What Investment Bankers Should Know about Mezzanine Debt - dummies

What Investment Bankers Should Know about Mezzanine Debt

By Matt Krantz, Robert R. Johnson

Mezzanine debt is a form of financing in investment banking that is between traditional debt and equity. In fact, mezzanine debt has attributes of both debt and equity and is often referred to as a hybrid form of financing. It’s very popular with LBOs that are in the middle-capitalization range (below $1 billion) — restructurings that are too small to have access to the junk bond market.

Mezzanine debt is typically structured as intermediate term debt — perhaps three to five years. Mezzanine debt usually has an equity kicker or equity sweetener. What this means is that the bonds will come with warrants attached in order to make them more attractive to the purchaser.

A warrant is simply the right to buy a specific number of shares of the company’s stock at a predetermined price for a specified period of time. For example, a warrant may be issued that allows the holder to buy a share of stock in a company over the next three years at a price of $10 per share.

Warrants are usually underwater when they’re issued, meaning that the current stock price is below the predetermined price (known as the exercise price). For instance, in our example, the current stock price might be $7 per share, and the exercise price of the warrants is $10 per share.

It would not pay the holder to exercise their warrant and buy the stock today for $10, because they can purchase the shares without using the warrant for $7. But what happens if the company is very successful and the stock price rises dramatically? The warrants will become extremely valuable.

Let’s say our company’s stock price rises from $7 to $21 in three years. The holder of the warrant would have the right to buy a share of stock that is worth $21 at a price of $10 — these warrants are very valuable because they’re $11 in-the-money (stock price is above the exercise price). What this implies is that, upon exercise, the warrant holder will realize a gain of $11.

Warrants give the bondholder a great deal of upside potential and allow the bondholder to participate like a stockholder in the event that the company is successful. The other advantage to warrants is that the holder has the right to either exercise the warrants (and buy the stock) or sell the warrants to someone else.

Either way, the warrant holder can realize the value of the warrants. The warrants are also detachable, meaning the holder can sell the warrants and still retain the debt.

As you can see, mezzanine debt really does represent a middle ground between debt and equity. It has the characteristics of traditional debt, because the holders of mezzanine debt receive periodic interest payments. Yet, it has the characteristics of stock, because the holders of mezzanine debt can participate in the growth in the value of the firm through exercising their warrants and becoming stockholders.

The benefit to the company of issuing mezzanine debt with warrants attached is that they can issue that debt at a much lower interest rate. Investors in mezzanine debt may be looking for annual returns in the 20 percent range. The bonds may be issued with an interest of only 8 percent. The other 12 percent return may come in the form of the value of the warrants.

This type of financing also preserves precious cash flow for the firm. If the firm can limit the amount of cash that needs to be spent to make the interest and principal payments on the debt, it will help the cash flow of the firm.

If the firm really wants to preserve cash, it will issue debt at a lower interest rate and attach more warrants. The more warrants attached to the debt, all else equal, the lower the interest rate that investors will be willing to accept on the debt.

Typical investors in mezzanine debt are large institutional investors such as insurance companies, commercial banks, mezzanine debt funds, and other private equity firms. But unlike investing in the equity of a typical LBO, this form of investment is passive, because the private equity firms buying mezzanine debt don’t take a management role in the restructuring of the company or in its operations going forward.

Mezzanine financing has some unique characteristics, including the following:

  • How it’s negotiated: Unlike junk bonds, the terms of mezzanine financing are generally negotiated between the issuing firm and the purchasers.

  • The difficulty of selling: Mezzanine debt is more difficult to sell than some other types of debt. It’s much less marketable than junk bonds, and it’s generally held to maturity by the entity originally acquiring the debt. If mezzanine debt is sold, it’s done in a private negotiation and typically involves price concessions on behalf of the seller.

  • The connection with the LBO sponsor: A portion of the mezzanine financing is typically provided by the same private equity company sponsoring the LBO.

  • Lower rights: Similar to junk bonds, mezzanine debt has lower seniority than traditional bank debt. In terms of claims to the assets of the firm, the holders of mezzanine debt stand in the claims line behind banks providing financing but in front of equity holders. Thus, the claims of mezzanine debt holders are subordinated (or below) the claims of other, more traditional debt holders.