Mezzanine finance, and the cost that only appears at the exit

What mezzanine is

Mezzanine sits between senior debt and equity in the order of who gets paid. It is subordinated lending: the senior lender is repaid first, the mezzanine provider next, and the shareholders last. Because it waits behind the senior facility, it carries more risk, and it is priced accordingly.

It exists to solve one problem. The senior lender will advance a certain amount, the deal costs more than that, and the buyer either cannot put in the difference or does not want to sell shares to raise it. Mezzanine fills that space with something that is still debt, so the buyer keeps ownership, and pays for the privilege.

How it is secured, and why the intercreditor deed matters more than the security

Security is often a second charge behind the senior lender, and sometimes there is no meaningful security at all. Either way, the document that decides what the mezzanine provider can actually do is the intercreditor deed between the two lenders.

That deed sets out who is paid in what order, whether the mezzanine interest can be paid in cash while the senior facility is outstanding, how long the mezzanine provider must stand still after a default before it can act, and what happens to it in an enforcement. Buyers read the facility letter and skim the intercreditor. It is the other way round: the intercreditor is where the real position sits.

How it is priced

The margin is higher than senior debt, because the risk is. What is more interesting is the shape.

• Part of the interest is often rolled up rather than paid in cash, so it does not compete with the senior repayments in the early years. Rolled-up interest compounds, and the amount owed at maturity is considerably more than the amount borrowed.
• An arrangement fee at the outset, and frequently a redemption premium or exit fee when the facility is repaid.
• An equity element in many deals: warrants over shares, or a share of the value on a sale. This is where the real cost lives, because it is paid out of the exit rather than out of trading, and it is invisible until the business is sold.
• Its own covenants, set alongside the senior lender's and usually a little looser, so the senior facility trips first.

The lender will quote terms once it has seen the model and the senior position. The parts most likely to move are the split between cash-pay and rolled-up interest, and the size of any equity element.

Where it fits, and what to try first

Mezzanine sits directly on top of senior term debt in the structure, and underneath the buyer's own money. How the pieces are ordered, and the order lenders expect to see them presented in, is covered in stacking facilities.

Before reaching for it, two cheaper things are worth exhausting. Money left in by the seller through vendor and seller finance occupies almost the same position in the structure and usually costs a great deal less, and a senior lender will often view it more kindly. And more from the buyer, where it exists, is cheaper than any of it, which is covered in equity contribution.

Where the gap is large and the plan needs capital rather than debt, the honest comparison is with equity, which costs ownership rather than interest but does not have to be repaid on a schedule.

Who it suits, and who it does not

It suits a business with strong, growing and genuinely predictable cash generation, where the extra cost buys a transaction that would not otherwise happen and the buyer ends up owning more of it than an equity route would allow. It suits a management buy-out where the team is credible and the gap is the only obstacle.

It does not suit a business with flat cash flow, because the total repayment burden after the mezzanine is added is what has to be serviced, and that is a bigger number than the senior schedule alone. It does not suit small transactions, where the diligence and legal cost of two lenders and an intercreditor deed is out of proportion to the money raised.

And it does not suit a deal where the gap exists because the price is too high. Mezzanine will fill that gap, and the buyer will spend years paying for a valuation that was wrong.

What goes wrong

The combined repayment schedule leaves no headroom. Each facility looks serviceable on its own. Together they consume the cash the business needs to trade, and the first bad quarter breaks a covenant.

The rolled-up interest is a shock at maturity. Compounded over the life of the facility, the redemption figure is much larger than the sum drawn, and it usually falls due at the same time as everything else.

The senior lender says no. Most senior facilities restrict additional borrowing, so a mezzanine layer needs consent, and it is not automatic.

The warrants dilute more than anyone modelled. An equity element agreed quickly in a deal room is worth real money at a sale, and the time to understand it is at the term sheet.

The intercreditor terms were never explained. Standstill periods, payment blocks and the mezzanine provider's rights on a default all matter enormously in the one scenario nobody wants to plan for.

What a provider will want to see

• A full financial model with both facilities in it, and the covenant position under a downside case.
• The senior lender's term sheet, and its position on additional borrowing.
• Three years of accounts, current management figures and the trading trend.
• The management team, and what happens if a key person leaves.
• The exit plan, because the equity element is repaid from it.

Terms that appear in a mezzanine facility and nowhere else are in the glossary.

Being told when the gap should be closed another way

A provider whose business is filling gaps has little reason to suggest that the gap should not be filled at all, or that the seller should be asked to defer more of the price instead. That conversation has to come from somewhere else.

We know this market and we know the people who fund both layers of it, which is why the useful thing we can do is tell you what the whole structure is likely to look like before you commit to the expensive part of it. Tell us where the gap is and we come back to you having spoken to the right people.