Mezzanine Financing

Mezzanine capital may be used to fund acquisitions in corporate build-up situations. Additionally, it can be used to finance fixed asset additions (such as new production plants), the development and launch of new products or moves into new geographical markets. In leveraged buyout transactions, typically between 20% and 30% of the financing is comprised of mezzanine.

In most cases, mezzanine capital takes the form of a subordinated medium-term loan facility with a maturity of 5-7 years. The mezzanine loan is contractually subordinated to senior ranking bank loans, such that the senior bank debt must be fully repaid and serviced in priority to the mezzanine debt.

In terms of risk profile, a mezzanine loan occupies a middle position in the borrower's capital structure, ranking behind the claims of the senior debt providers but ahead of the rights of the equity investors.

A mezzanine capital provider's risk is determined by the capital structure and debt bearing capacity of the borrower. In general, the greater a borrower's senior ranking debt and the smaller its equity capital base, the greater will be the risk taken by the mezzanine provider.

Since it is taking greater risk, the mezzanine capital provider seeks a return which is partly debt and partly equity related. Typically the borrower will pay interest on the mezzanine loan at an agreed rate. In addition, the mezzanine provider will have an equity interest in the borrower, usually in the form of a warrant to buy a pre-agreed amount of equity at a fixed nominal price. This will typically represent between 1% and 10% of the company’s outstanding shares. The warrants may be accompanied by put options exercisable by the mezzanine provider after a period of time.

Sometimes mezzanine capital is structured using other financing instruments, such as loan stock or preference shares. A mezzanine loan could also be structured as a debt instrument which is convertible into equity at a future date.

Bank debt is frequently secured by charges over the borrower's assets and the mezzanine lender will normally have second ranking security. It is generally only necessary to have one security package which is shared by both the senior and mezzanine lenders.

Mezzanine capital therefore should be viewed as a flexible financing instrument which shares some of the characteristics of both debt and equity and holds a middle position in the risk-reward spectrum.

Transaction Criteria

PME Capital focuses on arranging subordinated loans ranging in size from $1 million to $10 million, with terms ranging from five to ten years. These loans are secured by a second lien on property, plant and equipment. Principal amortization can be deferred during an initial period to conform to a business' cash flow constraints. Interest on these facilities can be fixed or variable, with rates depending upon the company's credit situation and the structural features of the loan. The loans will typically have attached warrants to purchase equity in the borrowing company.

PME Capital targets transactions where the company requiring financing meets the following criteria:

PME Capital does not target specific industries, although will favor transactions in manufacturing, distribution, retail, business services, media, telecommunications and information technology, PME Capital will not consider transactions in real estate.

The primary investment purposes targeted by PME Capital are strategic acquisitions and growth capital investments, although management buyouts and leveraged recapitalizations will also be considered.

Transaction Process

In the case of a mezzanine financing, a typical transaction process consist of the following steps:

1. PME Capital review and due diligence
2. Initial contacts with potential investors
3. Initial review by potential investors
4. Term sheet and non-binding commitments from investors
5. Due diligence process and preparation of investor documentation
6. Investor approvals and closing

Due Diligence Process

Clients must be prepared to assist the investors in a thorough due diligence process. In the context of an acquisition in the United States, the buyer will undertake most of the due diligence steps requested by the investors. A well prepared documentation with audited financial statements, financial projections, major legal agreements, real estate surveys and other important documents reduces costs and facilitates and expedites the review process.

The due diligence process typically consists of the following components:

1. Competitive Market Analysis – Analysis of the competitive environment in which the business operates including supplier power, buyer influence, impact of product complements, the threat of substitute products, the existence of barriers to entry and the relative strengths of other companies in the industry (i.e., low cost producer, brand equity, etc).

2. Operations Review – Evaluation of management and employees, payroll, operating permits and licenses, insurance policies, operating lease agreements, status and sufficiency of equipment and inventory levels. The purpose of such a review is to determine the ability of the operating company to continue to provide stable cash flow in order to ensure an attractive financial return to the investors.

3. Financial Review – Analysis of the operating company’s financial statements for the past three years, at a minimum. Evaluation of the efficiency and accuracy of the company's accounting and control systems. Review of the company's business plan and projections.

4. Facilities Review- Evaluation of the condition of all facilities and assessment of what major capital expenditures are required in the next few years and if such expenditures are accurately reflected in the company's projections.

5. Legal Review – Evaluation of important legal documents such as formation documents, buy-sell or co-owner agreements, material contracts, intellectual property, and mortgage notes. Insurance coverage, including the company’s ability to obtain directors' and officers' insurance, will also be evaluated.

6. Management/Principals Review – Evaluation of the principal equity investor in the transaction using references and industry contacts including bankers, vendors, partners, investors and community contacts. The financial position of the principal equity investor will be evaluated in order to ensure that there is additional financial capacity should the operating company default on its obligations.

7. Real Estate/Environmental Review - In situations where real estate plays an important role in the operations and/or valuation of the investment opportunity, an appraisal firm and an environmental consultant will be hired to complete site assessments. Where necessary a Phase I environmental review will be completed. Additionally, the operating company's adherence environmental regulations will be reviewed.