Mezzanine Financing Report 2005

Author: Khai Nguyen

Mezzanine Market Report

February 7, 2005

Overview A hybrid form of capital, private mezzanine debt securities (mezzanine debt) have become increasingly popular as a way to raise money. Mezzanine financing is mainly used for takeovers, IPO’s, and acquisitions. It has attracted investors looking for alternative asset classes to generate above average returns.

Exhibit 2: Characteristic Comparison Senior Lender

Mezzanine Investor/Lender

Equity Investor

Instrument

Loan

Loan + Warrants

Stock

Interest Coupon

Prime +

12 - 14%

Generally None

Yes - paid with interest Interest and fee Approx 3 years

No - paid at termination

N/A

20% - 30% IRR

40% + IRR

3 - 5 years

3 - 7 years

No

Negotiable

Yes

Principal

This market is geared more exclusively towards “middlemarket” companies looking to raise capital for specific financing requirements such as capital expenditures or recapitalizations. However it is also to fill financing gaps, fund growth opportunities, and install new product lines and distribution channels. Many companies use it as a hedging strategy or as debt and capital leveraging. Structurally, mezzanine debt is located in between equity and senior debt. It is subordinated in priority of payment to senior debt, but senior in rank to common stock or equity. Interest payments on the securities usually involve both a cash pay portion and pay-in-kind (PIK) portion; paying out a total of about 14% to 16%. Who Uses Mezz and Why? Companies looking to raise capital are turning towards mezzanine financing because of the current market environment. The overall market has seen existing lines of credit tightening in recent years. Bank lenders are continually reducing their commitment levels, making new loans from lenders harder to come by. Banks started putting up debt ceilings as a result of defaults and regulatory pressures. Additionally, the high-yield market has seen an increase in its minimum threshold level, which will spur the growth of the use of mezzanine debt to capture the extra return. Another trend contributing to the growth of this asset class is the increasing rate of refinancings. The low interest rate environment, along with a sluggish M&A environment, has aided this trend. Because it is treated as equity under the balance sheet, it allows a company to borrow more money and leverage its capital. Exhibit 1: Independent* Mezzanine Fund Raising 6,000

($ Millions)

5,000 4,000 3,000 2,000 1,000 0 96

97

98

99

00

01

*Excludes self -financed vehicles such as insurance companies, banks, aspecialty finance companies, CBOs, etc.

Expected Return Duration Seat on Board

Historically, the mezzanine capital market has been dominated by insurance companies and savings and loans associations. Recently, that list of players has expanded to include limited partnerships (LPs), pension funds, hedge funds, leveraged public funds, and banks with stand-alone Mez funds. Banks used to be the principal purchasers of mezzanine debt, but now are also placement agents & underwriters. This in return has ensured that the borrower gets the best deal in the market. Which Form of Capital Raising Using mezzanine financing is relatively cheaper than raising capital through equity. By issuing equity to raise capital, a firm essentially dilutes its shares and its enterprise value. Mezzanine investors are looking for 18-20% IRR versus 25% to 35% for private equity investors. However, even though it is generally more expensive compared to bank loans, mezzanine debt is less rigid and can be greatly leveraged. Overall mezzanine debt is considered to be relatively costeffective. (See Exhibit 2 above) Outlook and Trends Mezzanine financing is becoming more and more complex as investor demands weigh in. Its characteristics have become increasingly more aggressive and flexible. One example is the call protections on the securities have become shorter to increase its liquidity and make it more attractive to investors. The focus has been set on second liens and gap-ins, and the additional capital needs of the firms. The mezzanine market is less volatile than both the debt market and equity market. The conditions have produced a stable market value and stability in the coupon trend. This is due to the PIKs which add interest back into loans, so the amount of loan increases over time. With these continuing trends, investors must keep an eye out for the growth in mezzanine financing.