Mezzanine Finance

June, 2010 Corry Silbernagel, P.Eng., MBA Davis Vaitkunas

With amendments to Capital Structures section with Prof Ian

Giddy, NYU Stern School of Business

Copyright 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved.

940 - 1040 West Georgia Street Vancouver, BC Canada V6E 4H1 www.bondcapital.ca T 604.687.2663 F 604.688.6527

Mezzanine Finance
Mezzanine finance is used by companies that are cash flow positive to fund: further growth through expansion projects; acquisitions; recapitalizations; and, management and leveraged buyouts. Mezzanine finance comes in many forms. The common features of all mezzanine instruments and products are that they offer a risk/return profile that lies above that of debt and below that of equity. Mezzanine finance is used to increase the financial leverage of transactions where the senior bank has no appetite to lend further senior debt but there is still more financial capacity to support long-term borrowings. When mezzanine debt is used in conjunction with senior debt it reduces the amount of equity required in the business. As equity is the most expensive and dilutive form of capital, it is logical for a majority equity holder to want to create an antidilutive capital structure at the lowest cost in order to both maximize return on equity and fund the business plan.

What Is Mezzanine Debt?

Mezzanine debt is mezzanine finance. It is debt financed capital generally referring to that layer of a balance sheets liabilities between a company's senior debt and equity, filling the gap between the two. Structurally, it is subordinate in priority of payment and security to senior debt, but senior in rank to common stock or equity (Exhibit #1). In a broader sense, mezzanine debt may take the form of convertible preferred debt, junior debt, subordinated debt, private "mezzanine" securities (debt with warrants or preferred equity), second lien debt, and is sometimes referred to as quasi-equity.

MEZZANINE FILLS THE GAP BETWEEN SENIOR DEBT AND EQUITY

MEZZANINE FINANCE

SENIOR DEBT & ASSET BACKED (STRETCH) LENDING

SENIOR SUBORDINATED DEBT

CONVERTIBLE SUBORDINATED DEBT

Mezzanine

REDEEMABLE PREFERRED STOCK

EQUITY

Source: FitchRatings

Exhibit 1

Mezzanine capital is typically used to fund corporate growth opportunities, such as an acquisition, new product line, and new distribution channel or plant expansion; or for company owners to take money out of the company for other uses, or to enable management to buyout company owners for succession or exit purposes. Although it makes up only a portion of a company's total available capital, mezzanine financing is critical to growing companies and in succession planning. The gap in funding between senior debt and equity is common for the following reasons: 1. accounts receivable, inventories and fixed assets are being discounted at greater rates than in the past for fear that their values will not be realized in the future; senior lenders are reluctant to lend using goodwill or intangible assets as collateral, senior lenders may wish to limit their exposure to any one company or industry, and,

2. 3.

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Mezzanine Finance

4.

the availability and cost of equity may be limited and prohibitively expensive or highly dilutive.

However, with a gap in place the source of funds available are insufficient to finance the project. This leads to a search for complementary capital that can be priced for risk and in partnership with the equity and senior debt capital that is already in place or available. Mezzanine debt is complementary capital.

MEZZANINE IS A HYBRID WITH RISK PROFILE TARGETED BETWEEN THAT OF SENIOR DEBT AND EQUITY
Marginal Cost of Capital (% Percent) Equity

MEZZANINE FINANCE

Cost of Capital

Mezzanine

Senior

Leverage

Source: Bond Capital

Exhibit 2

A true mezzanine provider will generally seek a risk profile between that of senior debt and equity at a risk adjusted price. Mezzanine can often be thought of as borrowing equity, as senior banks will treat it as such, while the cost of mezzanine will be less than equity because of the interest paid and security preference it takes ahead of equity. While additional liquidity can be obtained from equity investors to provide funding to the company, equity is the most expensive source of capital. Moreover, existing shareholder dilution must also be considered. New equity will change the voting distribution which could result in an unwanted change in control or shareholder coalition. Dilution with mezzanine is limited as the majority of the mezzanine return is garnered through recurring interest payments. Additionally, it is common for a company to hold the right to repurchase any equity issued to a mezzanine investor through the use of puts and calls.

