Mezzanine Finance: What exactly do you do here?
Anyone who has taken a basic corporate finance class has probably run across the ambiguous term of junior debt. But what exactly does that mean and who exactly are the people working in the trenches. I had the opportunity to work with one of the more successful middle market mezzanine finance firms in the greater philadelphia/delaware/new jersey area and figured I'd provide some insight to try and help pay back all of the lurking I did over the past year and a half.
So to start with the basics, why do people even use mezzanine financing and how does it work? The most basic form of a capital structure within a company generally goes senior debt, junior debt, and equity. Senior debt is pretty well known; a large bank (TD, PNC, BoA, etc.) is willing to lend at modest rates in return for a first claim on hard assets (inventory, equipment, property, contracts). Banks tend to be very careful lenders though. The other common route for generating cash to grow your business is by raising equity. However, there becomes a certain point when the bank has no more assets to lend against and you don't want to dilute your equity any further (especially when EBITDA is $5-$10MM).
Mezzanine financing comes in at this junction then. Most loans are made with a 12-14% coupon, and some combination of an equity buy-in, PIKing, or warrants. Many smaller mezzanine finance firms are SBIAs, which means that they get part of their funding from the government (a large portion is still high net worth individuals and institutional investors) so long as they only lend to companies that meet certain requirements (in the US, where employees are, etc.).
With that basic outline, here are a few general questions that I think will come up so I'll do my best to answer them now:
Who works in the industry?
From what I've seen, the industry tends to be dominated by former senior lenders with investment bankers and corporate management types sprinkled in. Because Mezzanine lending focuses on the credit perspective, it's not too surprising that commercial lenders tend to transition into the space.
How do funds make money?
The 12-14% interest rates on loans are not high enough for funds to be successful. The extra money that makes a good firm profitable usually comes from identifying good portfolio candidates who will grow at a steady rate. The two main ways of benefiting from a company's success are through equity co-investments and warrants. Generally, equity co-investing is standard procedure when a company has demonstrated the ability to grow consistently and is a lower "risk". Warrants are essentially free upside in the equity of a company and are used when a company's credit profile might be weaker.
What are the hours like?
Generally very reasonable. Interning, I was putting in about 40-50 hours a week. Although the fund was small, I'd say everyone else was putting in about 10-11 hour days during the week with a few additional hours (maybe 3-5ish) on the weekend. Obviously hours depend with deal flow, but I'd say that's standard in this line of work.
What will I make?
As a lowly intern in a very small firm, I didn't have the cojones to probe people who could be my parents/grandparents on what they make. I have met people who came from BB banking programs as associates and work in the industry, so comp has to be competitive. Maybe someone else can chime in on this for me.
Will I get to flew my excel modeling muscles?
Yea buddy!
Will I be making powerpoints?
Hell no!
Feel free to let me know if you have any other questions and hopefully this was a useful primer.
Thanks -- specific laymen explanations go a long way
Good stuff, thanks for posting.
You say that there are some corporate management as well as commercial lending backgrounds present, which is a positive for those who haven't been fortunate enough to land a BB banking opportunity. My question is, what type of firm were you at? Is mezz the only product the firm offers (small firm), or is it a larger, more diverse investment management house?
It varies. The firm I was at was very small and only focused on mezzanine lending. However, other firms that we partnered with on deals also had private equity funds within the larger structure of the company. From what I saw, those tend to be the two types: only mezzanine and one large fund that has separate groups for PE and mezzanine financing. Most funds tend to be clustered along the eastern seaboard as well as midwest (Chicago, Minneapolis, etc.). For some reason, there is a relative over-supply of mezz financing in those two areas while the west coast is still quite open.
One more thing that I forgot to mention earlier was deal sourcing. It actually turns out that IBanks and PE groups are the major sources of new deals. If there's interest I can discuss some of this in further depth as well and what some of the benefits are to both sides.
There is a surplus of mezz financing in the midwest? Did not know that. Perhaps it's because of the stereotypical manufacturing companies out there?
