Monthly Archives: December 2006

Mezzanine Finance (a 2002 publication by Fleet)

Mezzanine Finance: Closing The Gap Between Debt And Equity

October 2002

This article was published prior to the 2004 merger of FleetBoston and Bank of America.

Existing lines of credit have been reduced. New loans from traditional lenders are harder to obtain. Access to the public capital markets is virtually non-existent and the economic downturn has been financially challenging for many businesses. Where then, in these times, does the typical middle-market company turn for capital? Increasingly the answer may be mezzanine financing.

A hybrid form of capital, mezzanine financing is sandwiched between senior debt and equity on a company’s balance sheet. Structurally it is subordinated or “junior” in priority of payment to senior debt, but senior to common stock or equity. Mezzanine capital typically is used to fund a growth opportunity, such as an acquisition, new product line, new distribution channel or plant expansion. Although it makes up a small percentage of a company’s total available capital, mezzanine financing has become critical to middle-market companies in recent months.

“These days, mezzanine finance is often the factor that influences whether or not a deal closes,” says Tim Shoyer, Fleet Securities managing director of high-yield and mezzanine debt. “As more cash-flow loans are being restructured, often there’s a gap between the new asset-based deal and the amount financed previously on a cash-flow basis. Mezzanine fills that gap. It’s been a big trend in the last 18 to 24 months.”

Gaps of this nature are common for two primary reasons: 1) accounts receivable, inventories and fixed assets are being discounted at greater rates than in the past for fear that their values will not be realized in the future; and, 2) as a result of defaults and regulatory pressure, banks have placed ceilings on the amount of total debt a company can obtain. While additional liquidity can be obtained from equity investors, equity is the most expensive source of capital. It also requires a greater “ownership give-up.” As a result, mezzanine finance can be an attractive alternative.

Typical Terms
“The biggest benefit mezzanine debt provides is reducing the amount of equity required in the transaction,” says Shoyer. “Mezzanine investors are looking for an 18 to 20 percent IRR (internal rate of return) compared to 25 to 35 percent for equity investors, so it’s more cost effective.”

While mezzanine debt is more expensive than bank debt, it is not as rigid. “Generally, it shares the same covenant package as a bank deal, but the measurement characteristics are looser. For instance, if the maximum leverage of EBITDA on a bank deal is three and a half times, a mezzanine deal would be closer to four,” Shoyer says.

Typically, mezzanine lending includes both subordinated debt and an equity component. The debt is issued with a cash pay interest rate of 12 to 12 1/2 percent and a maturity ranging from five to seven years. The remainder of the required 18 to 20 percent all-in-return consists of warrants to buy common stock, which the investor values based on the outlook of the company, or incremental interest paid on a “pay-in-kind” or PIK basis. The fee for raising the money runs between two and three percent of the transaction. Deal sizes typically range from three million to $25 million but can go as high as $150 million.

Growing Field of Players
Mezzanine lending has been around for more than two decades. In the 1980’s, the business was dominated by insurance companies and savings and loan associations. By the 1990’s, limited partnerships (LPs) had entered the arena. Today, investors include pension funds, hedge funds, leveraged public funds, LPs and insurance companies, as well as banks that have established stand-alone mezzanine efforts.

“During the mid-90’s, it was common for banks to function as principal purchasers,” says Shoyer, “but today, most of them are working as placement agents.” In other words, the placement agent shows a deal to a wide variety of investors and creates a competitive auction environment, much like an underwriter in an investment banking transaction. “The auction environment is important to the client because it ensures the company gets the best deal available in the marketplace.”

There are now more mezzanine lenders than active senior lenders as a result of industry consolidation and credit tightening. According to Chicago-based investment bank Lincoln Partners, there are approximately 113 mezzanine providers in the market today (Exhibit #1 — Mezzanine Lenders By Type).

Ronald Kahn, managing director of Lincoln Partners said, “When the senior debt market contracted, people thought this would be a great opportunity for mezzanine. However, in reality, M&A volume was so low that there were few opportunities for mezzanine lenders. We see more money than demand now in the marketplace.” Kahn’s comments were made at a recent New York Business Forums, Inc. conference on mezzanine finance.

Shifting Structures
The supply/demand imbalance has precipitated a shift in the market as mezzanine players compete with high-yield for larger deals. “Traditional mezzanine lenders are book-and-hold investors,” says Shoyer. “They’re generally focused on cash-flow lending and they look for call protection and equity participation to generate longer term results. Because there’s a dearth of traditional deals, mezzanine investors are bidding aggressively on deals and starting to show structural flexibility including shortening their call protection.”