Capital Structures
There are no hard and fast rules for optimizing a companys capital structure. However, return on equity (ROE) should be commensurate to risk. Unfortunately, risk is in a constant state of recalibration. This means a companys capital structure policy being the assortment of capital employed to achieve the ROE target must also be dynamic. The combination of senior debt, mezzanine debt, and equity capital in the balance sheet determines the companys weighted average cost of capital (WACC). The combination of senior debt and mezzanine debt determines the companies weighted average cost of debt (WACD). Where WACD exceeds target ROE, capital structure policy would be 100% equity, subject to availability of the entire equity requirement. Determining target ROE is the cornerstone to making logical business decisions. In order to achieve the profit objective investment in projects and transactions only need to be considered wherein the carrying cost is less than the internal rate of return expected from that investment. Mezzanine financings can be completed through a variety of different structures. Normally, the specific objectives of the transaction are usually a primary driver. Unfortunately, the capital structure policy strategy in place at the company is usually a secondary driver. Notwithstanding, this is likely backwards, it occurs because equity is usually dear and often timing cannot be controlled and most businesses do not have such a policy. As such, a businessperson will often be happy to agree to a
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Mezzanine Finance

mezzanine rate because they need nothing less than 100% project financing. Furthermore, the ability of a mezzanine lender to make flexible capital available quickly is often the sole reason for a company to choose this form of financing. The good news is that often and inadvertently the decision to include mezzanine debt actually leads to a more efficient capital structure. This is especially true when the target ROE was non-existent, misunderstood, or incorrectly stated in the first place. For example, return on average equity for the largest company in the world at the time of this white paper update was reported at 22.65%. With this illustration in mind as a form of target ROE a business smaller than the largest company in the world would logically consider an ROE adjusted upwards for smaller business risk, if nothing else. Our experience has guided us towards 25%+ as a reasonable target ROE. Moreover, given that upwards to 50% of a companys debt will usually cost less than 10% and the cash cost of mezzanine is usually towards 15% a good CFO will be able to show the owners that when considered on a weighted average cost basis the incremental increase in the overall cost of debt is most often de minimis. This means that mezzanine in addition to being a good project financing tool is also a strategic risk aversion tool in the form of safety capital whether immediately drawn down or available as a facility on standby terms.

COMPANIES WITH EFFICIENT CAPITAL STRUCTURES EMPLOY A NUMBER OF CAPITAL SOURCES

Expected Returns (% cost)

MEZZANINE FINANCE

Typical Private Equity Structure (% of total Assets)

Senior Debt and Asset Backed (Stretch) Lending 30% - 60%

5% - 12%

Mezzanine 20% - 30% Equity 20% - 30%

13% - 25%

25%+

Source: Management Magazine, Bond Capital

Exhibit 3

In Exhibit 3, mezzanine debt is shown adding an intermediate tranche of capital that enables a company to grow by creating and funding a new capital layer between senior secured debt and equity. On the positive side: the owners face little dilution and maintain their control of the business; the companies total cost of capital is reduced; and the mezzanine debt has a flexible payment term that is structured as self liquidating when paid off over time. On the negative side this is a debt structure that requires certain recurring interest payments and there is less free cash available for growth and shareholder distributions.

Remember the objective of a capital structure policy is to bring discipline and risk aversion to business investment. Every company should be interested in, and able to determine and state its proforma profit objective. With a transparent return on equity objective in hand the logic of business math can be quickly applied for decision support. Where an individual project or opportunity will provide an internal rate of return (IRR) that is greater than the companys WACD management should want to proceed and vice versa. An interesting and sometimes dangerous aspect of IRR is that it can be amplified with leverage. This brings us to the next question what is an appropriate WACD? Risk aversion should govern the leverage limit in consideration for the macroeconomic environment at the time the decision is made. Experience has shown that a long term

