Mezzanine Finance - How to make the most of your Trustee?

Mezz finance is a practical solution to a common ‘borrower problem’ (ie. How do I access additional leverage when my assets are fully encumbered?)

In Hong Kong a typical scenario may involve a list co that needs finance for a major acquisition, in circumstances where it has maxed out its senior secured facilities.

Post-Covid Bounce

The post-Covid environment will generate demand for agile finance solutions capable of extending the financial ‘runway’ for successful but financially stretched businesses.

For the trustee, this will be a fascinating era of refi’s, re-negotiating finance agreements, dealing with waivers of default and otherwise helping stakeholders take advantage of the post-Covid bounce.

Mezz or Subordinated?

The mezz structure was a development on the earlier ‘subordinated’ loan innovation.

In a subordinated loan, the borrower gains additional finance from a second lender by offering the original asset as collateral (although on subordinated terms).

The borrower is happy (it gets to purchase a bigger appreciating asset). The senior lender is happy (there is additional liquidity in the structure and its interest is preferred).

Finally, the junior lender is happy as it enjoys a higher return.

The 1980s real estate boom eventually came to an end and in a era of numerous large defaults lenders came to value the ability to deal with defaults without the complicating factor of additional secured lenders.

Structural Subordination

Enter the mezz solution! In a mezz deal the shareholder of the borrower pledges its interest in the borrower (rather than its interest in the underlying asset).

In a default scenario, the junior lender may seize the shares of the borrower (gaining some comfort) however they are unable to seize the underlying assets that are already pledged to the senior lender.

Intercreditor Agreement

The senior and junior lenders as well as the trustee typically enter into an agreement that describes the creditors' relationship and payment mechanics.

Conflicts of interest

Even with the existence of a intercreditor agreement, complex conflicts of interest can arise. Particularly in falling markets.

A lender enjoying super priority may not be supportive of high-risk restructuring plans, while a private credit manager enjoying equity upside might be amenable.

Your trustee

When kicking off your mezz deal, your trustee will help you think through a range of structural, collateral and risk issues:

(1)   Structure (ie. Does the structure work? Does it ring fence the right assets? Are payment instructions objective and workable? What level of covenant monitoring is required?);

(2)   Collateral/Security (ie. Are the collateral/secured assets clearly defined? Has collateral been perfected? How to deal with a default scenario?); and

(3)   Risk (ie. Are all parties identified? What is the commercial rationale for the transaction? Are trustee duties clearly defined? Are appropriate limitation of liability clauses in place?)

Innovation opportunities

Neither mezz nor subordinated loan arrangements provide a ‘perfect’ solution to the ‘borrower problem’.

Might there be more efficient ways to: (i) address conflicts of interests? (ii) simplify asset valuation? (iii) create cheap and efficient secondary markets?

For the financial services innovator, mezz and distressed debt present exciting innovation opportunities to link global investment opportunities with efficient secondary capital markets.