Question about Mezz debt/cap structure
Hi everyone. I am currently trying to learn more about credit/debt financing and had a question. Why would a company ever issue mezz debt? It seems like the terms for more senior debt like traditional unitranche or 1L/2L debt are way more favorable (lower rates, option to prepay, no incurrence covenants, no equity involved). I understand the benefits from an investors perspective, but what about a company.
Wasn’t sure what forum to put this post in but I’m assuming RX and LevFin bankers, distressed/special sits, PC folks could be helpful here. Thank you 🙏🏽
Well when you wanna lever up beyond what these more senior debt providers will be willing to provide, you need to move lower into the cap stack lol. Thats when mezz comes in. I highly highly doubt anyone would willingly choose mezz over 1L/2L, its more so once they've maxed out their senior debt tranches, they'll either need to move to junior debt like mezz or HY bonds, or fund themselves with equity.
Why are senior debt investors reluctant to provide more debt? They are secured and can provide at a lower rate. If they know someone is going to provide debt financing, why don’t they just do it themselves?
In simple terms.
I have $10 in collateral.
You make me a loan for $8 because you believe my collateral is only worth $8.
I want another $2 of debt.
So I go to a mezz lender that is OK underwriting the last $2 that also carries the highest risk in this example.
Thank you this makes sense
Let me give you an example using homes as an analogy.
I go and buy a million dollar home. Real estate prices, of course, are kind of inflated right now. I get a mortgage of 80% LTV (800k).
Now, why doesn't the bank just lend me all the money? Because at that point it is practically taking equity level risk, but with small and capped upside (interest). No one with over 3 brain cells would do that lol.
The logic is that even if home prices drop 20%, the lender won't take a loss on that collateral.
So you said senior debt is attractive because of low rates - they only offer low rates because their loans are SUPER secure. Collateral value is never guaranteed, it is subject to fluctuation and that's why they will never lend exactly as much as collateral.
Going back to the house analogy, the bank will only lend 80% of total value, but private lenders may lend up to 90% LTV, therefore helping reduce the down payment I need.
Also, you said "If they know someone is going to provide debt financing, why don't they just do it themselves?". Well, they could do it themselves. But since the risk is now going up, they will demand higher interest rates, more protective covenants, etc... which, of course, is sounding similar to mezz debt.
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