West coast being open is music to my ears, though. I'm ideally trying to get into a PE shop out in the Bay Area and the exposure I've gotten at my current firm is with the large mezz fund that we have.
I'd love to hear more about deal sourcing and any other topics related if you feel it's worth your time. This has been helpful for me!
Do you feel like a mezz. internship would pigeonholes you into, well mezz.?
Not necessarily; I learned a fair bit of modeling and analytic/diligence skills that I'd say could be applied pretty well to banking or PE.
I don't have a direct basis for this next part but:
I'd assume saying you have constructed buyout/merger models (mergers do come up frequently in mezz) and have conducted corporate and industry specific due diligence should help with banking or PE interviews. Experience is experience and as long as you aren't doing coffee runs all day you should have several good/memorable things to highlight from your internship to leverage into other positions or industries.
Mr. Anderson - just curious, what are you up to now? Was your experience as an intern? You working in PE/Mezz full time now?
I'm still in school so my experience was as an intern. I had a great time and learned a lot, but after working for the summer I think I'd be better off/more engaged using the quantitative skills in something like S&T. Terrific experience overall though not only with the fund I worked at but the other people in the industry I met during the summer.
Also, I'd agree with VanBuren in saying that there isn't an oversupply of mezz in the midwest, it's just competitive. States like Kansas though maybe have a handful of funds at best though. As for the the west coast, I've seen deals from LA to middle of nowhere Washington state, so it is definitely more related to the potential portfolio company, considering how large the region is.
Thanks for posting this! The information is especially helpful for me because I have been interviewing at a MM lending firm in the Midwest ($6B AUM), and basically just got an offer.
My offer is for a business analyst internship, part-time through my senior year of undergrad. It's technically under the IT project head, but would involve a lot of interaction with FO analyst teams and the CFO, as well as people on the technology side. Does working at a MM lending firm in such a role set one up, potentially, for FO roles there or somewhere else upon graduating?
I am at a non-target without much real finance experience; would such a MM lending firm be better than a FoHF, econ consulting, or a start-up investment firm (I basically have offers from all of the above)?
What would your role be at the start-up investment firm, and what do they invest in?
The start-up is focused on valuation of 'social impact' and social value, along with more traditional valuation, focused on major US companies; it's a spin-off of a boutique strategy consulting firm that specializes in measuring these things, especially for non-profits.
The investment firm is only 6 months old and the major product I'd be working on helping with modeling (still working out details) won't be out till Spring, and will determine the future of the firm. So it's risky in that I may have a non-existent name on my resume afterwards, but I would be working closely with the founders who are well-connected in finance.
Interesting article. I was wondering what would you say that you managed to learn in your first few weeks of interning? And secondly, what did you manage to learn by the end of the internship?
Mezzanine/Sub Debt Market & Deals - Info? (Originally Posted: 11/19/2009)
I've got to put together something about the mezz/sub debt market (current news and info in North American markets, deals - volume, size of deals, by sector and purpose, general trends, pricing, etc.)
I was wondering if anyone can tell me good places to find this info. So far I tried S&P LCD to get some really general LBO middle market deal info... but not too much else.
Anyone with good suggestions? Thanks in advance.
bump - anyone?
Mezzanine Financing comprehensive resources (Originally Posted: 11/27/2011)
I'm looking for a comprehensive resource where I can learn everything there is to learn about mezzanine debt. Any suggestions?
This PDF is a decent elementary overview: http://www.bondcapital.ca/media/pdf/Bond_Capital_Mezzanine_Finance.pdf
Thanks, I came across that as well. I need something more in depth though.
what do you mean by "more in depth?" what aspects in particular are you trying to learn more about? you could just read some literature on credit/debt structuring/investing and then likewise for equity. mezzanine is just sort of in between or a combination of the two.
Don't think it exists. Post about it here if you find something, though.
Really hoping you're wrong buddy.
There is a very successful individual named Gordon Tunstall who speaks around the country about mezzanine financing. If you google him and look up some of his online talks, articles, etc you should be able to find some great information about mez.
