UK and Europe: early signs of a return of mezzanine finance

Private equity firms are widely reported to be sitting on a vast amount of "dry powder" that will need to be invested. Alongside this, numerous direct lenders have raised funds that will also require deployment. This combination means that some in the leveraged finance market are expecting a resurgence of acquisition finance following – until now – a rather tentative 2023.

Over recent years, the leveraged finance market in the UK and Europe has benefited from an extended boom in private credit, with much of this growth rooted in a protracted low interest rate environment. During this boom, the mid-market leveraged finance space has utilised "unitranche" financing structures to great effect.

However, the economics of deals has shifted due to inflation and a spike in base rates, which has given rise to debt service and liquidity concerns. This has led some private equity houses and debt advisers to consider alternative structures, including mezzanine finance.

Will this retro structure – and some may say relic – of the past make a marked return? Only time will tell and the extent of its uptake will largely turn on whether a senior bank club plus mezzanine debt package is cheaper than the blended rate of a unitranche debt arrangement, which sits alongside a super senior revolving working capital facility.

The fundamentals

Mezzanine debt is documented in a separate finance document to the senior debt with the commercial provisions being substantially the same as under the corresponding senior facilities agreement.

The mezzanine facility is most commonly a single term facility, borrowed at the Bidco acquisition-vehicle level or above and utilised in full at completion for the purpose of funding the relevant acquisition. Alongside the debt, it is not uncommon to see warrants or other equity instruments issued to the mezzanine lenders by an entity higher up the structure.

The mezzanine facility is contractually subordinated to the senior facilities and the hedging instruments (the "senior secured debt") pursuant to the intercreditor agreement, which will also provide the senior secured debt with priority recourse to proceeds from enforcement of the security.

Senior lender protections

There are a number of specific protections for senior creditors participating in these structures, which include financial covenants, events of default, amendment provisions and mandatory prepayments.

• Financial covenants. Under the mezzanine facility, financial covenants are set using more headroom than those that apply under the corresponding senior facilities agreement. This is so that failure by the borrower to meet the specified financial targets should result in a default under the senior facilities at an earlier stage than it will under the mezzanine facility. A connected point to cover relates to the mezzanine facility cross-default position which should not be triggered by a default under the senior facilities resulting from a breach of the senior financial covenants.
• Events of default. Under the mezzanine facility, these should be limited to a smaller suite of the more material senior events of default (including with longer-dated grace periods than those included in the senior facility). Examples of these include non-payment and insolvency-related defaults. In short, a default under the senior facility should not immediately cross default into the mezzanine facility.
• Amendments. The mezzanine lenders should be restricted from amending or waiving the material terms of the mezzanine finance documents without the senior lender's prior consent. Subject to limited exceptions, any waiver or amendments granted by the senior lenders under the senior facility should also ideally apply in the same manner and to the same terms of the mezzanine facility agreement. For example, if the senior lenders waive a senior default, the same circumstances should not trigger an actionable default under the mezzanine facility agreement.
• Mandatory prepayments. In addition to other prepayment controls, the intercreditor agreement has traditionally prevented mandatory prepayments of principal from being made pursuant to the mezzanine facility prior to discharge of the senior secured debt.

Mezzanine lenders have the benefit of usual course of lending payments such as cash interest, scheduled principal repayments as well as customary fees, costs and expenses. The intercreditor agreement between the senior lender and the mezzanine lender will control the payments and, in particular, when these are prohibited. The automatic controls include, amongst others, the occurrence of a senior payment event of default, but there are also other rights afforded to the senior lenders to issue what is known as a stop notice.

The situations or occurrences that allow the senior lenders to issue a stop notice is consistently a hotly negotiated aspect of the intercreditor arrangements. Senior lenders push for all events of default whereas mezzanine lenders will argue for a sub-set of significant events of default. In addition to this negotiated point, the intercreditor agreement would also include other stop-notice issuance controls such as: length of stop notice period, how often a stop notice can be sent and logistics of delivering a stop notice.

Mezzanine lender protections

There are a number of specific protections for mezzanine creditors participating in these structures, which include:

• Board observer rights. Mezzanine lenders often seek to obtain enhanced monitoring and management rights, such as the right to appoint a non-voting observer to the board at the level of the Parent company or Bidco.
• Enhanced information rights: If the additional board observer rights are too tightly restricted or not commercially agreed, mezzanine lenders often seek more extensive information undertakings than those available to the senior lenders.
• Specific protections. These include restrictions on increasing the principal of the senior debt (except for pre-determined increases), increasing the margin or fees payable on the senior debt, amending how the interest rate is calculated, and amending the circumstances in which a mandatory prepayment is made.

Our next Insight on mezzanine finance will offer observations on the more heavily negotiated points of documenting a senior/mezzanine deal,  the senior and mezzanine creditor relationship and the overlaps between mezzanine and super senior lenders.