most lenders prefer a refinance exit since they can move on to other profitable ventures. However, there is major risk involved in refinancing. The interest rates at the refinancing date can change to a significantly higher percentage than what was involved when the loan was made. In order to reduce the risk brought about by higher interest rates, a mezzanine lender may protect itself by “stressing” or increasing the initial interest rate above the market rate at the time of underwriting. Generally, the amount of stress depends on the term of the loan and the current interest rate environment. Many mezzanine lenders will add 50 to 100 basis points per year. (100 basis points equals 1 percent.)
  • Sale Exit
    This exit strategy is generally applied to a mezzanine loan when the refinance exit does not work out or when the company has borrowed more than 85-90 percent of the capital structure. However, a sale exit generally will command a higher interest rate because repayment possibilities are more limited. The risks involved in a sale exit are (i) market position at the time of the sale, (ii) the strength of the capital markets after the sale, and (iii) the cap rate at the time of sale.
  • Self-Amortization Exit
    Apart from the refinance exit and the sale exit, there lies a third option of a self-amortization exit, which involves full repayment of the loan from the property cash flow. Although not quite common, several companies have been able to find the cash to repay the loan in full over the relatively short term of the mezzanine loan.

Establishing an exit strategy

Establishing a clearly defined exit strategy is pivotal to a mezzanine deal since the overall return on investment hinges on the investor’s ability to obtain the value of its equity position. Whatever exit strategy is chosen, whether through the sale of the company, a recapitalization, a refinancing, and on a smaller percentage an initial public offering, all are potentially viable liquidity events.

Always be sure to consult an expert financial advisor with sufficient experience in mezzanine deals. Alternatively, a reputed financial advisory firm with a good knowledge base of the private capital markets will also be able to guide you in the right direction.

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