4/7/11

Hey guys, quick question here: Could someone explain what kind of target is good for mezz debt investment in a LBO? Imagine some of the element will be similar (eg: steady cash flow). So guess the real question is, what are the different criteria that you will look at vs. a equity investment in an LBO?

Also, what are the key things that you will look at for a distressed debt (special situation) investment? Obviously you need to get convinced by the turnaround story, but anything that is more specific?

Thanks. Am having an interview coming up and the company invests in both mezz and distressed other than traditional sponsor equity.

Feel free to PM me if you want share the comments privately. Thanks!!!

Comments (10)

4/7/11

Cannot really speak to distressed, but for mezzanine investments, we tend to focus more on downside risk vs. potential upside. It doesn't need to be the moonshot homerun type of investment, we just need to make sure we'll get paid our 15-18% interest and get our principal back. So we look at coverage ratios, % debt repaid after 3/5/7 years, etc.

For an equity investment, you generally really have to believe there is significant growth potential or there is something about the business that will get you to your 25% IRR.

At my fund, we actually do a bit of both equity and mezzanine. If we don't really like the equity for the deal, we may throw our name in as a mezz lender.

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4/7/11
threatlevelmidnight:

Cannot really speak to distressed, but for mezzanine investments, we tend to focus more on downside risk vs. potential upside. It doesn't need to be the moonshot homerun type of investment, we just need to make sure we'll get paid our 15-18% interest and get our principal back. So we look at coverage ratios, % debt repaid after 3/5/7 years, etc.

For an equity investment, you generally really have to believe there is significant growth potential or there is something about the business that will get you to your 25% IRR.

At my fund, we actually do a bit of both equity and mezzanine. If we don't really like the equity for the deal, we may throw our name in as a mezz lender.

1. when you make mezz investments do/can you use any leverage besides your (equity) fund? so structured similarly to a CLO, except assets consist only of mezz loans.
2. how much of the 15-18% interest is cash pay, PIK, warrants?
3. How often is mezz refinanced? heard some crazy stories about mezz being refinanced after 6months, 1 year, so that 15-18% return will be very short.

4/8/11
fomc:

1. when you make mezz investments do/can you use any leverage besides your (equity) fund? so structured similarly to a CLO, except assets consist only of mezz loans.

You can, though the debt is more expensive and you get fewer turns of leverage (often times only 1). This is especially true when mezz referes to unitranche/senior lending to smaller MM companies. Sometimes a fund will also deploy its equity and then back-lever by securitizing their portfolio. This is because mezz debt funds can be slow to ramp and you don't want to have the cost of carry associated with the leverage until your funds are deployed, plus lenders will want to see what the portfolio looks like before buying the CLO debt. Here's an example of that type of mezz/MM CLO:
http://www.bloomberg.com/news/2010-07-29/deutsche-...

These types of deals are usually static, as well, unlike a standard broadly-syndicated loan CLO which is semi-actively managed.

fomc:

2. how much of the 15-18% interest is cash pay, PIK, warrants?

Totally depends on the deal.

fomc:

3. How often is mezz refinanced? heard some crazy stories about mezz being refinanced after 6months, 1 year, so that 15-18% return will be very short.

Again, totally depends on the deal. Call protection or discount notes and change of control language are another way that mezz facilities can be structured to take part in the upside-if the deal is a homerun and the sponsor flips in a year, you get paid out at a premium to your investment. On the flip side, mezz often has no amort/is structurally subordinated to other debt/etc and can stay outstanding a lot longer than the initial term debt.

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.

4/8/11
Kenny_Powers_CFA:
fomc:

3. How often is mezz refinanced? heard some crazy stories about mezz being refinanced after 6months, 1 year, so that 15-18% return will be very short.

Again, totally depends on the deal. Call protection or discount notes and change of control language are another way that mezz facilities can be structured to take part in the upside-if the deal is a homerun and the sponsor flips in a year, you get paid out at a premium to your investment. On the flip side, mezz often has no amort/is structurally subordinated to other debt/etc and can stay outstanding a lot longer than the initial term debt.

To clarify, this would mean that the senior note holders would have to approve any payout of the debt that's subordinated to them...which isn't likely to happen since that would essentially increase the risk to the senior lender.

Additionally, you will sometimes (often?) see a prepayment penalty structured in the terms which, like previously mentioned, boost the fund's return and discourages the company from refinancing you, even if the new mezz piece might appear to be cheaper. With that said, it certainly does happen. It's mostly a matter of the cost to refinance your debt (prepayment penalties, warrant ratchets, etc.) and the cost of the new debt (price of debt, transactions fees, etc.).

Ideally, as a mezz provider, you want to have your debt outstanding for as long as possible given the time and resources that get put into the diligence process of an investment.

Regards

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4/8/11
fomc:

1. when you make mezz investments do/can you use any leverage besides your (equity) fund? so structured similarly to a CLO, except assets consist only of mezz loans.
2. how much of the 15-18% interest is cash pay, PIK, warrants?
3. How often is mezz refinanced? heard some crazy stories about mezz being refinanced after 6months, 1 year, so that 15-18% return will be very short.

Kenny's right.

As far as interest goes, 12-14% current pay and 4-5% PIK. And yes, it's an expensive loan, and companies generally do not want to pay it longer than they have to.

We've been refinanced out in 1.5-2 years, and we have some still outstanding for the past 4-5 years, so it definitely varies. Don't really think I've heard as short as 6 months, but I'm new...

4/7/11

I'll also add that you usually won't see mezz pieces in huge buyouts; the shops that do mezz typically gravitate towards MM and lower MM deals (this is by no means ALWAYS true, but typically), due to risk and size.

The mezz piece is in the deal in the first place because the company can't get any more senior debt, more sponsor/mgmt equity will lower returns, and so the company looks to plug the funding gap with mezz. As the reatlevel mentioned, the mezz investor will not care as much about exits as PE (although there's usually warrants).

For distressed, basically the investor is usually betting that the face value of the debt will either (a) increase as restructuring becomes more plausible/feasible, or (b) that the securities will be converted to equity - "the fulcrum" - post Ch 11 and the investor thinks that th equity has value post-reorg.

4/8/11
analystforhire:

I'll also add that you usually won't see mezz pieces in huge buyouts; the shops that do mezz typically gravitate towards MM and lower MM deals (this is by no means ALWAYS true, but typically), due to risk and size.

Good point, holdco notes/PIK sub notes often substitutes for traditional mezz in large buyouts.

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.

4/8/11
Kenny_Powers_CFA:
analystforhire:

I'll also add that you usually won't see mezz pieces in huge buyouts; the shops that do mezz typically gravitate towards MM and lower MM deals (this is by no means ALWAYS true, but typically), due to risk and size.

Good point, holdco notes/PIK sub notes often substitutes for traditional mezz in large buyouts.

holdco notes/PIK sub notes are just HY bonds, with 100% PIK interest right? so large buyouts use loans (rcf, term loans) for their senior structure and HY bonds for their subordinated structure whereas MM buyouts are similar but instead of HY bonds, they use mezz loans for the subordinated structure?

4/7/11

Perfect.... Thanks for the response. Great insight here and really really appreciate it!

4/8/11

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.

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