Mezz fund interview

Hey guys,

I'm a 2nd-year DCM analyst with an interview lined up at a small (<$1bn) MM mezz/PE fund -- they invest across the capital structure, though I get the sense they do more mezz than straight equity. Anyways, I know what kind of questions may cover PE, but don't know what to expect for mezzanine debt-related questions. My background is high-grade with some select high-yield/secured financings.

On a related note, what is day-to-day like?

Thanks!

Comments (32)

 
Jul 16, 2012 - 6:02pm

Cash Flow modeling is important and knowing about covenants is also a good starting point. Mezz is generally pretty straight forward so you probably have the necessary skills to be successful, so don't be overly concerned.

I will try to get back and write some more, but I have to cut out of the office before this storm hits. Here is a link that looks like it had some solid information in it.

http://www.streetofwalls.com/articles/private-equity/recruiting-intervi…

Regards

"The trouble with our liberal friends is not that they're ignorant, it's just that they know so much that isn't so." - Ronald Reagan
 
Jul 16, 2012 - 6:31pm

Mezzanine Case - Interview - Paper Problem (Originally Posted: 01/21/2015)

I was given 15 minutes to solve this below problem in an in person interview at a Mezzanine Fund yesterday. I was wondering if anyone can provide the right solution to see if I got it right.

Brockway Moran & Partners purchased Woodstream Corp., a maker of wild animal cage traps, rodent control devices and pesticides, from Friend Skoler & Co. LLC. The $100 million purchase price is equivalent to between 6.5 and 7x EBITDA.

qOf the equity, Brockway contributed 85% of the total, with management chipping in 10%. Lenders Antares Capital Corp. and Allied Capital Corp. fill in the remaining 5% gap. Total equity represents approximately 40% of the purchase price. The equity sponsors aim for a 27% rate of return in this investment.

qOn the debt side, Antares led a $58 million senior facility, along with Merrill Lynch and GE Capital Corp. The senior debt component also contains a revolver to be used in the future as working capital (and not included in the $100 million purchase price). CIT Private Equity and Denali Advisors LLC provided a subordinated note in the amount of $17 million.

A summary of the financing terms follows:

Senior debt: LIBOR + 3.50%, 4-year amortization
Subordinated notes:
  7% cash interest
  7% pay-in-kind interest
 Warrants to purchase 5% of the company's equity at $0.05 per share q
 Repayment after 5 years or at exit event
 Fees 1.5%

The equity investors were seeking an estimated 27% rate of return.

Questions
1. What is the effective rate of return to the mezzanine investor?
2. What is the effective cost of the mezzanine finance to Woodstream?

 
Jul 16, 2012 - 6:32pm

I'll tackle question 1.

Couple comments:
1) I count $115MM of sources for a $100MM purchase price. (Fees and expenses?)
2) This sounds like a homework problem, not an interview question.
3) The exact IRR to the sub-debt holders will depend on when/if a liquidity event occurs inside of 5 years.

Anyways, that said, let's assume there is no liquidity event inside of 5 years. Let's also use round numbers since we don't have the benefit of a computer/financial calculator (I think this is impossible to get 100% accurately without one).

Your cash and PIK payments on the sub-debt get you a combined 14% IRR, and then you get a little extra boost from the upfront fees, basically 1.5% but "amortized" over 5 years for IRR purposes, so your IRR on the cash the mezz guys have actually lent is ~14.3%. (7%+7%+1.5%/5)

Now we need to look at the warrants. 5% of the equity is approximately $2MM of value today. These are issued at a very low strike price (called "penny warrants"), so basically they are (free) equity. At a 27% IRR, that $2MM is worth $6.6MM in 5 years. So you get another $6.6MM on your $17MM investment in Year 5.

This is where it gets tricky without a computer or financial calculator. Normally I'd ballpark it and say $6.6MM/$17MM=38%/5 years=7.5% per year, and add that to my 14.3% for a ~22% all-in IRR, but that's a little high. A quick check on Excel shows the actual IRR is 19.2%.

