Debt Types of Private Equity

Question 1

1. Briefly describe mezzanine financing.

Answer 1

• Mezzanine debt derives its name from its position in the capital structure of a firm: between the ceiling of senior secured debt and the floor of equity. Mezzanine finance defies generalization. Mezzanine financing is highly customized, often focused on equity appreciation while still maintaining the characteristics of (usually, high yield) debt, i.e. principal and interest payments.

Question 2

2. Does mezzanine debt with an equity kicker exhibit the J-curve return pattern of private equity? Why or why not?

Answer 2

• With a mezzanine fund, the J-curve effect is not a factor. One of the distinct advantages of mezzanine financing is its immediate cash-on-cash return. Mezzanine debt bears a coupon that requires twice-yearly interest payments to investors. As a result, mezzanine financing funds can avoid the early negative accounting returns associated with venture capital or leveraged buyout funds.

Question 3

3. What would be the primary justification for believing that the use of mezzanine financing can lower a firm’s weighted average cost of capital?

Answer 3

• The justifications for advantages to mezzanine debt are based on inefficiencies and imperfections in the capital markets for the size companies that tend to utilize mezzanine financing.

Question 4

4. How does mezzanine debt tend to differ from high-yield bonds and leveraged loans in seniority, term, and liquidity?

Answer 4

• Seniority: Mezzanine debt is usually lower in seniority than high-yield bonds and, especially, leveraged loans
• Term: Mezzanine debt is usually 4-6 years, similar to leveraged loans but shorter than high-yield bonds
• Liquidity: Mezzanine debt has minimal liquidity, especially compared the relatively high liquidity of leveraged loans.

Question 5

5. What are the two key distinctions between mezzanine funds and other private equity funds?

Answer 5

• There are two key distinctions between other private equity funds and mezzanine funds. The first is the return expectations. Mezzanine funds seek total rates of return in the 15% to 20% range. Compare this to LBO funds that seek returns in the 20% to 30% range and venture capital funds that seek returns in the 30% to 50% range. Second, mezzanine funds are staffed with different expertise than a venture capital fund. Most venture capital funds have staff with heavy technology-related experience, including former senior executives of software, semiconductor, and Internet companies. In contrast, mezzanine funds are inundated with financial engineers, experienced at structuring and negotiating loans that incorporate the use of equity kickers and/or warrants.

Question 6

6. By what standards or measures is distressed debt usually distinguished from non-distressed debt?

Answer 6

• Distressed debt is often defined as debt that has deteriorated in quality since issued and that: has a market price less than half its principal value, yields 1,000 or more basis points over the riskless rate, or has a credit rating of CCC (Caa) or lower.

Question 7

7. Provide two major sources of distressed debt.

Answer 7

• A company with a deteriorated financial condition

* Debt issued by a private equity firms or leveraged buyout firm

Question 8

8. What is the name of the more junior debt securities that are most likely to be converted into the equity
   of the reorganized company?

Answer 8

• Fulcrum securities

Question 9

9. What is the primary distinction between Chapter 7 bankruptcy and Chapter 11 bankruptcy in the U.S.?

Answer 9

• Chapter 7 bankruptcy is where the company is no longer viewed as a viable business and the assets of the firm are liquidated. Chapter 11 bankruptcy attempts to maintain operations of a distressed corporation that may be viable as a going concern.

Question 10

10. Who is the initial investor in debtor-in-possession financing?

Answer 10

• Senior and subordinated creditors