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What is Mezzanine Debt Structure?

What is Mezzanine Debt Structure?

Mezzanine Debt, which has been around for over 30 years, is most commonly used by companies for acquisitions, recapitalizations, management and leveraged buyouts and in some cases to further growth expansion projects. One of the primary reasons for the rising popularity of mezzanine financing is its easily adaptable capital structure to suit both the lender and the borrower.

Types of mezzanine structures

Typically, mezzanine financings are completed through a variety of different structures, which are based on the specific objectives of the transaction and the existing capital structure in place at the company. In most cases, the basic forms used in are subordinated notes and preferred stock, with specialist mezzanine investment funds, looking for a certain rate of return, which can come from four sources listed below. (It is important to keep in mind that each individual security can be made up of any one of the following or a combination of two or more.)

  • Cash interest
  • In a cash interest structure a periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing is taken. The interest rate used for such a structure is either fixed throughout the term of the loan or is floating based on LIBOR or other base rates.

  • Ownership
  • In most cases, mezzanine deals along with the typical interest payment associated with debt, also includes an equity stake in the form of attached warrants or a conversion feature, similar to that of a convertible bond. However, ownership as a debt structure is never used alone but is always used along with either cash interest or PIK interest and in some cases both.

  • PIK interest
  • PIK interest, which stands for ‘Payable in kind’ interest is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the principal amount of the security in the amount of the interest. This is best explained by an illustration. For a $100 million bond with an 8% PIK interest rate there will be a balance of $108 million at the end of the period without having paid any cash interest.

  • Participation payout
  • A fairly rare occurrence in a mezzanine deal, the lender may take an equity-like return in the form of a percentage of the company’s performance instead of equity. This will be measured by total sales, profits or EBITDA as a measure of cash flow.

Importance of structuring in mezzanine financing

While structuring a mezzanine security, it is of vital importance that the company and lender work together to avoid burdening the borrower with the full interest cost of such a loan. Since mezzanine lenders generally seek a return of 14% to 20%, the right structure helps in achieving this return through means other than simply cash interest payments. Furthermore, mezzanine financings can be made either at the operating company level or at the level of a holding company (also known as structural subordination). In a holding company structure, (with no operations and hence no cash flows), the structural subordination of the security and the reliance on cash dividends from the operating company introduces additional risk and typically higher cost. However, this can work out as an advantage as to how much a company can borrow, since the debt at the holding company level is not normally included in assessing the leverage or coverage ratios.

It is always preferable for companies seeking mezzanine financing, to seek the services of an expert financial advisor with previous experience in mezzanine finance and with access to a strong mezzanine lender platform.

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