Posted on: July 31st, 2020
The alternative debt market is constantly innovating and changing. As buyers paid higher prices in the late end of the investment cycle, new debt structures emerged to absorb the additional uses of funds. Many recent structures were in the form of a unitranche loan with different layers packaged together. The integration of two loan layers – one senior and one mezzanine debt– into one structure makes it easier to close and theoretically, easier to manage post-closing. This is certainly the case if all goes well and if the company hits all its numbers and covenants. When all does not go well, as many companies are now finding out, it is much riskier to have one lender than it is to have two lenders via a senior & mezzanine debt structure.
If revenue drops and EBITDA takes a large percentage haircut, suddenly your debt to EBITDA multiple ratio is in freefall. Whereas many companies may have comfortably sported a 4 times debt to EBITDA multiple pre-Covid crisis, a revenue drop of only 10% can cause an EBITDA decline of nearly 66%, on a ceribus paribus basis. This can cause a spike in your Debt to EBITDA multiple from 4 to 12 times EBITDA. While the Covid period is truly unique and is best seen as the mother of all extraordinary events, most loan agreements in their current form are not set up to neutralize its effects through pro forma adjustment.
This must be done through an amendment and usually involves a negotiation and a lot of back and forth between borrower and lender. When the debt multiple spikes, the equity is suddenly out of the money, at least in the short term, as the reduced enterprise value often exceeds the amount of the debt.
This is a scary place for a unitranche lender as well as the borrower, as the diminution in value results in potential risk of loss and an immediate course of derisking action. Given the low rates of unitranche lenders, their yields are not high enough to absorb large losses so the negotiate hard with the company to derisk their position. Because they are the only lender, they have more negotiation power and the borrower must comply with their requests.
The downside case scenario is much more company friendly with a two-layer debt structure where you have one senior lender and one mezzanine debt lender. In this traditional, bifurcated structure the senior lender and the mezzanine lender each have their own seniority position, and each has a predetermined role to play in the case of a downside case.
All senior lenders require the mezzanine debt lender to execute an intercreditor agreement which governs how the mezzanine lender will be treated in the case of a downside case. This gives the senior lender and the company more stability during a workout, as the mezzanine lender must stand still and be patient to give the company time to recover. This structural subordination of the mezzanine debt lender gives the company an automatic circuit breaker.
Mezzanine debt lenders are paid more than senior lenders and have longer time horizons provided they still believe in management and the plan of execution. This mezzanine debt stability helps companies absorb performance shocks and provides valuable insurance for a company in an uncertain performance market.