How Lenders Stress Test a Business Before Approving Mezzanine Debt

Lenders are conservative and use a number of protocols to test the business risk of their lending applicants.

This is especially true for mezzanine debt providers who usually do not have collateral securing their loan and are reliant on cash flow growth for loan repayment.

Lender credit committees are paid to think of worst-case scenarios, to ensure the company can hold up the various challenges that may befall it.

Companies are screened for industry and customer risks. Products are researched for customer satisfaction and lifecycle stage.

Sometimes the credit committee will identify an issue such as industry demand or competition. The underwriting team assesses how these issues will impact revenue and costs in the financial projection.

How Mezzanine Debt Lenders Stress Test Deals

This is what is known as a stress test, where the lender develops a number of very negative projections to see how the loan performs in each.

In some stress tests, the lender assumes the company’s revenue will decline substantially. In others, the gross margin deteriorates at a level beyond historical fluctuations.

Mezzanine debt lenders use stress tests to creatively speculate about what could go wrong and the magnitude of the impact on the Company’s ability to generate cash flow and pay their debt service.

The stress test assumptions are usually discounted 20% to 25% from the Company’s projection assumptions.

Often, stress tests fail to capture how businesses really perform in a negative cycle. They may overstate the company’s ability to cut costs quickly or overstate the ability to grow revenue after a large drop-off.

Lender stress tests can make or break your deal, so the initial financial projections given the mezzanine debt lender matter.

Sometimes, companies are uncomfortable projecting growth so they haircut their numbers and show little to no growth.

This is a rookie mistake and akin to shooting yourself in the foot. The mezzanine debt lender sees this as a signal of no confidence.

Their stress test will take your no-growth projection and discount it 20% resulting in an extremely negative projection that is unlikely to service the interest much less the principal.

All companies should work with an investment banker skilled in understanding mezzanine lender stress tests, before they launch their debt raising process.