Thank you, I'll be sure to look him up.
You could always ask questions on here and get some answers/ridicule.
Regards
haha, I could have have. I was working on a case for a class but the case was fairly straightforward. I just wanted to feed my intellectual curiosity and learn more about about the fundamentals.
As you probably figured out, Google is your best friend. There are tons of articles and links here and there that explain portions of mezz, but nothing really comprehensive. I've always found it best to read through what I can find and then come ask more pointed questions. There are a number of guys here on WSO that work in mezz or have knowledge of it so they should be able to provide answer for any questions you have even if it's for your general education.
Regards
Hoping you can chime in.
To be specific - the most interesting aspect to me was the equity kicker that is used to hit the target IRR. Specifically, how exactly firms value warrants. I also wanted to learn about how sub-debt is usually paid off (bullet/amortized).
There's another thing that threw me off while building my model. You guys can point out if I'm approaching this wrong:
To determine the firm's free cash flows (to determine how much debt it will be able to take on), I calculated the unlevered FCF. This involves tax-affecting the EBIT, but taxes take into account the capital structure so if I'm looking at a scenario with different levels of debt/different interest rates, is there a better way to incorporate the interest tax shield?
here are a couple of free resources on debt. the bank loan info is better, although, maybe not what you're looking for. https://www.lcdcomps.com/d/pdf/LoanMarketguide.pdf https://www.lcdcomps.com/d/pdf/hyprimer.pdf
regarding the valuation of warrants - you just value them like equity. you're getting a specified % claim on the equity value of the company (these are usually structured like options with a strike price above which they are "in the money"). if you have warrants for 5% of a company with a strike price of $100M equity value and the company is sold for $200M equity value, you get 5% of the $100M gain = $5M. you just plug that $5M and the timing into your IRR calculation. I think most funds would run a full LBO-type model to value the total equity of the company and the implied value of their warrants, but I suppose you could also use some type of option pricing model.
regarding paydown for sub debt, it is usually a bullet at maturity. the reason for this is that the secured bank loan lenders don't want junior/sub debt being paid back before the secured loans are completely paid back. this is one of the reasons that sub debt gets paid a higher interest rate. if you are talking about a mezzanie sub debt deal, then mezz deals are a lot more "bespoke" like someone else mentioned. a mezz lender can essentially structure their security any way they want as long as it doesn't conflict with the terms of other debt that is already outstanding and it conforms to existing securities law.
to build a model to determine how much debt a company can take on, at least for leveraged finance situations, you don't really need to look at an unlevered FCF metric (that is more of a tool for DCF modeling). you look at credit ratios like debt/ebitda, debt/(ebitda-capex), debt/FCF, ebitda/interest expense, (ebitda-capex)/interest expense to determine how high the debt burden is relative to the income/"cash flow" of the company and you build a projection model that shows you if the company is paying off debt over time and deleveraging. if you run your projection model with an assumed debt load and the company doesn't have any cash flow because its interest expense is too high and it doesn't pay off any debt, than the company probably can't sustain that much leverage and you need to bring the debt level down.
anyone?
Call a Mezz fund and ask to speak with an analyst or associate, explain you are trying to learn about their products....you're asking very fund specific questions.
would this really work?
I'll answer the simplest of the questions - repayment:
Debt in all forms in very bespoke, as such it's hard to generalise. For example in some on the infra assets we have on our books mezz tends to follow the senior amort. as is the nature of infra (it almost always amorts, because lets face it who is gunna want a 25+ year slice of bullet mezz). But on the other hand in one of our LBO loans it's a bullet with PIK characteristics with, as you'd expect, a standard 7yr tenor.
It's worth noting that we only deal with warrant free mezz, but as a stab warranted debt would be a bullet. Or the warrants would at least have to have some sort of ratchet on them in line with the amort, but seems tricky. Correct me if I'm wrong.