Another trend that is emerging is an increased focus on second liens. In the credit hierarchy, second lien investors are junior to bank debt. But, a second lien is not pure subordinated debt because it uses residual asset value. “Let’s say a bank will lend at 85 percent of the value of the assets — plant, inventory, receivables, etc. The second lien holder will lend up to the remaining 15 percent depending on cash-flow strength and other factors,” says Shoyer. “This is a small niche market dominated by hedge funds, but it’s important to middle-market companies and is expected to continue to grow.”

Unlike equity or high-yield, which fluctuate with economic conditions, traditional mezzanine finance is a very consistent and stable market. Over the past three years, the coupon rate on mezzanine notes has remained fairly steady — even drifting upward slightly in recent months — in spite of the downward drift in the prime rate. The total targeted return has remained stable as well (Exhibit #2 — Mezzanine Median Target Returns). However, the use of PIKs is becoming more prevalent as company valuations have grown more complex and less predictable.

“PIK income is less risky than warrants and effectively increase the defined return portion of the deal,” says Shoyer. “With PIK, the interest is added back into the loan so that the amount of the loan increases over time.”

Speaking at a recent workshop on mezzanine lending for The New York Business Forums, Inc., Robert Ammerman, managing partner of Capital Resource Partners, said the rise in prepayment penalties appears to be more prevalent among funds than insurance companies, “because we don’t want to get refinanced in a year. Our LPs are just as focused on multiples of cash-flow as they are on internal rates of return. Getting the targeted IRR for a short period of time such as six months, nine months or twelve months just doesn’t do that much good for them. So, we may charge as much as a full year’s interest in the first year as a prepayment penalty.”

He went on to say he’s also seeing more guaranteed target returns or “straight rates without equity,” while noting that when there is an equity component, it tends to be more complex. “As we’ve become less certain over the past two years about business and management forecasts, two things have happened: more sliding scales are being used to determine exit value or financial performance, and, if the equity sponsor has an unusually structured security, we’re seeing options and warrants tied into that security and not into common stock.”

Secure More Total Capital
Some closely held companies, particularly those that are family controlled, are reluctant to consider mezzanine financing because historically it requires relinquishing a certain amount of ownership. However, a mezzanine investor’s goal isn’t to be a long-term shareholder, but rather to achieve a target return rate by some specified time. “It’s also important for a business owner to realize that a large ownership interest in a stagnant or underperforming business may not be as valuable as a smaller ownership in a growing company,” says Shoyer. What’s more, having mezzanine debt in place actually can help a company secure more total capital.

“For example, if a client approached a bank and said, ‘I’m buying a company for $100 million and I want all the debt to be bank debt and I’ll put the rest in equity,’ the bank may lend $50 of that $100 million. However, with a mezzanine component, the bank may lend less, let’s say $40 million and the sub-debt lender might put in $25 million, bringing the total debt raised to $65 million.” As the overall level of debt increases, the actual amount of bank debt shrinks due to increased risk, but the total amount raised is higher when the mezzanine layer is added. Ultimately, this would reduce the equity requirement from $50 million to $35 million.

In addition, banks often look more favorably on companies that are backed by institutional investors and may extend credit under more attractive terms. Mezzanine lenders also may reserve a portion of their available capital in order to make additional investments in those companies that perform well.

Tapping the Mezzanine Market
The amount of money raised for mezzanine financing has grown dramatically in recent years (Exhibit #3 — Increase In Mezzanine Fund Raising). Currently mezzanine providers are struggling to find good investments for billions of dollars of committed, untapped capital. Their approach to evaluating opportunities is similar to that of equity investors. “First and foremost, they’re looking for a strong, credible management team,” says Shoyer, meaning stable leadership and a team of professionals with an industry track record. “Does the company have a defensible position in its industry? Is it a leader or does it fill some niche? What’s the overall outlook for the industry? Are the long-term prospects favorable? These are the kinds of issues that are probed in the due diligence process,” he says.

Finally, a clearly defined exit strategy is pivotal to the decision since the overall return on investment hinges on the investor’s ability to obtain the value of its equity position. The sale of the company, a recapitalization, a refinancing, and–less frequently these days — an initial public offering, all are potentially viable liquidity events.

Regardless of the exit event, experts agree that now is a great time to invest in this asset class. Lincoln Partners’ Kahn believes that companies that are constrained by traditional bank debt increasingly will turn to mezzanine lenders for junior capital. “Over the next 12 to 18 months, there’s tremendous opportunity for mezzanine to fund a company’s growth and working capital needs,” says Kahn. Fleet Securities’ Shoyer concurs. “By tapping into this liquid source of capital, middle-market companies can make the strategic investments required to take their business to the next level.”

