Mezzanine and Subordinated Debt

Mezzanine and Subordinated Debt
Mezzanine debt is a hybrid financing instrument occupying an intermediate position between senior debt and equity in a company's capital structure. The name comes from the architectural term “mezzanine” — an intermediate floor between the main floors of a building. Mezzanine combines characteristics of debt (fixed coupons) and equity (participation in upside through warrants).

Position in the Capital Structure
Typical capital structure with mezzanine

Layer	Share	Cost	Priority
Senior Secured Revolver	5-10%	SOFR + 300-400 bps	1st (super priority)
Senior Secured Term Loan	35-45%	SOFR + 400-550 bps	1st (pari passu)
Second Lien / Senior Subordinated	10-15%	SOFR + 700-900 bps	2nd lien
Mezzanine	10-15%	12-16% total return	Subordinated/unsecured
Equity	30-40%	20-25% IRR target	Residual

PIK (Payment-in-Kind) Mechanics
PIK Structure

PIK is a form of interest payment in which the interest is not paid in cash but is added to the principal debt amount (capitalized).

Coupon Structure	Description	Example
Cash Pay	100% interest in cash	12% cash
PIK	100% capitalization	14% PIK
Cash/PIK	Combination	8% cash + 6% PIK
PIK Toggle	Option for borrower to choose	12% cash or 13.5% PIK

PIK Toggle: Selection Mechanics
The borrower receives the right to choose the form of interest payment:

Why does the borrower need a PIK toggle?
Preserves cash during periods of stress
Why does the lender need it?
PIK rate is usually 100-150 bps higher than the cash rate
Limitations: Maximum PIK periods (usually 2-4 quarters), prior notification

Example of PIK Growth
Initial principal: $100M
PIK rate: 14%
Term: 5 years

Year 1: $100M × 1.14 = $114M
Year 2: $114M × 1.14 = $130M
Year 3: $130M × 1.14 = $148M
Year 4: $148M × 1.14 = $169M
Year 5: $169M × 1.14 = $193M
Total PIK accrual: $93M (93% of initial principal)

Equity Kickers and Warrants
Types of Equity Participation

Instrument	Description	Typical Terms
Detachable Warrants	Right to purchase shares at a fixed price	2-5% fully diluted equity, strike = current value
Co-investment Rights	Right to invest in equity on same terms	Pro-rata up to 10% facility size
Equity Co-invest	Direct investments in equity	5-15% of mezzanine amount
Exit Fee	Extra payment at redemption	1-3% of principal

Warrant Math
Example:
Mezzanine: $25M
Warrant coverage: 4% fully diluted
Entry EV: $250M
Exit EV: $400M (5 years, 2.0x MOIC)
Warrant strike: $1.00/share (at-the-money at entry)

Warrant value at exit:
Entry equity value: $100M (40% equity / $250M EV)
Exit equity value: $200M
Warrant claim: 4% × $200M = $8M
Less strike: 4% × $100M = $4M
Net warrant proceeds: $4M

Mezzanine Returns Decomposition
Components of Yield

Component	Contribution	Typical Range
Cash interest	Current yield	8-10%
PIK interest	Deferred yield	2-4%
OID amortization	Upfront fee	0.5-1%
Warrant/equity kicker	Upside participation	2-5% (scenario-dependent)
Fees	Amendment, waiver, prepayment	0.5-1%
Total target return		14-18% IRR

Scenario Analysis: Mezzanine Returns

Scenario	Cash	PIK	Equity Kicker	Total IRR
Base case	8%	4%	4%	16%
Upside	8%	4%	8%	20%
Downside (no equity value)	8%	4%	0%	12%
Impairment	6% (2y)	—	0%	-5% to 0%

Use Cases and Deal Examples
Typical situations for mezzanine:

LBO financing gap: When senior debt does not cover the acquisition price
Growth capital: Financing for expansion without dilution for founders
Dividend recapitalization: Dividend payout for the PE sponsor
Bridge financing: Temporary funding before IPO or sale
Management buyout: MBO with limited equity contribution

Example: LBO with Mezzanine
Acquisition:
Target EBITDA: $50M
Purchase multiple: 10x = $500M EV
Fees & expenses: $25M
Total uses: $525M
Sources:

Source	Amount	Multiple	Cost
Senior Term Loan	$200M	4.0x	SOFR + 500
Mezzanine	$75M	1.5x	12% cash + 3% PIK
Equity	$250M	5.0x	—
Total	$525M	10.5x

Risk-Return Profile vs Senior Debt
Comparison of Risk Profiles

Parameter	Senior Secured	Mezzanine
Yield	9-11%	14-18%
Security	First lien	Unsecured/2nd lien
Recovery in default	70-85%	30-50%
Equity cushion	45-55%	30-40%
Default probability	2-3%	4-6%
Expected loss	0.3-0.9%	2-4%
Covenants	Maintenance	Springing/Incurrence

Subordination Provisions
Mezzanine is subordinated to senior debt through:

Payment subordination: Mezzanine does not receive payments in case of senior default
Lien subordination: Senior has priority on collateral
Standstill provisions: Mezzanine cannot take enforcement actions (90-180 days)
Turnover provisions: Any mezzanine payments are transferred to senior until full repayment

Intercreditor Agreement (ICA)
Key Provisions

Payment waterfall: Order of cash flow distribution
Enforcement rights: Who may initiate enforcement
Amendment restrictions: Which changes to senior documents require mezzanine consent
Purchase option: Mezzanine’s right to acquire senior debt at par
Release of collateral: When and how collateral is released

Historical Returns on Mezzanine

Vintage	Gross IRR	Net IRR	TVPI	Comments
2012-2015	14-16%	11-13%	1.5x	Post-GFC recovery
2016-2019	12-14%	9-11%	1.4x	Spread compression
2020-2022	14-17%	11-14%	1.3-1.5x	COVID volatility
2023-2024	15-18%	12-15%	TBD	Higher rates environment

Recommendations for CIO

Equity cushion is critical: Minimum 30-35% equity beneath mezzanine
Sponsor quality: Top-tier sponsors are willing to protect mezzanine
Industry selection: Preference for defensive, low cyclicality
Warrant upside: Do not overestimate equity kickers — base case excludes them
Documentation review: Examine ICA and subordination provisions in detail
Manager experience: Workout capability is crucial for recoveries