Mezzanine finance's return to the UK mid-market will renew focus on creditor negotiations
Published on 25th Sep 2023
What contentious issues could creditors come up against, particularly where there is likely no recent precedent?
Mezzanine financing provides an alternative source of capital for companies and can be flexibly utilised across varying sectors and investment strategies. Structurally, it is positioned between senior debt and equity, rendering mezzanine investors vulnerable to a range of risks. Mezzanine investors learned hard lessons from the fallout of the great financial crisis of 2008, when value breaks occurred in the senior debt. They found themselves lacking protections, notably when it came to enforcement, realisation and amendments.
The mindset of a mezzanine investor as regards approach to enforcement, realisation and amendments can be considered aligned with that of a super senior lender, notwithstanding that they are at opposite ends of the creditor priority stack. Both creditors traditionally form a smaller proportion of the overall financing structure and want to limit the senior lenders' ability to exercise rights that impact on their particular creditor position, both during day-to-day solvent operations and in a "downside" scenario.
In terms of enforcement and realisation, mezzanine investors will be eager to have the senior and mezzanine debt provided at the same level, restrict other senior or higher-ranking debt from existing at an operating company level, and prevent the senior debt being pushed down.
Mezzanine investors – similar to popular positions adopted by super senior lenders – will want to see value preserved when the senior lenders have the right to enforce. These protections will often take the form of:
- Mandatory consultation between creditor classes when it comes to enforcement strategy, third-party appointments, etc.
- Proof of value. Fairness and fair-market-value opinions via independent third parties and controls on enforcements being conducted via public auctions.
- Participation as bidders. Rights to acquire assets on enforcement (including through credit bidding) and potentially "take the keys" from the senior lenders.
Debt for equity
Mezzanine investors will want to minimise any controls on their ability to receive new equity (or debt-like-equity) from a holding company upon a release of the mezzanine debt, including the ability to swap their debt for equity with the agreement of the borrowing group but without senior lender consent. However, the intercreditor agreement would usually require the consent of the majority senior lenders for this action. While agreeable to senior lenders in principle, caution should be applied if the senior leverage financial covenant ratio in the senior facilities agreement is tested on a total debt basis. This is because the sponsor would be provided with extra covenant "headroom" by virtue of the debt for equity swap. Senior lenders should consider a "springing" senior debt (that is, not total debt) leverage financial covenant, which springs into effect upon conversion in order to protect against this scenario.
Some mezzanine investors will insist on share security over an entity above the banking group. The benefit of this is to create a block on the sponsor's direct economic interest in the banking group. From a senior lender perspective, this perhaps means negotiating with the mezzanine investor as the primary equity holder rather than the sponsor with whom the stronger relationship exists.
Mezzanine 'stop notice'
The intercreditor agreement controls the payments to mezzanine investors and at what times these are prohibited. In addition to the customary automatic payment stop upon a senior payment default or senior insolvency default, senior lenders also have rights to issue a "stop notice". The types of defaults that allow the senior lenders to issue a stop notice are usually closely contested: senior lenders push for all events of default, while mezzanine lenders will argue for a sub-set of significant events of default. The intercreditor agreement would also include other stop-notice issuance controls such as length of stop notice period (often 120, 150, or 180 days, or a combination depending on the type of default), how frequently a stop notice can be sent (often limited to twice in any 12 month period and limited to 4 or 5 times over the life of the life of the financing) and how as stop notice can be delivered.
The function of this mechanism is familiar – albeit inverted – to super senior enforcement notices and standstill period controls that super senior creditors will seek in unitranche and super senior structures, and with which many mid-market leverage finance parties will be more familiar.
Amendments: further senior debt
A borrowing group accessing additional finance will likely first turn to all (or some) of the senior lenders to provide debt on a senior or super senior basis.
Under the Loan Market Association recommended form of intercreditor agreement, consent from a majority of the mezzanine investors would be required if a new senior or super-priority debt would result in an increase in the size of the senior facilities in excess of the senior headroom; that is, the pre-determined amount (historically between 10-15% above opening senior debt) by which senior debt can be increased and rank as senior debt without mezzanine investor consent. What is and is not included as senior debt in this context is often heavily debated, focusing on hedging positions, face value of letters of credit, PIK'd interest, waived senior prepayments as well as other considerations.
It would also be common to include anti-layering provisions preventing the creation of more tiers of debt between the senior and mezzanine investors.
Consent for amendments
Mezzanine investor control over material amendments to the senior documentation is an important feature of intercreditor agreements. The consent of the majority mezzanine lenders is usually required for increases in senior debt, senior interest, senior fees, deferrals of amortisation and others, in each case subject to pre-determined permitted levels.
Mezzanine investors can be expected potentially to take a firmer approach to what senior lenders can amend without their consent than has historically been seen, perhaps drawing on the points of focus that a super senior lender would look to cover off as part of their amendments control position, such as significant disposals protections.
A focus of mezzanine investors has consistently been on the tightening of senior financial covenants given the associated risk that would then apply to the mezzanine debt position, especially in scenarios where there is no required corresponding change to the mezzanine financial covenants.
Osborne Clarke comment
There are other well-negotiated points that senior and mezzanine lenders will need to work through, such as permitted payments, issuance of warrants and equity instruments, information rights, mezzanine cures, exit strategies, and others. We would be happy to discuss these further.
Mezzanine investors occupy a distinctive position within the capital structure, bearing increased risks due to their subordinate position to senior lenders. However, by negotiating and documenting comprehensive protections in relation to amendment and security enforcement and subsequent realisation of proceeds, mezzanine investors can mitigate these risks and safeguard their interests effectively.
Senior lenders will want to ensure their continued position as the largest part of the debt stack and ongoing ability to exert the corresponding levels of credit control without allowing the mezzanine investors to frustrate operational flexibility of the borrowing group or delay enforcement in such a way as to undermine realisation of value.
Our previous Insight in this series provides a primer on the fundamentals of mezzanine finance.