Bloomberg’s Mark Gilbert on Outsourcing in the Investment Industry

The Next Job Outsourced to India Could Be Yours

By Mark Gilbert
Link to the original article

Oct. 26 (Bloomberg) — “We Think, They Sweat,” wrote author and former hedge-fund manager Andy Kessler in an article on Asian manufacturing and the U.S. trade deficit for the Wall Street Journal two years ago. If “they” start thinking for us as well, maybe we are the ones who should be sweating.

When you hear the words “outsourcing to India,” what springs to mind? Customer-service grunts answering queries in call centers from prepared scripts, perhaps? Number crunchers processing and cleaning digits in a data farm? Low-level programmers knitting bits of software?

Here are a few alternative visions. Master of Business Administration graduates scrutinizing earnings reports and regulatory filings in a Bangalore research laboratory, and publishing buy/sell notes. Master of Science holders in Chennai analyzing the debt profiles of global borrowers and writing research about their creditworthiness. Doctors of mathematics in a Mumbai trading room shifting billions of dollars between stocks, bonds, currencies and derivatives, going head-to-head with the guys and girls in New York, London, Tokyo and Singapore.

Instead of relying on countries such as India just to cut wage costs, the world’s smartest companies are likely to start tapping Asia for brainpower. Since global investment banks claim to be stuffed with people skilled at divining how to make companies as efficient as possible, they should be leading the charge to hire knowledge workers in locations other than the world’s main financial centers.

`Talent Pool’

“Globalization means that banks will increasingly be looking to places like India for future hiring,” says Steve Major, global head of fixed-income strategy at HSBC Holdings Plc in London. “If your strategy is to just focus on cost, you’re doomed to fail. You have to look at deepening the talent pool first, getting the quality employees.”

Entry-level jobs in bank research departments have been the first to drift to India. As regulators around the world cracked down on allegations of bias in recent years, research lost its subsidies from investment banking. Banks responded by slashing the volume of analysis, and cleaving the cheaper business of building spreadsheets from the more costly exercise of writing reports and marketing trading ideas to clients.

“The analytical need to keep the roles whole clashed with an operational need,” says Darren Sharma, the founder of Frontline Analysts in Bangalore. “We’re essentially tribal. Customers weren’t keen on receiving market views from a place that wasn’t on their mental map.”

Credit Research

That resistance is slowly fading, he says. Frontline has a team of three senior analysts assessing the creditworthiness of financial-services companies for WestLB AG, Germany’s third- biggest state-owned bank and Sharma’s former employer, where he spent five years as a London-based credit strategist. He’s in negotiations to build a second team for WGZ Bank Group, a central and wholesale bank for 240 of Germany’s cooperative lenders.

JPMorgan Chase & Co. has more than 80 analysts in India, while Merrill Lynch & Co. and Morgan Stanley each employ more than 50 there. Goldman Sachs Group Inc.’s Bangalore office will soon reach 1,500 employees, overtaking its Tokyo office as the firm’s third-largest, the Financial Times reported last month.

That shift has been driven by cost. The average 2005 Wall Street salary was almost $290,000, according to a report this month from New York State Comptroller Alan Hevesi. That’s about 6.6 times more than the nation’s average per-capita income of $43,740, based on World Bank data.

Beyond Cost

Apply that multiple to India’s average income of $720, and you get to an annual salary of a bit more than $4,700. Even at three or four times that level for qualified banking staff in India, the cost attractions are clear.

“Research has now become a cost which cannot be subsidized by the banking business,” says Krishnan Sakotai of Karvy Global Services in Hyderabad, India. “On the other hand, there are some firms who are also outsourcing research in order to gain competitive advantage, something beyond just cost.” Sakotai runs a team of about 33 people selling research to banks and brokerages.

Most of the hiring so far has been for junior workers in low-level jobs. Frontline’s Sharma says that has led to disenchantment among highly qualified Indian employees frustrated at the lack of opportunity for promotion. “You have to recruit commensurate to the job offered,” he says.

For now, senior analyst positions in India are more likely to be in bond research than in stock analysis, Sharma says. “Fixed income never had data crunchers versus opinion formers,” he says. “Equity analysts aren’t always opinion owners, whereas all fixed-income analysts publish.”

Traders Next?

Once you have a research team in India, it might make sense to open a trading floor. Deutsche Bank AG, Germany’s biggest bank, is hiring staff in Mumbai for its Global Markets Center, according to a recruitment e-mail from Ma Foi Management Consultants Ltd., which says it is India’s largest human- resources service provider.

