A Comprehensive Overview of Mezzanine Debt Covenant Tests

Mezzanine debt is an extremely valuable form of growth capital often used to fund acquisitions or intense growth stages that stretch beyond bank financing limits. It is available to middle market companies with minimum revenue and EBITDA levels of $15 million and $3 million respectively, in loan sizes ranging from $7 million up to $100+ million. The mezzanine debt industry is comprised of several different types of providers including SBIC mezzanine debt firms, public funds known as business development corporations and private debt funds affiliated with larger asset managers. These mezzanine debt lenders provide the hard-to-fill capital requirement residing between where a bank loan ends and where the equity layer begins. An equity layer in a non-change of control deal is the implied equity value of a company, assuming it was being sold.

In these situations, mezzanine debt lenders will lend to a company without the need for cash equity to come in behind them, relying solely upon the cash flow growth and implied equity value. They are frequently the only institutional provider of risk capital to a company and lack sufficient collateral or a personal guarantee to secure repayment of principal. Their loan amount is usually 3 to 4 times a company’s EBITDA, translating to an even larger multiple of free cash flow when capital expenditures, taxes and working capital requirements are factored in. Given the ubiquity of performance volatility in the middle market corporate sector and the risk level of these loans, mezzanine debt lenders use various covenant approaches to ensure the underlying health of the borrower.

Covenants are used as an early warning signal by mezzanine debt lenders to detect financial issues before they spiral out of control, allowing the company to quickly get back on track. The major financial covenants used are a fixed charge coverage ratio, a leverage ratio, and a minimum EBITDA level. The fixed charge ratio covenant uses EBITDA minus capex, taxes and distributions as the numerator and interest expense and loan principal payments as the denominator.  This metric tests if the company has enough cash flow to cover all its fixed charges, and a ratio lower than 1.0 spells possible trouble. The market level for the Fixed Charge covenant ratio is 1.25 and well performing companies are usually at the level of 1.5+. The leverage ratio covenant uses total funded debt as the numerator and EBITDA as the denominator. The standard market level is usually a quarter to a half of turn higher than the funded multiple at closing.

If the deal closes at 3 times, then the leverage ratio covenant is usually set at 3.25 to 3.50 times. Minimum EBITDA is straightforward and is usually calculated at a 15% discount to projected EBITDA. All covenants follow a twelve-month historical look back on a trailing twelve-month basis, which means there is a lagged effect to covenant activation. If a company has three strong quarters followed by a disastrous quarter, the trailing twelve-month measurement convention functions to smooth out the effect of the bad quarter. If the bad quarter is the start of a long down trend, then usually by the end of the second bad quarter, the covenants will be tripped. Most mezzanine debt lenders use covenants as constructive guardrails for their borrowers. If there is a covenant breach, they usually work with the company to get it back on track. If there is good faith between the parties, a default is rarely called.