Chapter 22 - Debt Types of Private Equity Flashcards
How does the control of the underlying company in the case of an LBO typically compare to the control of the underlying company in the case of mezzanine financing?
Mezzanine financing typically does not necessarily involve control of the underlying company.
True or false: An exit strategy for mezzanine debt may occur when the underlying company obtains capital through a large equity issuance.
True
How liquid is mezzanine debt when compared to leveraged loans or high-yield bonds?
Liquidity of mezzanine debt is minimal
Who are typical investors in mezzanine funds?
Pension funds, endowments, and foundations
What is the typical size of mezzanine funds compared to LBO funds?
Mezzanine funds are typically considerably smaller than LBO funds
Describe common restrictions placed by a mezzanine lender on a borrower.
Lender may approve or disapprove the issuance of additional debt, may require that new debt be subordinated to the original mezzanine debt, and may enjoy final approval on dividend payments by the borrowing firm.
What characteristic of mezzanine investing allows an investor to purchase the senior debt once it has been repaid to a particular level?
Takeout provision
Company XYZ has a simple capital structure where assets are financed 70% by bank loans (cost of debt 10%)and 30% by equity (cost of equity 27%). Suppose now that half of the equity capital is replaced with mezzanine debt at a coupon rate of 16% and that, as a result of equity capital being now more risky, the cost of equity capital rises to 31% Calculate the WACC when there was no mezzanine debt and when mezzanine debt was contracted (assume corporate tax rate is 0).
WAAC (without Mezzanine debt) = (70% x 10%) + (30%x27%)=15.1% WACC (with Mezzanine debt) = (70%x10%)+(15%x16%)+)15%x31%)=14.05%
ABC’s assets are currently being financed 70% by bank loans at an IRR of 9% and 30% by equity. ABC’s beta is 1.5, the risk-free rate is 3% and the expected return on the market portfolio is 12%%. Calculate the WACC of ABC (the corporate tax rate is 0)
Calculating cost of equity using CAPM; Rf = B(E(Rm)-Rf) , 3% + 1.5(12%-3%) = 16.5%. WACC of ABC; (70%x9%) + (30% x 16.5%) =11.25%
In bankruptcy proceedings, what is the meaning of the term cramdown?
Cramdowns can occur when creditors and debtors cannot reach an agreement. According to the US bankruptcy code, a reorganization plan under Chapter 11 may be confirmed by the court over objections so long as the plan 1) does not unfairly discriminate against the members of any impaired class that may have voted against it. 2) Fair and equitable with respect to the members of that class.
Keyword ‘Absolute priority’
(Distressed debt) Concept of which claim ranking. Payments to employees, payments for taxes and accounts payable generally take priority over payments to security holders.
Keyword ‘Acceleration’
Requirement that debt be repaid sooner than originally scheduled, such as when the senior lender can declare the senior debt due and payable immediately. This typically forces a default and allows the senior lender to enforce the collateral security.
Keyword ‘Assignment’
(Mezzanine debt) Senior lenders typically restrict the rights of the mezzanine investor to assign, or sell, its interest to a third party. However, generally senior lenders allow an assignment, providing the assignee executes a new intercreditor agreement with the senior lender.
Keyword ‘Blanket subordination’
(Mezzanine debt) Prevents any payment of principal or interest to the mezzanine investor until after the senior debt has been fully repaid.
Keyword ‘Blocking position’
(Distressed debt) A single creditor can block a plan of reorganisation if it holds a third of the dollar amount of any class of claimants.