Posted on: January 15th, 2021
In today’s funding world, things are not always what they seem to be. Groups presenting themselves as funds are sometimes fund less. Debt funds purport to have one strategy, only to practice a completely different strategy. Given the expansion in the types of debt funds in the market, some strategy shifting is to be expected. Yet there are established norms around each form of debt capital, that most fund practitioners adhere to.
Afterall, senior lenders are called senior for a reason. They are in first position with respect to ranking, lien position and repayment. Most senior lenders are asset based in structuring but can also be cash flow based. Beyond the senior layer lives the mezzanine debt level, which is in second position, and almost universally not asset collateralized, structured upon cashflow. As the mezzanine debt providers, they are taking more risk and getting paid more to take it than the senior lender. They are senior to the equity, junior to the bank and enter into a standard intercreditor agreement which governs how they will behave, should the company underperform. These are established tenets of corporate finance that have been built up over the last 50 years.
The Mezzanine Debt Masquerade
Lately, some special situation funds, masquerading as mezzanine funds or second lien funds have popped up in the market, let by slick operators who claim ties to reputable finance companies. They may be family office based, BDC affiliates, or hedge fund affiliates or at least they claim to be. They use the reassuring language of traditional middle market finance descriptors to convey a homespun traditional approach to their targets. As they go further into their diligence and analysis, their approach belies their advertised intention, as they are more of a special situation, lender of last resort. Rather than accept the established position of a mezzanine debt lender, they are determined to have first lien positions on the assets.
Instead of accepting normal credit risk, they require cash guaranties from their investors to cover any covenant shortfalls. Rather than allowing the bank to control the intercreditor relationship and standstill and allow interest blockage, they refuse the standard intercreditor arrangement. Yet these funds still expect to earn 12 to 15% on their money and have rapid principal amortization. Unlike standard mezzanine debt lenders, these special situation vulture funds are obsessive in their drive to mitigate risk from both the senior lender and the equity level and force non-market terms into their deals.
Rather than representing a good debt solution, these types of loans are ill-conceived and toxic. They create downside risk and present value destroying potential to a company. When you are considering your debt capital solutions, it is best to avoid these mezzanine debt imposters and ensure you pick a well known and referenceable debt fund who conforms to industry standards.