Mezzanine Fund Interview

Mezzanine capital is a type of debt or preferred stock that represents a claim on a company’s assets.  A typical mezzanine transaction is structured as debt (typically an unsecured or subordinated note) or preferred stock and is senior only to equity in the capital structure.  A fund can earn a return on its mezzanine investment in three different ways: through cash interest, payable-in-kind interest, or equity ownership.  Cash interest is periodic cash payments based on a percentage of the outstanding balance.  Payable-in-kind (PIK) interest is periodic payments in which the interest payment is not paid in cash but rather through increasing the principal balance by the amount of interest.  Mezzanine capital will sometimes include an equity stake in the form of attached warrants or conversion features.

A career in mezzanine financing is considered to be a light version of private equity since those who work in this field typically do the same work but have better hours.  Most people that interview into Mezz are people that are also interested in private equity.  I was one of these people and there are a few critical differences you need to know before going in.  Private equity and credit investors think about an investment a little differently.  The best way to explain this is through an example.  A private equity investor and a credit investor both receive a CIM of the same company.  The private equity guy will immediately flip through the pages and try to  determine ways to grow the business  focusing on revenue and operating builds (a glass half full  mentality).  A credit investor will open the CIM and immediately start trying to find things that are wrong with the company and potential problems that  that could cause the company to not make  its interest payments (a glass half empty  mentality).  Equity investors tend to be optimists where credit investors tend to be pessimists.   Equity investors demand the highest returns, so they take on the most risk at the bottom of the capital structure.  Credit investors, on the other hand, are not as focused on growth; their main concern is getting their interest payments and principal back.

Here are some interview questions I was asked:

What are the advantages of using mezzanine capital from the company’s point of view?

–     Increased leverage

–     Might offer lower cost of capital (since cheaper than equity) with less equity dilution, and hence higher returns

–     Interest paid on Mezz debt is tax deductible where dividends are not

–     Senior creditors benefit from the cushion of the junior debt

–     Debt under mezzanine arrangements is often payable after certain years (PIK interest), delaying obligation to buyer

–     Additional upside can be generated from upfront fees, call protection including call premiums and equity co-investments or warrants

Why consider a job in Mezzanine Financing?

–         I believe there is great opportunity to provide debt financing to private equity deals in a time where banks are more cautious to lend given the current economic condition

–         You do basically the same work as you would do in PE, but you do deals with a much greater frequency and do less portfolio management

–         I like the riskiness of the investment; since mezz is lower on the capital structure, you have to be very diligent and build detailed models to make sure you are making the right decisions.  I like to take risk

What are a few different debt metrics we look at in Mezzanine Financing?

–         Senior Leverage

–         Total Leverage

–         Fixed Charge Coverage Ratio = FCF / Fixed Charges

o       Fixed Charges include amortization, interest & taxes

–         Debt Service Coverage Ratio (EBITDA / Interest)

–         Maximum Capex

–         Mimimum EBITDA

Let’s look at “Company XYZ.” We are considering making an investment in XYZ, but we are not sure of the exact route to take.  Given the current condition of the firm and macroeconomic conditions, do you think we should invest in the equity piece, the senior debt piece, or the mezz piece and why?

You will be sure to get this question in a mezz interview, so be prepared.  It is important to understand the key elements of a debt investor   The two biggest things to look at when trying to answer this question are risk and growth (these can go hand-in-hand).  If we are looking at a tech company with a lot of growth, we might want to invest in the equity (and less so in the debt).  If we are looking at an infrastructure like asset that has steady cash flows and low growth, we might invest in the senior leverage or mezz piece.

I am company XYZ and I reach out to you about possibly getting mezzanine financing for a proposed acquisition.  Company XYZ already has senior debt financing in place with a debt covenant of 4.75x total debt / EBITDA.  As a mezz investor, when negotiating the debt covenants, should I negotiate above or below 4.75x?

When  negotiating mezzanine debt covenants, you need to be aware that you are lowest on the capital structure besides equity,.    so you need to be absolutely certain you can get your  investment back.  In this case you would want to  negotiate a debt covenant below 4.75x.  From a mezz perspective, if a company starts to perform poorly, you want to be the first  tranche  that trips covenants.  Once covenants are tripped, you are able to start enacting certain provisions to  recoup your investment.

What is the difference between an option and a futures contract?

The main difference between an option and a futures contract  is margin calls.  When an option does unfavorably, it is just “out of the money,” but in a futures contract, you actually have to post margin.

How do you value an option?

The answer to this question is to say, “It depends, but I would probably use Black- Scholes option pricing”.  There are five key elements you need to price an option under Black- Scholes.   They are listed below:

1.)    Price

2.)    Volatility

3.)    Interest Rate

4.)    Strike Price

5.)    Duration

If a company trading at 10x P/E buys a company at 5x P/E in an all stock deal, is the transaction most likely accretive or dilutive?

Accretive. Generally when a company with a higher multiple acquires a company with a lower multiple, the transaction is accretive.  This is true because the  acquirer is paying less for every dollar of earnings than the market is currently valuing   Not sure of the meaning here—it is that than the acquirer is paying less for every dollar of earnings than their current market value?

What are the different ways you can make a transaction more accretive?

1.)    Decrease the purchase price

2.)    Incorporate synergies

3.)    Using more cash to fund the transaction

4.)    Increase the duration of the amortization of intangibles

5.)    Use a lower cost of debt

You have a 5% note with a maturity in five years trading at 80.  What is the current yield?

Quick is better then accurate when answering this type of question.  The easiest way to calculate this is by asking yourself how much you’ve lost on your investment.  In this case par is 100 so you lost 20 cents on the dollar (100-80).  That twenty cents is divided by five since you still have five years left on the investment (20/5=4).  So the current yield on the note is 9% (5+4=9).