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Publications
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Vol. 7, No. 8, September 2009
HOW MEZZANINE DEBT CAN FILL IN BALANCE SHEET GAPS: Today’s improving economy may put more stress on corporate balance sheets than the recession itself. However, mezzanine funds raised a record level of new capital in 2008, and remain a favorite alternative investment vehicle.
In the article below, "Mezzanine Debt—A Source Of Secondary Capital In An Improving Economy," FOCUS Partner John Slater explains how mezzanine fell out of favor during the bubble, and then describes the subsets of mezzanine lenders. He notes how—with renewed demand and competitors gone—the negotiating leverage of mezzanine providers has improved tremendously.
John Slater is an M&A and capital raising veteran of twenty-four years who has managed more than 200 M&A and capital raising transactions with aggregate values in excess of $3 billion. Before joining FOCUS, Mr. Slater was Managing Principal of Slater & Company and its predecessor, Asset Services, LP. For nine years Mr. Slater had a successful law practice concentrating on financial and securities law.
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Operating nationally and internationally, FOCUS is currently working with buy- and sell-side corporate clients, private equity groups, holding companies and late stage venture capital firms in the following areas:
- Advertising & Marketing
- Building Materials
- Business Consulting Services
- Business Process Outsourcing
- Call Center Services
- Distribution
- Education and Human Capital
- Electronics
- Energy
- Engineering
- Financial Services
- Food, Beverage and Restaurant
- Government, Aerospace & Defense
- Healthcare & Life Sciences
- Information Technology
- Manufacturing
- Media
- Parking Services
- Retail Franchising
- Semiconductor Equipment
- Telemarketing
- Warehouse Distribution
We have executed dozens of transactions in a range of market segments, but the same fundamentals apply across all of them. Our on-going transaction process provides us with up-to-the-minute market knowledge in these sectors that may be of corporate development interest to you.
Inquiries should be addressed via e-mail to info@focusbankers.com, by telephone to 202-470-1973 or by fax to 202-785-9413.
Mezzanine Debt—A Source Of Secondary Capital In An Improving Economy
By John Slater, Partner, FOCUS
Often an improving economy and renewed growth put more stress on corporate balance sheets than the recession itself. During a business decline, liquidity is generated through the impact of lower sales which leads to lower receivables outstanding, and a net generation of cash (after some lag). Similarly, as inventories are worked off, the need for working capital declines and cash may even be generated through asset sales as closed plants and operating divisions are liquidated.
When better times return, this serendipitous process goes into a quick reverse. Increased sales result in increased receivables; inventories must be rebuilt—often at a higher cost as raw materials markets begin to tighten—and, if growth is truly robust, the need for additional equipment and plant facilities will soon become apparent.
Banks May Be Slow to Fund the Rebound
Unfortunately, the traditional sources of liquidity may be slower to return. Banks that were quick to tighten credit standards during the bust may be slow to recognize an improving economy and loosen their standards to fund the rebound. Many companies will have lost money during the recession, particularly if they had high levels of fixed costs, or if they were forced to liquidate excess inventories at fire sale prices.
With retained equity down, loan covenants may have been breached, leaving no room for growth in credit lines. Compounding these issues, tightened credit standards mean that banks are looking for more, not less equity on borrower balance sheets. We regularly see banks demanding equity injections from shareholders, imposing strictly monitored asset-based loan formulas where none were required previously, and requiring much higher cash flow coverage ratios.
Companies that were overleveraged in the boom may find themselves forced to further shrink their balance sheets to meet these requirements. Rather than enjoying renewed growth as the economy improves, these companies may find themselves forced to turn away customers absent the ability to raise new capital. In this article we discuss one important source of secondary capital—mezzanine debt.
Mezzanine Debt Can Fill in Balance Sheets Gaps
The purpose of mezzanine debt is to fill in gaps in the balance sheet that can be supported with company cash flow, but that are unsupported by pledgable assets or too risky to be underwritten by a bank. To a great extent, mezzanine fell out of favor during the bubble.
Banks that traditionally would not have lent more than two times cash flow were fighting each other for leveraged loans at three and a half to five times EBITDA. These loans were readily supplemented by Tranche B and second lien loans from hedge funds, business development companies (BDCs), and special purpose entities (SIVs) that supplemented aggressive bank loans to enable private equity groups to participate in a feeding frenzy of ever-increasing purchase multiples.
Post-Bubble, Traditional Mezzanine Lenders are in Demand
The hedge funds are licking their wounds and the non-bank investment pools are in liquidation. More traditional non-bank lenders are either in deep trouble (CIT and Textron) or pulling back existing commitments to deleverage their balance sheets. Once again, the traditional mezzanine lenders find their capital in great demand.
Mezzanine lenders generally are funded as investment partnerships backed by high net worth individuals and institutional investors such as pension funds and not-for-profit entities. Many are sponsored by private equity groups to provide financing support for buyouts, but others are independent, typically focusing on growth financings and dividend recapitalizations.
These funds generally focus on transactions of five million dollars or more and require that the borrower have a proven track record of generating three million or more of EBITDA. Many set the bar higher, targeting borrowers with earnings of $7 million (EBITDA) or more.
A subset of mezzanine lenders look at smaller deals down to $2 to $3 million, but few target companies with EBITDA less than $2 million. At the lower end of the market, mezzanine-like loans also are available from government subsidized investment pools including Small Business Investment Companies (SBICs), which can obtain inexpensive leverage from the U. S. Small Business Administration (SBA), and smaller BDCs.
In the past year, the SBA has announced its intent to increase the matching leverage available to SBICs. We are aware of several groups intent upon forming new SBICs, but have received mixed reports on their ability to raise the required capital. Since these entities are among the few sources of secondary funding for smaller companies with capital needs down to $1 million, success of these ventures is critical to future business growth.
