This Way to the Mezzanine

New instruments called ''reversible warrants'' enable fast-growing issuers to take back equity rights forfeited in financing, provided that the issuer hits certain performance milestones.

Mezzanine financing deals — bridge loans that span funding gaps until cheaper capital can be had — are on a roll. Last year, 159 buyout/mezzanine funds raised $86.2 billion, the highest yearly total for these funds ever recorded, reports Thomson Venture Economics, which groups the two funding sources together. That tally represents a 67 percent rise over 2004, when 129 funds raised $51.6 billion.

The upsurge in mezzanine lending follows the general private-equity trend of abounding capital chasing a relatively low number of deals. It may also signal that more small companies are reaching a growth stage in which such financing makes economic sense.

In general, mezzanine loans are short-term debt — usually averaging about three years in length — provided by private-equity firms rather than banks. The loans tend to be subordinated debt, exposing investors to more risk than bank lenders have in case of bankruptcy. So to entice investors into mezzanine funds, returns are set relatively high, between 30 percent and 50 percent. Further, the deals often feature warrants, which are options issued by the borrowers that give the lender the right to buy equity at a predetermined price.

Warrants are used to “juice the return” by enhancing an investor’s potential yield with equity, explains Ricardo Chance, a managing director with investment bank Trenwith Securities. But to an entrepreneur shepherding a growing company, warrants are a double-edged sword. While warrants help lure capital, they can cede a good deal of equity — and thus control — to the lender.

One form of such arrangements, however, might quell at least some entrepreneurial concerns. Called a “reversible warrant,” the new instrument was trademarked by Snowbird Capital Inc., a mezzanine-debt fund based in Reston, Virginia. As their name suggests, reversible warrants enable issuers to take back some of the equity rights forfeited as part of the financing deal. The proviso is that the issuer must hit certain performance milestones, such as cash-flow targets.

So far, five companies have arranged for a mezzanine loan featuring reversible warrants, according to Nelson Carbonell, Snowbird’s chairman. Companies that use mezzanine financing typically have annual revenues under $250 million and tend to be caught in a thorny growth scenario — they don’t have enough extra capital to fund expansion to meet increasing demand.

That was true in the case of U.S. Modular, an Irvine, California-based maker of data-storage devices that took in revenues of $24 million in 2005. According to a U.S. Modular spokesman, the four-year-old company was being stifled by its inability to fund growth. If it was to survive, the company needed to add equipment and manufacturing space and expand its management team (including the hiring of a vice president of finance). But sources of capital were limited.

U.S. Modular had outgrown seed-capital providers, such as angel investors and venture capitalists. Most of those weren’t interested in concentrating big chunks of their limited capital in a single company. For their part, private-equity firms wanted a bigger piece of the company than founder and president Nick Payzant wanted to hand over, and bank lenders were only willing to provide asset-based lines of credit that didn’t fully meet the company’s expansion needs.

But the reversible warrant deal offered by Snowbird piqued Payzant’s interest, mainly because the hybrid feature had “fewer strings attached,” he recalls. In September, U.S. Modular closed a $1 million mezzanine financing deal with Snowbird on terms that included a 12 percent annualized interest rate, and reversible warrants, which give Snowbird the future right to own 1 percent of the value of U.S. Modular.

The reversible warrant is similar to the better-known “clawback” feature of mezzanine deals. But clawbacks usually work in two opposing directions. If deal targets are achieved, equity rights are given back to the issuer; if targets are missed, the warrant holder gets a larger piece of equity.

Clawbacks are usually written into deals by lenders who identify a valuation gap in borrowers, contends Trenwith’s Chance. That gap is exposed when management believes the company will hit higher performance milestones (revenue, cash-flow, profit) than the lender estimates, and is therefore worth more. So to make sure that management is serious about hitting its performance targets, lenders tack on a clawback to the deal.

If the company hits its performance goals, everybody wins. If they miss, the lender gets a piece of the company.

That’s not the case with reversible warrants, which are a one-way street, notes Carbonell. Missed corporate targets don’t trigger a bigger equity stake for the lender.

But not every company fits Snowbird’s lending criteria. For example, the company’s mezzanine loans are capped at $5 million, and the fund lends only to companies with strong cash flow. Interest rates are relatively high — about 4 percent to 8 percent above prime. That means that in the current interest-rate environment, Snowbird charges between 10 percent and 14 percent on its deals.

Unlike private-equity funds and other more aggressive firms, the debt fund expects investment returns in the 20 percent to 25 percent range. But if a portfolio company fails to hit performance targets — and eventually defaults and sinks into bankruptcy — Snowbird would be ahead of private-equity funds on the creditors’ line.

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