The jobs on offer include creating hedging strategies for the bank’s energy customers, advising insurers and pension funds on multi-asset investments, and coming up with borrowing strategies for Latin American clients. “The teams in GMC will be front-office teams acting as virtual extensions of the trading desks in London, New York, Singapore,” the e-mail says.

India has a couple of key advantages over China in the race to become the West’s offshore intellectual workforce. Language barriers are lower, and there’s a diaspora of Indian managers already running business units all around the world.

Two-Way Traffic

Most of the U.S. and European literature on the growth of financial services in Asia focuses on whether the locals will lock up their domestic markets before Western firms can establish a beach-head to market insurance and banking and credit cards to the 2.4 billion inhabitants of China and India.

“A threat may come from the use of local expertise to establish a separate rival indigenous financial services industry that shifts the balance of global services toward Asia,” said the City of London Corp., a local government body, in a report this month on how India and China might affect London’s financial district.

Maybe that emphasis is wrong. Instead of focusing on what we might or might not be able to do to “them,” we should be worrying about what “they” might do to us.

While I’m not quite in the camp that says we should all be teaching our children Mandarin, the words of former Chinese Vice Premier Qian Qichen resonate with me. In the official China Daily newspaper’s November 2004 online edition, he said the U.S. “is dreaming if it thought the 21st century was the American century.”

In Kessler’s 2004 article, he takes comfort from how U.S. companies are “moving low margin, low paying jobs overseas, but, fortunately, are left with high margin, high paying intellectual property jobs.” Anyone who believes the U.S. and Europe have some kind of monopoly on intellect is cruising for a bruising.

(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)

Finance and inspiration

A question from Yahoo! Answers:

Does finance offer any inspiration or enlightenment in our life?

Of course it does. For example, we intuitively like the freedom to choose. We feel it is valuable, but how valuable exactly? This was uncertain until 1973, when Fisher Black, Myron Scholes, and Robert Merton published their works on options pricing. Now we have a way of making educated guesses about the value of choice…

What is Goth?

A question from Yahoo! Answers:

What is Goth?

I wanna know what goth is. I am goth, and has no clue what it is. I wish I did. . .

The Goths were an East Germanic tribe who are believed to have left Scandinavia in the 1st century AD, initially settled in present-day Poland, and by the and of the 2nd century expanded to a large part of Eastern Europe. Goths were one of the first “barbaric” groups to successfully invade the Roman Empire.

The “Goth” subculture started in the UK as an offshoot of post-punk. In the UK, there were several post-punk bands that were called “gothic” in the late 1970s (opinions differ as to how the word “gothic” became associated with post-punk). In the early 1980s, gothic rock became its own subgenre within post-punk, and followers of gothic rock bands started to come together as a distinctly recognizable movement. The movement further solidified with the opening of the Batcave club in London in July 1982, which has become the primary “Gothic” stomping ground…


Globalization at a point of no return?

A question from Yahoo! Answers:

With globalization at a point of no return what is the future for US workers?

Lets face it -you gotta export to sell our goods and services to the countries selling us most of what we buy in the US..
When you elimnate the impact of all gov.,fed/state/local the military and all the support directly or indirectlly of the people who have jobs because of Government we’re only talking30-40%%of total work force and the majority of their work is paid for by people who work for or because of the gvernment———————-
So what are we going to export except money and related prodict—-not much demand overseas for lawn boys or fast food workers———–what?———–What is the future of the US economy and its direct effect on you?

Let’s face it — you live in a dream world…

The U.S.’ imports are equivalent to about 15% of the U.S. GDP, imports, approximately 10%. So your point about “the countries selling us most of what we buy” is simply wrong; most (about 85%, to be precise) of what you buy is still made in the good old U.S. of A.

The largest trading partner of the U.S., in spite of the recent rise of China, is still (surprise, surprise!!!)… Canada (you didn’t know this, did you?) And the source of Canadian competitive advantage is very simple: Canada has a (much less expensive) single-payer health care system, so instead of providing expensive health care benefits, employers pay an additional payroll tax, which costs them about half of what health benefits cost in the U.S.

Also, there is no such thing as “globalization at a point of no return”. If you read The Economic Consequences of the Peace by J.M. Keynes, you will learn that sentiments similar to yours ruled in Europe about 1900. Globalization between 1880 and 1910 was in many respects more profound compared to the one we see today (in particular, international movement of labor was much more extensive than today). And it pretty much ended when World War I began…

Income gap: international comparisons?

A question from Yahoo! Answers:

What are the top 10 countries in the world that have widest income gap (income inequality)?