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Mezzanine Finance

sustainable target WACD can be bank prime plus 9%. However, for certain golden opportunities WACD could be managed strategically higher for short periods of time. Then in times of risk aversion and austerity WACD should be managed lower for periods of time. This is often best managed by increasing and reducing the total amount of working capital in the business. Risk aversion should be about the budgetary sacrifices and ongoing discipline required to create equity. Then in turn the use of that equity can be considered to form a leverage base or pay down debt or as shareholder dividends until a growth opportunity emerges in accordance with the capital structure policy. The table in Exhibit 4 outlines differences between capital sources:

CAPITAL SOURCES OFFER VARYING LEVELS OF FLEXIBILITY

Senior
Security Ranking Covenants Term Coupon Amortization Rate Equity Kicker Prepayment Penalties Secured Senior Tight Demand Coupon - Floating ~ 5 years or less Prime none Yes

MEZZANINE FINANCE

Stretch
Partial

Mezzanine
Subordinated

Equity
none Third none Patient Dividend Indefinite Market Adjusted Shares No Private Capital / Capital Markets Low Right of Sale / Shotgun

First on Specific Assets Second Tight Term Coupon - Fixed Tied to asset life Prime Adjusted Success Fee Yes Flexible Term / Patient Coupon - Fixed Flexible / Engineered Risk Adjusted Warrants Fixed Period

Capital Providers Bank Recovery % Liquidity High High

Bank / secondary lender Private Capital medium medium Low Low

Source: FitchRatings, Bond Capital

Exhibit 4

Secure More Total Capital

Some closely held companies, particularly those that are family controlled, are reluctant to consider mezzanine financing because it requires relinquishing a certain amount of ownership. However, a mezzanine investor's goal isn't to be a shareholder, but rather to achieve a target return rate by some specified time. In fact, a typical mezzanine transaction has the mezzanine fund as a minority equity holder, with buyout terms to payout the mezzanine fund at the appropriate time. It's also important for a business owner to analyze the difference in value between an ownership interest in a stagnant or underperforming business and an ownership interest in a growing company. What's more, having mezzanine debt in place actually can help a company secure more total capital and avoid the cumbersome business pitfall of being under capitalized. For example, a business owner approaches a bank to provide a $10 million senior debt facility for the purchase of a company with a purchase price of $20 million. A conservative bank may discount the request and offer 75% of funding requested ($7.5 million) leaving the business owner to fund the balance of $12.5 million with equity. In this situation a mezzanine lender might offer to fund $5 million in mezzanine and work with the business owner to secure more senior debt through its own deeper rooted relationships. With a mezzanine component, the bank sees the mezzanine as equity and in certain cases as a reputable risk reducing partner. As a result of a perceived change in risk profile the bank is willing to lend the original request of $10 million. The total amount raised through external sources is now $15 million with the mezzanine layer compared with $7.5 million without. Ultimately this reduces the equity requirement from the owner from $12.5 million to $5 million. Banks often look more favorably on companies that are backed by institutional investors such as mezzanine lenders and may extend more credit under more attractive terms. This is a result of the mezzanine lenders' reputation and the increased involvement of the mezzanine lender with the company as compared to with a bank alone. Simply put, the risk to the banks investment is reduced because of their knowledge that the mezzanine lender through a more active role (often with a board
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Mezzanine Finance

seat) may enhance the success of the business. Additionally, mezzanine lenders are a source of reserve capital for a business owner helping to diversify a companys banking relationships thus reducing dependence on any one lender.

Lowering the Cost of Capital and Improving Equity Returns

In addition to securing more capital a mezzanine structure also allows a business to reduce its cost of capital, and boost both return on equity and absolute profits. The following three cases illustrate a traditional all equity company (Case 1: Mature) transitioning to a more efficient capital structure through a small recapitalization into a typical company with debt (Case 2: Growing), and then recapitalizing again to a final optimized structure using a higher degree of leverage (Case 3: Event Driven). The result of the transition from traditional lower growth or mature company into a more efficient capital structure lowers the companys cost of capital, improves the return on equity, and releases significant capital to a companys existing owners for an event driven transaction as demonstrated in Exhibit 5.

