What Happens when Mezzanine Debt Deals Go Awry

An important consideration of selecting a lender is their track record in tough situations. All Companies face turbulence during the life of a mezzanine debt term, the question is how much and when? If the turbulence is an air pocket, a short-term disturbance, then there’s not much to worry about. You may miss your debt service coverage or debt multiple covenants for a quarter or two.

Mezzanine Debt Lenders Covenant

However, your cash flow will still be strong enough to make your interest payment which is what your mezzanine debt lender cares most about. Throughout 30 years of mezzanine debt lending, I have rarely seen a company not bust a covenant at some point. Most lenders set covenants at relatively tight levels, so minor misses can trip them even at immaterial levels of underperformance. It is a much different ballgame if there is a material adverse change in the business that leads to a large-scale default. This would include loss of a large customer, unexpected external event (like a pandemic) or operational system failure (like a hacked ERP system).

When this happens, it is not a matter of waiting a quarter or two for the business to improve, there is grave concern as to going concern viability. Suddenly, revenue can buckle in half leading to large losses, never contemplated even in the most conservative downside financial projection. Projections never really capture the true asymmetry of business losses, as revenues can plunge 50% overnight, yet operating expense can take weeks if not months to address. Most mezzanine debt financed businesses are not equipped with sufficient liquidity reserves to absorb these types of losses, and a company can become illiquid quickly.

So, when this happens, and the business stabilizes at a much lower level of EBITDA, say 50% lower, all loan levels in the capital structure suddenly have significantly higher default risk. Senior debt takes on mezzanine risk, and mezzanine debt takes on equity risk. If the Company is salvageable, the mezzanine debt lenders usually do a few things. They are likely to take out the senior loan, if it is small enough. They ask the equity investors to put in more money to keep the company afloat. If the investors are not able or unwilling to, the mezzanine debt lenders will put the money in and then foreclose on the stock and take over the business, to ensure an orderly path to business renewal. While not interested in really owning the company, they do so protect their interest.

Concurrently, they usually work out an agreement with management to allow them to earn back a large controlling position in the company, once their loan is repaid. Mezzanine lenders are not set up organizationally to operate the business so will usually be generous and flexible with management, provided they believe management was not the cause of the problem to begin with. In a disaster scenario, mezzanine debt lenders need to recover their principal which locks them into a patient, long term, management-centric renewal plan.