Mezzanine lenders typically provide a second tier of capital behind asset-based or senior bank loans. Where the senior debt might typically be underwritten at two or two and one half times cash flow in the current market, addition of a mezzanine tranche will likely add one turn (i.e. one times cash flow) to bring total debt to three to three and one half times EBITDA. Though far more restrictive than what was available at the peak of the bubble, these leverage multiples are not overly conservative when compared with many past lending environments.
Negotiating Leverage of Mezzanine Lenders Has Improved
During the bubble, mezzanine lenders had to compete with numerous other sources of secondary capital and found their total returns often driven down to the low to mid-teens (and even lower on some larger financings). Equity warrants, which were the norm for mezzanine deals in the 1990’s, became impossible to negotiate except with the smallest and weakest credits.
Now, with renewed demand and competitors gone, the negotiating leverage of the mezzanine providers has improved tremendously. Today, typical mezzanine deals will carry a current coupon of 13 to as much as 15 percent (versus historical levels of 12 to 13 percent). Additionally the lender may receive four percent or more in payment in kind return (i.e. interest accrued, but not paid in cash, which is added to the principal as it accrues).
Finally, the lender will almost certainly require equity purchase warrants to push total annual returns from the high teens to low twenties on strong deals and as much as the mid-thirty percent range when the credit carries more equity risk.
Increasingly, Deals Are Structured as Secured Second Lien Financings
Traditionally, mezzanine debt was structured as an unsecured term loan with a bullet payment due five years out, sometimes structured with a provision for excess cash flow recapture. In the current environment, deals are increasingly structured as secured second lien financings.
Additional terms may include required amortization payments and put provisions to guaranty a minimum return from equity warrants. Mezzanine lenders also may request observation rights on corporate boards and other covenants to position them to take action to protect their interests in the event borrower performance deteriorates.
Mezzanine funds remain a favorite alternative investment vehicle for institutional investors who increasingly prefer the safety of a minimum cash return rather than the grab for the higher returns theoretically possible from control investing. As a result, mezzanine funds raised a record level of new capital in 2008, and sponsors indicate that additional funding is available as required.
FOCUS Adds Two Managing Directors
Bob Beard Joins FOCUS’ Atlanta Office as a Managing Director
Bob Beard has joined FOCUS’ Atlanta office as a Managing Director. According to Jonathan Wilfong, Regional Managing Partner of FOCUS, “Bob has more than 25 years of merger and acquisition placement and financing experience, and has structured over 50 transactions involving more than $700 million of capital, and specializes in raising capital.”
About Bob Beard
Prior to joining FOCUS, Mr. Beard managed his own financial advisory practice, Diversified Financial Solutions where he arranged the successful placement of over $200 million of debt and equity capital. Also, he was co-founder of Capital Business Credit, served as the Southeast Region underwriting manager for the cash flow lending group of Heller Financial, and was employed by Price Waterhouse. Mr. Beard has been a licensed CPA in Georgia, and received an MBA from Emory University… Read more...
Rich Pierce Joins FOCUS’ Washington, DC Office as a Managing Director
Rich Pierce has joined FOCUS’ Washington, DC office as a Managing Director. According to Doug Rodgers, CEO and Managing Partner of FOCUS, “Rich has more than 10 years of investment banking experience in an area that will be of great value to our clients. Also, he brings with him a wealth of knowledge in the telecommunications industry.”
About Rich Pierce
Prior to joining FOCUS, Mr. Pierce was a Director in the Communications and Media Group of Stifel Nicolaus. He also was a member of the Telecommunications and Media Group at Legg Mason. Before becoming an investment banker, Mr. Pierce had a successful seven year career as an officer in the U.S. Army Military Intelligence Corps., and is a graduate of the Army’s Airborne and RANGER training programs. He has a BS in Electrical Engineering from Brown University and an MBA in Finance from the University of Pennsylvania’s Wharton School, where he graduated with distinction. Read more...
FOCUS Web Watch
New FOCUS Government, Aerospace and Defense Group Summer 2009 Report Available
According to Manan Shah, FOCUS Partner and Government, Aerospace, and Defense Team Leader, the Government, Aerospace, and Defense (GAD) sector, shows promise for a turnaround in the second half of 2009. The latest issue of the FOCUS Government, Aerospace and Defense Group Summer 2009 Report—highlighting aerospace—is now available. The newquarterly GAD report includes:
- Next Generation Airspace System (NextGen): An Overview of Six Transformational Programs
- NextGen Institute
- JPDO’s Evolving Role in Achieving NextGen
- GAD Market Trading Metrics
- Overall Aerospace and Defense Q1 2009 Transactions
- Selected Recently Closed FOCUS GAD Transactions
Click here to download a copy of the FOCUS GAD Summer 2009 Report.
RECOMMENDED READING:
Leading Indicators Rise; Bottom of Recession Seen
In the August 20, 2009 issue of The Wall Street Journal, Ruth Mantell writes that, “An economic recovery may begin soon, and the recession is bottoming out, the Conference Board said… For its fourth consecutive monthly gain, the index of leading economic indicators rose in 0.6 percent in July, following an upwardly revised increase of 0.8 percent in June..
The interest rate spread was the largest positive contributor, while a reading on consumer expectations was the largest negative contributor. Overall, six of the 10 indicators were positive contributors, three were negative, and one was steady…”
FOCUS Industry Practice Groups
► Education & Human Capital -- www.focusbankers.com/education
► Energy -- www.focusbankers.com/energy
► Food, Beverage & Restaurant
► General Middle Market Businesses
► Government, Aerospace & Defense - www.focusbankers.com/gad
► Healthcare & Life Sciences
► Information Technology -- www.focusbankers.com/technology