I've hit a wall without a computer but hopefully someone else here can explain an Excel-less shortcut, or maybe I'm thinking about the warrants wrong.

 
Jul 16, 2012 - 6:33pm

mrb87:

I'll tackle question 1.

Couple comments:

1) I count $115MM of sources for a $100MM purchase price. (Fees and expenses?)

2) This sounds like a homework problem, not an interview question.

3) The exact IRR to the sub-debt holders will depend on when/if a liquidity event occurs inside of 5 years.

Anyways, that said, let's assume there is no liquidity event inside of 5 years. Let's also use round numbers since we don't have the benefit of a computer/financial calculator (I think this is impossible to get 100% accurately without one).

Your cash and PIK payments on the sub-debt get you a combined 14% IRR, and then you get a little extra boost from the upfront fees, basically 1.5% but "amortized" over 5 years for IRR purposes, so your IRR on the cash the mezz guys have actually lent is ~14.3%. (7%+7%+1.5%/5)

Now we need to look at the warrants. 5% of the equity is approximately $2MM of value today. These are issued at a very low strike price (called "penny warrants"), so basically they are (free) equity. At a 27% IRR, that $2MM is worth $6.6MM in 5 years. So you get another $6.6MM on your $17MM investment in Year 5.

This is where it gets tricky without a computer or financial calculator. Normally I'd ballpark it and say $6.6MM/$17MM=38%/5 years=7.5% per year, and add that to my 14.3% for a ~22% all-in IRR, but that's a little high. A quick check on Excel shows the actual IRR is 19.2%.

I've hit a wall without a computer but hopefully someone else here can explain an Excel-less shortcut, or maybe I'm thinking about the warrants wrong.

Are you saying this looks like a homework problem because the level of difficulty? Seems sort of ridiculous to ask someone to answer both questions in 15 minutes. Took a third of that time for me to just sort out who the players were and what the deal structure was given how they wrote it.

 
Jul 16, 2012 - 6:36pm

Anyone can explain the difference between questions 1 and 2?


Effective cost of giving up the equity if their return hurdle is 27% isn't the actual return that equity goes on to earn.
"After you work on Wall Street it’s a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side.” - David Tepper
 
Jul 16, 2012 - 6:37pm

I was able to take a picture with my phone while trying to solve the problem and tried to provide as much of the original question as possible. They said I could ball park the IRR and gave me a financial calculator to solve it. I ended up with a blended IRR of 15%. Right off the bat, I knew it was on the lower side and did something wrong when I was perhaps including the warrant returns.

FairValue - I had the same issue regarding question 1 and 2. I thought they referred to the same thing.

 
Jul 16, 2012 - 6:40pm

Mezzanine financing/investing interview (Originally Posted: 07/23/2015)

Does anyone have any suggestions on how to prepare for an interview for a fund that does senior debt and mezz financing for companies? What are they key drivers to understand?

Does also anyone have any conceptual or case study approaches to questions? E.g. how would you determine whether a company with certain assumptions is a viable candidate to provide mezzanine financing to, how to assess this?

Or alternatively, how do you determine the maximum purchase price company A could offer without worsening their credit rating by more than 2 notches?

How do you assess and compute returns based on cash interest and PIK interest?

What does the DD process involve in assessing company's capital structure, intercreditors, etc. e.g. in a buyout process (LBO?)

Are there any good general case studies to the debt side of financings to help prepare and understand the underlying concepts?

 
Jul 16, 2012 - 6:43pm

Well in general I am just trying to understand the advantages and disadvantages of different financing structures - e.g. I have done research independently and so far no guide or book has illustrated the advantages of using for instance Floating Rate Notes over a term loan B. Therefore it would be great to understand the mechanics of the LevFin market and I am just asking for fellow WSO members here with more experience in the market to share their pearls of wisdom on the dynamics as well as current trends, thats all.

