'Mezzanine" Debt

January 2008

INTRODUCTION

In the panorama of financial tools offered to companies, a person may sometimes have difficulty in dealing with the various terms used by financiers. One of these sometimes-confusing terms is the "mezzanine debt". This article therefore presents the characteristics of this financial tool.

DEFINITION

The mezzanine debt generally refers to the riskiest debt in a leveraged buyout arrangement, the repayment of which is normally subordinated to the company's classic bank debt, namely the senior debt. That's why it is also occasionally referred to as the subordinated debt.

PERFORMANCE

Given its subordination to the senior debt, the mezzanine debt is riskier and the financier offering it requires a higher return than that of the senior debt. While the senior debt will be offered, for example, at Base Rate + 2.5%, the subordinated debt may represent Base Rate + 6% or even more. In addition, the lender will often be able to request stock warrants from the company for even greater returns.

UTILITY

The mezzanine debt allows companies to obtain an even greater leverage effect and finance more important transactions. In fact, traditional bankers will very often treat the mezzanine debt as equity (or equity capital) allowing the company to borrow even more while respecting the debt/equity ratio normally required by bankers.

BENEFITS VERSUS EQUITY

Setting up a mezzanine debt for the company is a little like adding equity (or equity capital) to its balance sheet without having to dilute the existing shareholders (except by the warrants but to a lesser extent).

The benefits of such a financial tool compared to an equity investment offered by a venture capital firm can be summarized as follows:

• - no significant dilution at the shareholding level;
• - no presence on the board of directors;
• - often faster to set up because there is no need to negotiate an agreement between all shareholders of the company.
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However, although the banker of the company may consider the mezzanine debt as equity, there will inevitably come a time when the debt will be repayable, and as such, it is considered a company debt. It is therefore necessary to ensure the cash flow of the company allows the repayment according to the terms negotiated with the lender and does not put the company in default towards the conventional lender. If the cash flow does not allow it, equity investment would then be preferable.

 

LEGAL DOCUMENTS

In terms of legal documents required to support the implementation of this financial tool, it is generally necessary to provide:

• - a loan agreement between the company and its mezzanine lender;
• - a subordination agreement between the mezzanine lender and the senior debt lender;
• - a warrant agreement (where there are such warrants).
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It will be necessary to be pay particular attention to the various commitments (covenants) required from the company in the loan agreement. There will often be restrictions preventing the company from doing certain things without the prior authorization of the mezzanine lender.

CONCLUSION

In light of the above, the mezzanine debt is a very useful tool for companies seeking a financing which will differ from the conventional bank debt. It can be an interesting alternative (or even a complementary option) to an equity investment.