OPTIMIZING CAPITAL STRUCTURES CAN SIGNIFICANTLY IMPROVE RETURN ON EQUITY

Company Capital Structures (% of Company Value) Bank Debt
Mezzanine (non-bank Debt) Equity

MEZZANINE FINANCE

60%
Equity Capital Replaced by other sources

50%

100%

20%

50%

20%
Case 3: High Growth Weighted Average Cost of Capital Return on Equity 11% 40% Case 2: Typical Debt 19% 21% Case 1: Debt Free 35% 12%

Source: Bond Capital

Exhibit 5

Mezzanine Terms
Mezzanine investors include pension funds, hedge funds, leveraged public funds, business development companies, private equity funds, and insurance companies, as well as banks that have established mezzanine departments (also known as captives). Traditional mezzanine lenders are book-and-hold investors, generally focused on cash-flow lending, looking for a minimum term (call protection) and equity participation to generate longer term results. Mezzanine lenders will also look at the value of the enterprise as an investment consideration. Unlike traded equity, high-yield debt, and interest rates which fluctuate with economic conditions, traditional mezzanine finance has been a fairly consistent and stable market.

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Mezzanine Finance

The coupon rate on mezzanine notes and targeted returns of mezzanine investments have remained relatively constant as shown in Exhibit 6.

TARGETED MEZZANINE RETURNS HAVE REMAINED RELATIVELY CONSTANT AT ABOUT 20%1)

MEZZANINE FINANCE

Mezzanine Targeted Returns (Internal Rate of Return IRR %)

30%
35% 30%

Internal Rate of Return

2008 2009 2010

20% 15%
Low Median High

% Occurrence

25%

25% 20% 15% 10% 5% 0%

IRR %

10%

06

07

08

09

<16%

16-17.9%

18-19.9%

20-21.9%

22-23.9%

24-25.9%

IRR %

Source: Fleet Securities Inc., PNC Mezzanine Capital, Bond Capital

Exhibit 6

Typically, mezzanine lending includes both subordinated debt and an equity component. The debt is usually issued with a cash pay interest rate of less than fourteen percent and a maturity ranging from four to seven years with the ability of the borrower to buy out the debt earlier and repurchase any equity. The biggest benefit mezzanine debt provides is reducing the amount of equity required in the transaction. As illustrated in Exhibit 6 mezzanine investors are looking for a risk adjusted return (target 16% IRR) without dilution compared to an IRR of 22%+ with dilution for equity investors. In addition, mezzanine is more cost effective in absolute terms because of a tax shield benefit from the tax deductibility of interest. The basic forms used in most mezzanine financings are subordinated notes and preferred stock with warrants for private companies and high yield debt (junk bonds) or convertible debt for public companies. Specialized mezzanine investment funds, look for a certain rate of return which can be made up through a variety of securities (each individual security can be made up of any of the following or a combination thereof) including:

Cash interest a periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing. The interest rate can be either fixed or floating and with or without a floor and or ceiling. PIK interest payable in kind interest is a periodic form of payment in which the interest payment is not paid in cash but rather by capitalization of interest (increasing the principal amount by the amount of PIK interest). Ownership along with the typical interest payment associated with debt, mezzanine capital will often include an equity stake in the form of warrants or a debt conversion feature, similar to that of a convertible bond.

Other sources can include royalty payments, bonus interest payments and other derivative like mechanisms. Mezzanine lenders will also often charge an arrangement fee, payable upfront at the closing of the transaction and ongoing administration fees to cover administrative costs, opportunity costs, management time, and as consideration for capital structure policy advice.
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Mezzanine Finance

In structuring a mezzanine security, the company and lender work together to avoid burdening the borrower with the full interest cost of such a loan. Because mezzanine lenders will seek a return range of 13% to 25%, this return must be achieved through means other than simply cash interest payments. As a result, by using equity ownership and PIK interest, the mezzanine lender effectively defers its compensation until the due date of the security or a corporate liquidity event Exhibit 7 is an example of a mezzanine facility that is back end loaded, meaning that payments (interest, principal and equity) are deferred until later in the facility term, and further demonstrates reward for delayed payment risk for the mezzanine investor.