Could you elaborate on the rationale behind avoiding warrants? Is it simply to avoid taking an equity stake in these companies? If so, can you give examples of the types of securities you accept when you offer loans with PIK interest?
Warrants are also really hard to come buy with companies above $5mm in EBITDA. They are just viewed as more sound and they can almost always find someone to loan them money...especially post meltdown since so many PE funds, HF funds and, to some extent, BDCs have sat on so much capital looking for a decent/good deal. Over the last year good deals would come around every so often and the pricing on the debt would be absurdly low because some of these funds did virtually no investing in '08 and '09 and were looking to put money to work so they didn't piss off their LPs.
Some firms avoid warrants because they typically require more thorough due diligence, which costs time and money. Some are strictly debt shops so they have no interest. The firm I'm at actually evolved from an equity shop, so we look for warrants when we can and, as we've been told by many people, we do 'equity like diligence' on our debt deals to begin with, so it's really no additional skin off our backs.
We also like having a PIK in most cases because it helps bump up the returns. Again, in this scenario you are increasing your risk by leaving a greater sum of principle uncollected but there is a return aspect as well. Like with anything else, you have to weigh the risk-reward scenario. We've looked at a few deals where we didn't want any sort of PIK at all because of the nature of the business. I think we structured a deal like that for a government contractor...although we didn't end up doing the deal...but structured no PIK because they operated on a contractual cycle, so they had steady earnings for 3 years, but after that you just hoped that the contract renewed...if it didn't the company would have been hard pressed to pay back the loan from the cash generated from operations and they would have had a very difficult time finding a new lender to refinance the debt at a reasonable rate, so we did cash flow sweeps into an escrow and would have early payments made on the debt, etc.
Regards
^^ Just to confirm the thought process was PIK > no PIK > cash sweep? What was the underlying ( i assume bullet) in the end? Why was PIK an initial consideration, was the opportunity cost of paying interest that high? And if so why were sweeps considered (or were they a % or FCF).
We work on the lower end of the market so we typically try to target a certain return for the perceived risk. If the company is comfortable with that pricing then we can do just a cash coupon or part cash and part PIK depending on what they prefer...assuming we are okay with it.
In the case above, the company essentially had guaranteed money for 3 years of the 5 yr note. Chances were they would get the contract renewed but in the off chance it didn't happen, we decided to not do a PIK because of the additional 'risk'. In addition to that we structured a cash flow sweep with the company that would basically hold money in an escrow because we didn't want our loaned paid off immediately (and they didn't want to pay pre-payment penalties) but we also didn't necessarily want them taking on new capital projects that might not pay off before our loan comes due, especially if they were to somehow fumble the contract renewal process and not get re-approved or if the government starting slashing spending because of the budget crisis and this was one of the areas impacting by those cuts.
We also did something similar with a company that generated sales through TV advertising...like an infomercial. We ended up not doing that deal either but got to the very end with them. Essentially they were hawking a product (that was legit) via TV spots. Each spot generated a substantial amount of money for the given investment of producing the spot...partially because they can be reused. This company had the exclusive distribution rights in the US for this product but as with anything sold as a medical miracle type product (again, it was still a legit product) there is risk. Additionally the product was produced from something that could easily be impacted by inclement weather or an industrial accident in the region it was 'farmed' so there was a ton of uncertainty surrounding the supply line. All of that made us a bit hesitant with the investment so we structured a cash flow sweep that would essentially make us whole should this product tank or the supply line got cut off.