Income equality is like mission impossible for every country, developped or underdevelopped…we consider a country’s economic policy effective if it can keep the gap as narrow as possible, since there’s no way the gap would be completely closed. But apparently there are many countries in the world, despite of their efforts, still can’t close the gap a bit…So I am wondering what are the top 10 countries that have widest income gap, or greatest income inequality…

The answer is, we simply don’t know. To start with, there is more than one way to measure income inequality; you can compute a Gini coefficient, estimate the share of national income received by 1% of the richest households, compare income of top and bottom quartiles, quintiles, or deciles, etc. But even more importantly, in developing countries, reliable income data are hard to come by, because they are distorted by informal economy on the low end and sophisticated tax evasion on the high end.

For example, the official government data for Russia (based on tax returns) indicate a Gini coefficient of 0.38. Alternative estimates conducted by Russian economists Sergei Aivazyan and Stanislav Kolenikov based on the data or Russia Longitudinal Monitoring Survey suggest a much higher Gini coefficient of 0.55-0.57.

Countries where estimated Gini coefficients are consistently high include Brazil and Nigeria.

Another issue is that income inequality is the wrong target; it is possible that a good policy should target WEALTH inequality instead…

Anyhow, the World Bank maintains a database of income inequality studies and their results. You can get a copy here:…

If the dollar crashes…

A question from Yahoo! Answers:

If the dollar crashes, as Warren Buffet thinks it will, What effect will it have on the poor and middle class?

Next to none. It crashed in 1985-87, remember? And very few people even noticed…

The value of U.S. imports is about 15% of GDP, the value of exports, about 10%. So if the dollar crashed, 15% of the economy would be affected (somewhat) adversely, while 10% will be affected (somewhat) favorably…

A debate on outsourcing

A question from Yahoo! Answers:

Have debate, need help. outsourcing.?
I have a debate this Thursday on outsourcing. I am on the team that is opposed to it. i need help. give me reasons that we should not outsource. the person with some freakin sweet reasons will get 10 big fat juicy points.

Well, it sucks to be you; it sucks to be your opponent, too… You are about to waste a lot of time debating something completely unimportant…

There is absolutely no evidence that outsourcing has had any significant impact on employment anywhere. The effects that popular press attributes to outsourcing are in fact squarely due to technology; jobs that are supposedly going to China in reality go to machines. The process is going on worldwide. As a result, China loses manufacturing jobs even faster than the U.S.; between 1995 and 2002, U.S. has lost 11.3% of its manufacturing jobs, China, 15.3%. The fastest loss of manufacturing jobs during that period was in fact observed in Brazil (19.9%)…

Manufacturing is undergoing the same transition agriculture went through. In 1910, about a third of U.S. workforce worked in agriculture; today, it’s 3%. Where did the remaining jobs go? They got taken over by tractors and harvesters… In 1962, 27.7% of the U.S. non-farm workforce worked in manufacturing; by 2002, the percentage declined to 11.5%, while the manufacturing sector’s contribution to GDP remained roughly the same, about 17%…

Delivery terms

A question from Yahoo! Answers:

Help please!!!?

I work for a manufacture company. We make presses. China is interested in buying 160 presses from us. We are located near a harbor where they will be ship does any one know if we have to take our machines to the harbor or do they have to send someone to pick them up?? Who’s responsible for that??

It depends on delivery terms written into the contract between you and your customer. One extreme is EXW (Ex-Works), when the buyer arranges transportation, including picking the product up at the seller’s location. The other extreme is DDP (Delivered Duty Paid), when the seller pays for transportation to the buyer’s location (but not unloading at the buyer’s location) and related charges, including any taxes and duties. There are 11 other standard delivery terms, falling between those extremes.

A brief summary of standard delivery terms is available here:

Engineering human beings?

A question from Yahoo! Answers:

Human Engineering?

As the future grows humans become more and more artificial and by which teh book Halo explains detailed, Will the government be allowed to secretly grow and test humans that they clone? I am curious about this.

Ultimately, it will depend on the legislative and public oversight. But, more importantly, why would the government want to clone HUMANS? Humans are weak, plus, they have all those pesky instincts, like self-preservation and procreation… Evil government experiments must go beyond simple cloning… Imagine, for example, a human equivalent of a worker bee or a soldier ant; intelligent, but uninterested in entertainment, obedient to masters, but ferocious to perceived threats to its “hive” (whatever that may be), completely asexual (perhaps even void of reproductive organs), but capable of taking care of the young in the “hive”, free from dependencies and addictions by design, etc. Imagine every family being given a couple of those for free, with the government retaining the right to draft them into service in the event of war… Scary stuff, eh?