Mezzanine Debt in the Age of Covid-19

Despite the Covid-19 crisis impact on many companies’ toplines, mezzanine lenders continue to lend. Their unique strengths give them the ability to continue to lend and help companies navigate the pandemic. Mezzanine debt lenders focus on the big picture of cash flow growth and flexibly determined debt capacity. Through using pro forma techniques and growth forecasting, mezzanine lenders look past temporary market conditions and rely on historical and future cash flow performance. As opposed to bank, who may get bogged down with implementing new regulations, mezzanine lenders are agile and quickly adjust lending parameters to the new economic reality. So, what are the unique strengths of mezzanine debt lenders that position them as a critical cog in the direct lending market? It boils down to their credit expertise, pro forma awareness and transitional capital expertise.

Credit Expertise of Mezzanine Debt Lenders

Mezzanine lenders are seasoned practitioners with many years of experience dealing with performance volatility from their portfolio companies. They maturely understand that companies rarely perform according to plan and always have an unexpected down stretch. Most successful mezzanine debt funds have been in business for over 10 years and their owners have been in the business far longer than that. They have all had to deal with companies affected by black swan like events, and tough economic headwinds. This helps them understand that good companies ultimately outlast tough times. They can see the intangible parts of a company’s creditworthiness and provide valuable support to a company in time of need. This allows them to be patient when a company is going through short term distress.

Pro-Forma Awareness of Mezzanine Debt Lenders

Mezzanine lenders are adept at understanding the impact that extraordinary and non-recurring events have on a company. They routinely analyze a company’s historic performance through this lens, allowing them to give a company credit for one-time cost adjustments to their EBITDA. They also are good at evaluating revenue trends in multiple ways. This gives them flexibility in calculating a company’s future revenue level, giving the borrower latitude to exclude any truly extraordinary revenue events. The Covid-19 impact is the mother of all extraordinary events.

Due to the deus ex machina nature, befalling companies through no fault of their own, mezzanine lenders will certainly exclude depressed revenue levels from the Covid-19 period in their pro forma analysis. The term EBITDAC has been coined for this purpose, though a different version of this concept that looks at “equilibrium pre-covid revenue and EBITDA” is likely to become the standard. This will allow borrowers to raise the level of capital they need, based on normal operating conditions.

Transitional Capital Understanding of Mezzanine Debt Lenders

Greater understanding of transitional capital allows mezzanine debt lenders to provide more relevant amounts of capital in a more nuanced and balanced structure. They know how much capital a company needs to be able to get through a transitional period. Because mezzanine debt occupies the riskiest level in a capital structure, mezzanine lenders are intensely focused on adequate capital liquidity for companies. Companies going through transitions, whether its hypergrowth, acquisition or temporary revenue distress have unique capital needs to be met. All growth scenarios require different amounts of working capital and growth capital. Together, working capital and growth capital are known as transitional capital.

Mezzanine debt lenders have deep understanding of transitional capital, regardless of the underlying growth scenario. Fast growth companies need higher levels of working capital whereas acquiring companies need both growth and working capital. Companies going through Covid-19 related revenue distress need capital to restore working capital and to absorb losses. Mezzanine lenders can provide both, as they approach each loan structure from a bottom up perspective. Their loan facilities usually give borrowers a bespoke debt structure rich in both working capital and growth capital abundance.