Capital Raise Blog Series - Vol 9 - Types of Capital (Senior Debt & Mezzanine Capital)
As investment bankers, RKJ Partners possesses a breadth of knowledge and experience in advising clients that seek growth capital. In our latest blog installment, we define and outline the key elements involved in the process of raising capital.
It is fairly common for business owners to believe there are only three sources of capital – their local bank, the Small Business Administration (SBA) or personal loan/savings. However, if certain business criteria are met, there are other viable sources of capital available to fund growth opportunities. Capital is generally grouped into three main classifications: Senior Debt, Mezzanine Capital and Equity Capital.
Most entrepreneurs are very familiar with senior debt offered by traditional banks. Senior debt is first in seniority and is often secured by collateral in the form of a lien. Senior debt is financing that has been loaned to a company for a pre-negotiated period of time with interest paid on the principal. Senior debt is among the safest form of financing for the party providing the funds. Due to its inherent low risk, it also provides the least amount of return. However, in exchange for this low return, significant protection is provided to the lender even in the event of bankruptcy.
In this blog issue, we attempt to demystify a not-so-common type of capital – Mezzanine Capital (also called Mezzanine Debt).
Mezzanine Capital/Mezzanine Debt - Overview
In practice, most mezzanine financing takes the form of subordinated, unsecured debt. Initial discussions often focus on whether the debt should be structured in the form of loans or debt securities, with the investors’ view of the likely resale market being the strongest determinant. Mezzanine financings in the form of debt are commonly characterized by the inclusion of an equity participation, usually in the form of warrants, options and/or conversion features or co-investment rights associated with the primary mezzanine investment.
The maturity of mezzanine debt is typically five years or longer, but the maturity for a particular issuance often depends on the scheduled maturities of other debt in a company’s capital structure. For mezzanine debt that is incurred at the same time as traditional bank debt, senior lenders often insist that the mezzanine debt mature later than their bank facility. However, because mezzanine capital tends to have a higher rate of return relative to other debt in the capital structure, some issuers prefer shorter maturities. Conversely, some issuers agree to longer maturities on their mezzanine debt in exchange for more flexible optional redemption terms.
Mezzanine debt instruments generally feature a cash coupon with a fixed rate, which can be payable semi-annually or quarterly. Mezzanine investors usually target a higher internal rate of return (“IRR”) on their investment than high-yield or bank loan investors, and seek to achieve their target IRR by a combination of the interest rate, fees and the equity component. Mezzanine preferred equity investments are typically structured with a high fixed-rate dividend, which may be paid in cash or in-kind, and may feature an optional or mandatory conversion into common equity.
Ranking in the Capital Structure
A key consideration in structuring a mezzanine financing is determining the position (technically referred to as being “senior” or “junior”) of the mezzanine debt in the issuer’s capital structure. In some situations, mezzanine investors agree to invest in a preferred equity instrument that is junior to all debt in the capital structure. For mezzanine investments structured as debt, senior lenders generally expect that the mezzanine debt is subordinated to the credit facility and possibly other senior lenders, such as high-yield bondholders. Therefore, mezzanine debt holders typically agree to be contractually subordinated or “junior” to existing and certain future holders of senior debt of the issuer.
One of the defining characteristics of mezzanine debt is that it is typically unsecured. In those instances where mezzanine debt is issued on a senior basis at the same level with other debt of the issuer, the remaining senior debt is secured, so the mezzanine debt will be effectively subordinated to any secured debt of the issuer to the extent of the value of the collateral securing that senior debt.
Covenant packages used in mezzanine debt financings are usually based on high-yield style covenants or bank facility covenant packages. If the issuer has an existing senior bank facility, or is entering into a new bank facility in connection with the mezzanine debt investment, the mezzanine debt covenant package may be largely based on the covenants in the credit facility. Key negative covenants in mezzanine debt may include limitations on: incurrence of additional debt; restricted payments; liens; change of control transactions; asset sales.
Mezzanine investors regularly seek to enhance their returns by negotiating for equity participation alongside their debt investments (sometimes referred to as an “equity kicker”). Mezzanine equity investments can take various forms, including:
- Warrants or options to purchase a specified percentage of equity (often 1% to 5%) in the issuer.
- A right to co-invest in the issuer alongside the controlling stockholder or a private equity sponsor.
- A conversion feature that allows mezzanine investors to convert all or a portion of their principal investment into common equity of the issuer.
Equity Component of Mezzanine Investment
Because the overall return to the mezzanine investor includes the investor’s ability to realize the value of its equity participation, a viable exit strategy is critical to the decision to participate in a mezzanine funding. Potentially viable exit events include: sale of the company/issuer; recapitalization; refinancing; or an initial public offering.