MEZZANINE RETURN CAN BE MADE UP OF SEVERAL COMPONENTS

MEZZANINE FINANCE

Example Simplified Mezzanine Facility Components and Return

($000's) Opening Principal Closing Principal Initial 10,000 Year 1 10,000 10,300 1,523 (300) 1,223 Year 2 10,300 10,609 1,568 (309) 1,259 Year 3 10,609 10,927 1,615 (318) 1,297 Year 4 10,927 8,255 3,000 1,439 (328) 4,111 Year 5 8,255 5,503 3,000 1,032 (248) 3,784 Ending 5,503 5,503 2,500 8,003

Principal Repayment Interest Less PIK Component Bonus / Equity Participation Mezz Cash Flow (10,000)

Faility Assumptions Loan Size ($000's) Maturity (Years) Interest Rate PIK component Simple Annual IRR

10,000 5 15.0% 3.0% 16.5%

Source: Bond Capital

Exhibit 7

While mezzanine debt is more expensive than bank debt, it is not as rigid. Generally, it shares the same covenant package as a bank deal, but the measurement characteristics are looser. For instance, if the maximum leverage of EBITDA on a bank deal is three and a half times, a mezzanine deal would be closer to four or five. Mezzanine facilities are often customized or Engineered to match the cash flow profile of each company by changing the timing and amounts of interest, PIK, principal and equity portions of its return. Exhibit 8 depicts average debt multiples of leveraged companies and differentiates between bank debt as a multiple of EBITDA, and non-bank debt (often mezzanine debt) as a multiple of EBITDA. For example, an average US highly leveraged company with EBITDA of $10 million per year in 2004 would have had 3.2 time EBITDA or $32 million in bank debt, with 1.0 times EBITDA or $10 million in non-bank debt. In general, smaller businesses (less than $50 million EBITDA) and companies operating in more volatile industries may have reduced access to financing and thus the leverage levels of these companies may be less than the averages shown. An experienced advisor is critical to successfully reaching the upper end of the range. Exhibit 8 also depicts macro economic factors at work and ties the availability of capital in general to the amount of growth and sentiment on growth in the economy at a given point in time.

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Mezzanine Finance

MEZZANINE DEBT IS OFTEN A SIGNIFICANT DRAFT COMPONENT OF A COMPANYS CAPITAL STRUCTURE

MEZZANINE FINANCE

US Average Debt Multiples of Highly Leveraged Loans (multiple of EBITDA1))

Non-Bank Debt / EBITDA Bank Debt / EBITDA 1.1 2.3 1.9 2.1 1.8 1.2 1.2 1.5 3.5 3.6 3.5 1.4 1.7 5.1 3.3 3.3 2.9 3.2 2.2 2.4 2.3 3.6 4.0 2.5 3.0 1.0 1.3 1.7

1.7

0.8

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

1)

EBITDA = Earnings before interest, taxes, depreciation and amortization

Source: S&P LCD, Bond Capital

Exhibit 8

Mezzanine Exit
Most mezzanine investments are repaid through cash generated by the business, a change-of-control sale or recapitalization of the company. Many mezzanine capital providers believe the IPO "home run" is a rarity. Furthermore, mezzanine investors also hold the view that cash streams with a high quality of earnings are managed for pace of growth rather than to generate a specific shorter term liquidity event. While some mezzanine providers may look to invest in companies that represent strong IPO candidates, more frequently the mezzanine capital provider is looking for longer term capital deployment which receives a return commensurate with the risk being taken. The useful incorporation of mezzanine debt into both strong and less strong balance sheets results in a wide range of risk adjusted pricing. It also shows that a majority of companies are continually seeking access to customizable capital. It is very common that mezzanine investors are bought out by the initial owner. Other exits occur through recapitalizations, the accumulated profits generated by the business, initial public offerings, or an acquisition of the company by a competitor, consolidator, or other control equity investor. About Bond Bond Capital provides capital for growth, succession and equity withdrawal strategies to small and medium sized enterprises. Bond Capital focuses on mezzanine lending for expansion, M&A, MBO and LBOs.

Copyright 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved.

940 - 1040 West Georgia Street Vancouver, BC Canada V6E 4H1 www.bondcapital.ca T 604.687.2663 F 604.688.6527

Copyright 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved

Mezzanine Finance