This question arose on a course in debt structuring, conducted by one of our trainers, for Spain's largest bank. Here are some points on mezzanine finance:

1. Mezzanine is expensive

The first point I make about Mezzanine is that it is expensive. Whereas a bank lending to a levered deal could want a margin of say around 3% above base, as an order-of-magnitude comparison, a mezzanine provider might be looking for a total return of around base plus 10%. This makes it an expensive product and a finance director in a buy out would only want to use a little of it.

2. Mezzanine can enhance returns

Mezzanine is risky for the provider (they rank behind other creditors) and they're going to price it highly, making it expensive for the company. So why use it at all? The answer is that it can still enhance equity returns. Imagine a private equity investor purchasing a business for 100m, contributing 20m of its own equity and raising the 80m balance from the bank (in the good old days - when debt was more freely available!). When selling 5 years later say for 140m, the private equity firm would pay off the 80m debt, leaving 60m equity proceeds and enabling it to have tripled its 20m equity investment (3x money multiple). Alternatively, if the private equity firm were able to get just a little bit more debt into the deal, e.g. from a mezzanine provider, its returns could be further enhanced. For example, imagine that the private equity firm raised a further 10m in mezzanine meaning the business purchase was funded 80m debt, 10m mezzanine and 10m equity from the private equity firm. When selling for 140m, the private equity firm would pay off the 80m debt, pay off the 10m mezzanine making equity proceeds 50m. With a bit of extra debt from the mezzanine provider, equity out = 50m, equity in = 10m and the money multiple has gone up from 3x to 5x - which represents a huge increase in return. Although mezzanine can be used to reduce the size of the initial equity investment and enhance returns as described above, it could also be used to pay more for the business (and perhaps win the auction process to purchase the asset and earn the M&A adviser his fee). So - there are good and bad reasons for using mezzanine. The good reason for using mezzanine is to enhance returns. The bad reason is to pay more for the business! 3. The terms of mezzanine are highly variable Although the mezzanine provider will be looking for a high return for providing finance via this risky product, the actual terms of mezzanine are highly variable and subject to negotiation. Some of the mezzanine provider's return will be received as interest, and some would be received as equity upside. For example, when/ if the business is sold at a price above a certain level, then the mezzanine provider receives a share of that upside, just like a regular equity investor would. The equity upside can be implemented in a number of ways but often it would be implemented through share options or warrants (= company issued share options) or it could be implemented as a straight purchase of shares in the buy out. The split between interest and equity upside is variable but, from the mezzanine provider's perspective, biasing his return towards the equity upside will mean he has to wait longer to get his return, and so it may make him want to charge a higher overall return (i.e. it's not going to encourage him to reduce his say base + 10% target return figure). 4. Rolled up interest is often a feature of mezzanine

Although a mezzanine provider might expect to get some interest along the way, because the deal will be highly levered, it is unlikely that the buy out will be able to afford to pay much interest along the way. As well as a negotiation over the split between interest and equity upside, one of the key negotiations around mezzanine is how much interest is paid along the way and how much is rolled up i.e. accumulates and is paid out later. Interest that is rolled up and paid out later is called "PIK" or "Payment In Kind". In fact, you can get a pure PIK instrument where the provider waits until maturity to receive rolled up interest as well as return of principal. 5. Lots of scope for negotiation

So, lots of negotiation to be had around Mezzanine: - Over the total acceptable return (e.g. base + 10%); - Over how much equity upside the mezzanine provider receives (i.e. how long it has to wait for its

return); and - Over how much interest is paid along the way v.s. how much accumulates. 6. The senior lender's perspective We can understand why the private equity firm and the buy out's management team might be in favour of using a little bit of mezzanine to enhance returns, but how is the senior debt provider thinking about things? The senior debt provider may be worried that an aggressive adviser has used mezzanine to pay the highest price to the previous owner of the business, allowing the advisor to walk away with a big fee. The senior debt provider, after hearing that mezzanine is involved, may start worrying that his clients are paying a bit too much for the business and that the whole deal is in danger of quickly falling into bankruptcy post buy out. Although the senior debt holder ranks ahead of other finance providers, he still doesn't want to be involved in a structure where the mezzanine provider can exercise conditions of default. So, rather than relaxing because he is first ranking a senior debt provider, having found out mezzanine is involved the senior debt provider is going to want to

understand: - The conditions under which default can be exercised (the senior debt holder is unlikely to want to find himself in a liquidation situation, even if he expects to get repaid); - Whether the business can afford to meet its total debt repayments (how much of the interest on the mezzanine rolls up and how much has to be paid along the way); and - What happens to surplus cash in a good year (the senior debt provider may want cash retained in the business whereas the company may want to pay off some of its mezzanine or at least the accumulated interest on mezzanine). For a senior banker, finding out that mezzanine is being used in a buy out structure is not necessarily a great thing! It's certainly not likely to increase his appetite to lend into the situation! 7. Summarising mezzanine

How can we summarise mezzanine? - A little bit can be useful to enhance returns; - It's expensive so buy outs shouldn't want to use a lot of it; - It's risky - high interest costs mean that, unless the business grows strongly, it may have difficulty re-financing its mezzanine. Many buy outs will get financed on a combination of A senior debt (amortising over say 5-10 years) with a small amount of B senior debt (repaid in one lump sum, or a bullet, after the A is repaid). Occasionally mezzanine will be used but it carries risks for the company and is also risky for the provider. It's not suitable for all deals (strong growth is required to ensure it will be repaid) and these days, it's not as easy as it used to be to find someone who will tell you they have an open cheque book when it comes to providing Mezzanine! Please see http://www.financialtrainingassociates.com/financialtrainingcourses.htm for details of financial training courses conducted by Financial Training Associates.

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