Posted on: February 20th, 2023
As the mezzanine debt asset class has transformed from sleepy funds to large, multi-line asset managers, pricing approaches have changed as well. In the early days of mezzanine debt finance, there were a finite number of ways to pay your lender – interest rate, fees, and a small warrant. The warrant was usually the equilibrating variable that solved for the lender’s return requirement.
Current Mezzanine Debt Market
In warrant resistant deals, a payment in kind interest could be substituted which led to the buildup of a deferred obligation to be repaid at maturity. The current mezzanine debt market populated with traditional funds, BDC’s and private credit funds has introduced a variety of new approaches, some of which are best avoided. These include guaranteed returns, revenue royalties and exorbitant prepayment fees. Guaranteed returns can be listed explicitly as a standalone term or can be embedded in the fine print of the term sheet. This essentially means that the borrower owes the lender a certain return for a certain period of time, irrespective of the loan being outstanding.
Basically, they are asserting the right to get paid even though they have no loan outstanding. Some mezzanine debt lenders will justify this as protecting their overall return, as quick pay offs reduce their portfolio return. You are effectively paying a steep price for money you are no longer using. For a deal that matures early, they can cause a borrower million in excess cost. Royalty based mezzanine debt loans provide a percentage of revenue to the lender. Essentially your interest payment is pegged to your revenue performance and not to the outstanding loan. The more revenue growth, the more interest payment is due.
Even though more revenue growth significantly de-risks the lender’s position, they end up receiving windfall royalties compared to the size of the loan. Finally, prepayment fees have become more exotic with some requiring payment of interest for the remainder of the term. This is akin to the aforementioned guaranteed return, where even through the lender is taken out, they still have a right to receive income. It is reasonable for a lender to have at least a one-year non-prepayment clause. However, beyond that, the prepayment fee should be at most 3% and decline thereafter. It is predatory to expect to receive income for the entirety of the loan term after repayment of the loan principal.