 
Jul 16, 2012 - 6:45pm

trionfatore:

E.g. can anyone answer the questions in this link on the following case study?
http://people.stern.nyu.edu/igiddy/cases/cognis_se...

1. Why would a company choose to finance with second lien debt rather than conventional mezzanine notes with warrants?
2. This deal was a refinancing. Could second lien debt be used for a leveraged buyout?

  1. I can think of two things off the top of my head: a) they don't want to give away equity upside through the warrants; and b) noteholders might want to "move up" in the capital structure as compensation for div recap. Although I'm confused by the writer of the case study using "2nd lien" and "subordinated" interchangeably, which, even if he just means "subordinated [to the 1st lien debt]" is a horribly confusing way of putting it for anyone in the business. Lastly, maybe as c) the incurrence covenants might be more palatable to the sponsors than the maintenance ones depending on their plans for the company.

  2. I don't see why not?

 
Jul 16, 2012 - 6:46pm

Mezz Fund Interview...need quick help!? (Originally Posted: 08/13/2013)

Starting sophomore year in a week and received an email this morning to schedule a call for internship with mezzanine fund.

I really have no idea what to expect for call. If there's technicals I will be cooked!

Basically have competed two semesters of college...

What can I expect?? I'd like to PM the fund to someone. Nervous...

 
Jul 16, 2012 - 6:48pm

I don't understand how people apply to internships they have no idea of. (it sounds unlikely to me that you were approached by them). The search function works well and I remember there were threads about it. I would recommend you to understand how it works for a mezz fund and how does it differ from a PE fund. Understand the basic mechanics of mezz debts etc. Personally don't think they will grill you with hard tech questions. But if it's a BO position then you shouldn't worry too much

 
Jul 16, 2012 - 6:52pm

I'll ignore your rather large generalization at the beginning, for I was actually targeted by an associate, because my initial internship with a PWM group fell through. It was completely out of the blue...of course I'm not going to deny the phone call so I'm going to prep and try to see how much I can possibly learn in 24 hours.

Otherwise, good feedback, thank you.

 
Jul 16, 2012 - 6:50pm

Know whether a bond will be at a premium or a discount if yield is X and coupon is Y. Understand where mezz sits in the capital structure and the risks and benefits of investing in such a piece of paper. Read up on maintenance vs incurrence covenants. At the very least bring these up and ask questions you have. At your age they will respect your curiosity and hunger to learn vs expecting you to have it all down.

 
Jul 16, 2012 - 6:55pm

The response I was hoping to receive. Thank you, NYU! I have a good concept of bonds, but the other areas I need to study.....Will do all you mentioned and try to retain it. I have just about a day...who knows what will happen.

Considering you're certified and a very smart man, I'd like to PM you the fund to see what you think?....

 
Jul 16, 2012 - 6:56pm

I'm reviewing how the three statements link and debt metrics etc..I've definietly learned more than I thought in about six hours. I'm hoping this isn't overkill but I feel like it could be. His email said just a "call"...so it may be more fit oriented and I can only hope I don't get grilled. I just don't picture it going like that...

For perspective, and yes, this is highly superficial, but how would a mezz fund look on my resume? This entire opportunity I have is a result of losing a chance with a PWM firm...so I wonder (for potential IB anyway) how this would be viewed?

 
Jul 16, 2012 - 6:57pm

FCP4:
For perspective, and yes, this is highly superficial, but how would a mezz fund look on my resume?

For a sophomore, very impressive. Much better than PWM if you are thinking about moving to banking next.

Good luck.

"For I am a sinner in the hands of an angry God. Bloody Mary full of vodka, blessed are you among cocktails. Pray for me now and at the hour of my death, which I hope is soon. Amen."
 
Jul 16, 2012 - 6:58pm
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