This wasn't a 100% bullet in the end since towards the end of the loan the cash from the sweep would have paid down some of the debt 'early'. For us PIK is always a consideration. Since we deal with smaller companies, reinvestment of cash flow for growth is usually a big deal for them so we gladly do PIKs because we end up getting an extra point or two of IRR out of it and it makes us look more sensitive to the company's capital needs. For a lot of our companies the owners don't want to give up equity, so they are sometimes willing to pay (slightly) above market rates. As far as the cash flow sweep was concerned above, the company needed a good portion of capital up front to pay for the ads they were creating, some which included celebrities, athletes, etc...so there was a 'substantial' up front investment. Historically they were able to take the money they spent on ads and multiple that exponentially through sales over a period of about a year and a half. Because the product was essentially taken as a medicine the customers would use it for extended periods of time, I think on average it was like 14 months. Given the metrics of the sales data, the company could have stopped selling that day and carried on with the business for basically another 2 years because of the recurring payments made by their current customers, so their focus was to get more ads played and more current customers and keep them happy for as long as possible because you don't know when your product will be one-up'd by the next new miracle plant or bug or juice or animal gallbladder extract. Essentially, for them, if you aren't running ads you aren't generating new customers. And the cash flow sweeps were a % of FCF.
Hopefully that answered the question, as long winded as I was, lol.
Regards
Yea that's good stuff, cheers. I never did any time on the sellside and am really interested in knowing the rational behind captial structures (would have loved some Lev Fin time). Sounds like a very good way of funding certain firms at certain points of their life in a very bespoke way.
Great stuff guys, thanks for contributing!
Mezzanine Financing (Originally Posted: 04/26/2012)
Long time reader, first time poster...
Could someone please provide an abbreviated crash course on 'mezzanine financing'? I will be meeting with a representative from a fund similiar to those below in the next several days. Does anybody have any insight as to what one could expect in terms of employment opportunities (mid level analyst)? Is it a desirable/growing field? Interesting work? Respected in the rest of the VC community? Your help would be very much appreciated.
http://www.tmfund.com/ http://www.floridamezz.com/
Read this: http://cyprium.com/pdf/PR62.pdf
1) What do you mean by employment opportunities (exit ops, job responsibilities, ...)?
2) Desirability is really an individual, subjective barometer. Do you find subordinated debt and minority equity interesting? Growing? Yes, particularly in the middle-market. A lot of fundraising activity among BDCs, SBICs, unitranche shops, and traditional mezzanine firms over the past few years. Blackstone just raised a huge ass $4B mezz fund.
3) Interesting? Again, that's a personal matter. Today, mezzanine is mostly high yield financing to support private equity firms in their LBOs. There are many different strategies in mezzanine, as well. Some shops just do sub debt, some competitors provide capital throughout the capital structure, and others require 50% of their investment in equity.
4) VC community? Mezzanine firms, for the most part, do not interact with VC firms, as early stage companies do not have the cash flow to support mezzanine financing. Mezz firms interact with PE groups, mostly, and individual companies themselves.
The two firms you posted look more debt-focused. Not as exciting as other mezz strategies.
Well said.
Thank you, VanBurenBoyz. Much appreciated. The reading material should prove to be very helpful in my upcoming meeting.
Got any other reading material? I would be interested.
http://pages.stern.nyu.edu/~igiddy/articles/Mezzanine_Finance_Explained… http://www.stblaw.com/google_file.cfm?TrackedFile=4B46116607DFEED896B17… http://pdf.lincolninternational.com/DebtAdvisory/102511_PEHUBWIRE.pdf
Series of articles last year: http://www.churchillnet.com/ontheleft/2011/0620/otl.html http://www.churchillnet.com/ontheleft/2011/0627/otl.html http://www.churchillnet.com/ontheleft/2011/0704/otl.html http://www.churchillnet.com/ontheleft/2011/0711/otl.html
[quote=ThaVanBurenBoyz]http://pages.stern.nyu.edu/~igiddy/articles/Mezzanine_Finance_Explained… http://www.stblaw.com/google_file.cfm?TrackedFile=4B46116607DFEED896B17… http://pdf.lincolninternational.com/DebtAdvisory/102511_PEHUBWIRE.pdf
Series of articles last year: http://www.churchillnet.com/ontheleft/2011/0620/otl.html http://www.churchillnet.com/ontheleft/2011/0627/otl.html http://www.churchillnet.com/ontheleft/2011/0704/otl.html http://www.churchillnet.com/ontheleft/2011/0711/otl.html[/quote]
Good stuff
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