Des mezz

With an unstable debt environment predominating, a resurgence in mezzanine loans is anticipated. Tania Bedi reports

Given the current volatile debt markets and restricted ­liquidity available to businesses, creative and flexible finance offerings are required to fill in some genuine funding gaps.

In recent times no single class has ­dominated the debt capital markets and the capital structure often includes many variants of debt and equity, each with a different set of covenants and exit strategy. This ­mismatch has led to complex intercreditor relationships. Uncertainty prevails, in some cases leading to a greater emphasis on the protection and representation of the junior tranches, especially where they hold a ­larger share of the overall capital structure.

Immediately prior to the credit crunch, due to the introduction of second-lien debt and covenant-lite facilities, there were not many leveraged buyouts (LBOs) where ­mezzanine financing was used. Post-credit crunch, and until very recently, the high-yield markets provided much-needed ­liquidity and the flexibility of incurrence-style covenants, which also limited the appetite for mezzanine finance other than in those transactions where a large part of the mezzanine finance was provided by institutions associated with the M&A process.

Debt relief

In the current climate, where the bond markets are not an option and bank liquidity is limited due to overexposed balance sheets, the market expectation is that mezzanine loans may provide a stable financing tool for LBOs and could offer much-needed relief where there is a ’hung’ bridge or an ­expensive fundable interim loan.

Mezzanine’s appeal, playing to both ­economics and reputation, is clear to both bank arrangers and their corporate clients. This climate has fuelled a demand for ­specialist mezzanine providers that are expected to be increasingly active, while the influence of the mezzanine houses is likely to be strong. Recent deals such as the private equity buyout of Securitas provide evidence of the flexibility mezzanine funds can offer and the speed at which they are able to ­commit with limited execution risk.

While the mezzanine lenders’ covenant package would usually follow the senior bank debt package, albeit with less stringent ­financial covenants, it will be interesting to see if this new phase of mezzanine finance follows this approach. Some mezzanine investors are of the view that, where the mezzanine finance is a sizeable part of the capital structure, tighter covenants are a valid demand; although it should be noted that, where mezzanine is used to refinance high-yield bridge loans, to some extent the terms will be dictated by the underlying financing.

Safety issues

The bone of contention in the mezzanine world has traditionally been the intercreditor agreement. The intercreditor’s importance for mezzanine creditors has been reinforced by events in the last round of restructurings, where in some situations mezzanine lenders have found themselves stripped of their claims through enforcement sales of assets at a time of depressed prices.

In such situations the intercreditor agreements offer mezzanine lenders no ability to participate in any distressed sale process, no communication or cooperation from the security trustee and a limited ability to ­compel the seller to undertake a full marketing process. In the absence of competing offers there is limited ability to contest ­disposal value in European restructurings.

The key component of the intercreditor in such an enforcement sale is the ability to release junior stakeholder claims against the group being sold. Traditionally intercreditor agreements have allowed such releases to be effected with little or no conditionality.

Recent deals, following the WorldPay example, indicate that the old order may be changing. Senior creditors are acknowledging that old-style intercreditor arrangements may not be acceptable. The language relating to the release of mezzanine claims, where there is a distressed disposal of the business, is much clearer now than with the vintage 2005- 08 deals and is less likely to lead to the confusion and argument over construction, which led to the recent European Directories (HHY Luxembourg SARL & Anor v ­Barclays Bank plc & Ors (2010)) litigation.

Also, certain core protections relating to permitted payments and limited mezzanine payment-stop events have made an appearance in the revised Loan Market Association recommended intercreditor agreement. Recent deals, where there is senior bank and bond debt with a mezzanine tranche, have incorporated high yield-style protections relating to delivery of a fairness opinion on the sale price. Certain additional requirements, such as cash consideration, a competitive auction process, full release of senior claims and access to information and professional adviser reports, have also surfaced.

Unsurprisingly, with more negotiation leverage on their side this time around, the focus of mezzanine creditors is to ensure that a distressed sale process is fair and ­inclusive. From a commercial perspective, mezzanine funds are often willing to be part of the ­business and during a restructuring can ­provide additional capital.

With both liquidity and flexibility on their side, mezzanine funds have something novel to offer in the current market. They are not restricted by overexposed balance sheets and are sophisticated and nimble in their approach. They are generally more flexible in relation to the form of their junior piece, ranging from a private high-yield note to a unitranche or mezzanine loan.

In a dynamic macro-economic ­environment the mezzanine legal space is one to watch and an exciting one to work in. It will be interesting to see how it evolves. n
Tania Bedi is a partner at Ropes & Gray in London