Illuminating Mezzanine Debt Covenant Breakage

Posted on: April 4th, 2024

mezzanine-debt

Most mezzanine debt borrowers are rightly focused on the downside of breaking a covenant and for good reason. Most borrowers have had to deal with overly sensitive banks in the past which often exhibit trigger happy default notices during covenant breakages, especially when they want to get out of a loan. Most banks are fully collateralized by asset value or have a guaranty which enables them to push their way through a default to their desired outcome with impunity.

However, the covenant breakage scenario is very different with a mezzanine debt loan, whose covenants are set at a more lenient levels to begin with. Mezzanine debt covenants are designed to give a company more room than bank covenants, to reflect the transitional growth state of the enterprise. Leverage ratios are set far above the bank level at 3.5 to 4.0 times. Debt service coverage is set far below the bank level at 1.15 to 1.25 times and is further advantaged by the fact that the mezzanine loan has only interest and no principal repayments to include in debt service. The reality is that most mezzanine debt loan packages factor in an underperformance buffer of 20% into the budget which gives the company a significant performance cushion.

Despite this cushion, covenants are frequently broken in mezzanine debt deals for a wide range of reasons. Sometimes there is a major performance issue such as a market downtrend or loss of a material customer. Other times there is a reporting lapse which prevents the company from supplying monthly financial statements to the mezzanine debt lender on a timely basis. Mezzanine debt lenders do not have the collateral or security position of banks which forces them to have a more understanding and constructive attitude toward their borrower than a bank would.

The saying “You can call a loan, but it doesn’t have to come” reflects the dependency of the mezzanine debt lender on the current management team and future cash flow of the business. If the mezzanine debt lender feels comfortable that the company is communicating and providing good visibility on the growth plan, they will usually hang in there and continue to support the business. There is usually one way out of a mezzanine debt deal for the lender and that is through the cash flow. This reality results in a more tempered and judicious response from the mezzanine debt lender than the company may expect.

In the acquisition financing arena, capital availability is destiny as companies require reliable access to capital to grow over the long term. Unforeseen capital needs usually arise when acquirers least expect it. This can cause some concern for the acquisition financing provider, especially when covenants tighten up and that working capital availability is utilized faster than expected.

Mezzanine debt borrowing is usually a straightforward activity that many companies use for funding of transitional growth. Mezzanine debt lenders are highly transparent about their due diligence approach and their post-closing loan management making it easy for companies to engage with.

Elections have consequences and positive ones at that for the acquisition financing middle market. While much media attention is paid to the direction of the yield curve and the Fed’s likely rate cuts, scant attention is paid to the more important drivers of the acquisition financing market – business psychology and regulatory climate.