On some transactions, mezzanine lenders play a crucial role to bridge the funding gap between equity and senior debt. Immediately post GFC, senior lenders became less inclined to allow payment of mezzanine debt or to permit restrictions on the senior lender's priority, viewing mezzanine debt as a form of equity with the corresponding risk and reward. However, the market for mezzanine debt has since evolved, and now, it is not uncommon for mezzanine lenders to push to retain some protections in relation to their outstanding debt and security.
What follows below are, from a senior lender's perspective, some of the more common concessions requested by a mezzanine lender.
Subordination deeds, priority deeds and intercreditor deeds
There is, at times, confusion regarding these three types of documents and it is not uncommon for these documents to be referred to interchangeably. However, each is distinctly different:
- Subordination deeds: set out the payment arrangements between two or more creditors, in respect of the order of payment of each creditor's debt. Subordination deeds can apply to both unsecured debt and secured debt where the security held by each creditor do not overlap.
- Priority deeds: deal with the situation where two or more creditors hold security over the same assets, and contractually determine which creditor's security has priority over the other. Priority deeds do not regulate payments to creditors prior to a default or enforcement of security, but rather, govern the enforcement process between the creditors after a default and how enforcement proceeds will be applied.
- Intercreditor deeds: are essentially a combination of both a subordination deed and a priority deed, and are used where two or more creditors wish to regulate both the payments from the borrower and the overlapping security held by each creditor.
A typical bargaining position adopted by a senior lender is that no payments to the mezzanine lender are allowed without the prior consent of the senior lender. Whilst this approach is still common, where the mezzanine lender is a genuine third party financier, senior lenders may agree on a permitted payment regime which allows certain payments to be made to a mezzanine lender. Typically, these payments will be limited to interest and upfront establishment fees and costs, and cannot be paid if certain conditions are triggered, such as:
- the occurrence of an event of default under the senior lender's finance documents;
- the senior lender has issued a stop notice in respect to payments;
- the borrower being overdue on any payments to the senior lender;
- breach of a financial covenant (either under the senior finance documents or a more onerous covenant set for the purposes of permitted payments);
- an insolvency event occurs in respect of an obligor; or
- a cap on interest payments to the mezzanine lender has been reached.
The scope of the above conditions are subject to negotiation between the parties, and may include detail such as whether a mezzanine lender can retain 'catch up' payments of interest where payments were stopped temporarily but then subsequently resumed. Depending on the type of transaction, permitted payments may not be appropriate during certain periods of the transaction, for example, during the construction phase of a development transaction.
Note that payments of any principal to the mezzanine lender are usually not permitted until the senior debt is fully repaid. Although, in some cases, if scheduled payments of principal have been agreed between the Borrower and the mezzanine lender, some senior lenders will allow those to be made provided there is no event of default under the terms of the senior finance arrangements (or subject to other conditions).
Restrictions on senior debt
Senior lenders may cringe at the thought of any restrictions on their debt imposed by a mezzanine lender. However, changes to senior debt (particularly the quantum that ranks ahead of a mezzanine lender) is a real risk to the mezzanine lender and the financial viability of the funding they provide. A mezzanine lender may request certain restrictions on senior debt such as:
- cap limits on the amount of priority senior debt that can rank ahead of the mezzanine debt;
- limits on the senior lender increasing the margin of its debt (other than by way of default interest) or fees payable;
- limits on amendments to amortisation of debt or deferral of interest or principal payments;
- limits on any extension to the maturity date of senior debt;
- restrictions on the senior lender taking additional security or guarantees;
- priority to reduce with any principal reductions; or
- restrictions on transfer or assignment of the senior debt.
These restrictions are more commonly seen in respect of highly structured or leveraged transactions, however, some elements, such as limits on increases to margins and fees, are being increasingly requested on more 'regular' transactions.
Enforcement rights and standstill periods
The right for a mezzanine lender to accelerate repayment of its debt or enforce its security is usually postponed under an intercreditor deed, even where an event of default has occurred and subsists under the mezzanine finance documents. The postponement of enforcement rights means that the mezzanine lender is left with no mechanism to act on a default unless the senior lender decides to take action.
To avoid being held in abeyance indefinitely, the mezzanine lender may seek to include a standstill arrangement in the intercreditor deed. Under such an arrangement, the mezzanine lender can notify the senior lender of its intention to accelerate its debt or take other enforcement action. Upon delivery of the notice, if the senior lender does not take enforcement action and the default subsists after expiry of a specified 'standstill period' (which may be a period of 90, 120, 150, or 180 days, or even a variable combination depending on the type of default), the mezzanine lender is entitled to take enforcement action.
Standstill arrangements essentially force the senior lender to act on borrower defaults, either by commencing enforcement action or by waiving the default (if it is within the power of the senior lender to waive that default). Consequently, the senior lender should seek the longest standstill period it can reasonably obtain, taking into account the identity and credit worthiness of the borrower or project, the type of industry and the available internal resources of the senior lender.
A mezzanine lender may seek the right to cure defaults under the senior debt to avoid acceleration of the senior debt, the charging of default interest, and enforcement of the senior lender's security, all of which are events which may jeopardise the full repayment of the mezzanine debt. Ordinarily, cure rights for a mezzanine lender are limited to payment defaults and financial covenant breaches, by way of injection of additional mezzanine debt (or perhaps equity).
For a senior lender, cure rights create a layer of additional risk, as the injection of more debt may not necessarily cure underlying financial problems of the borrower's business or project. Instead, adding further mezzanine debt may simply 'kick the can down the road' and postpone the senior lender's right to take action following a genuine 'first warning sign' default. If agreeing to cure rights, the senior lender should add certain restrictions to those rights, such as a maximum number of 'cures' per financial year, and that a cure can only be applied to one instance of the same default.
Buy out rights
The inclusion of a 'buy out' right for the mezzanine lender to purchase the senior debt at par is becoming increasingly common in intercreditor deeds. Prima facie, a buy out right seems like a win-win situation for all parties; with the senior lender able to exit the troubled transaction at par, and the mezzanine lender (who has a higher risk profile) being able to take charge of its own destiny on the deal.
However, a buy out right also means that the senior lender surrenders the economic upside of being in the transaction, and so the senior lender must negotiate to retain some discretion as to when it is willing to exit the deal. Usually, a subsisting default under the senior finance documents is the trigger for a mezzanine lender to exercise a buy out right. The timing for the subsisting default, the ability of the senior lender to give a waiver (and therefore veto the buy out right), and the calculation of buy out price, are all matters to be negotiated in a buy out clause.
The borrower should also be wary of buy out rights contained in intercreditor deeds. Depending on their relationship with the mezzanine lender, a buy out right may mean the borrower becomes beholden to the sole demands of the mezzanine lender (as opposed to a senior lender who may act more generously upon a default).
Negotiating with a mezzanine lender
When negotiating an intercreditor deed, senior lenders should keep in mind that in Australia, there is no 'market standard' or 'market principles' that dictate how a senior lender should negotiate the intercreditor deed. Ultimately, the bargaining position of the mezzanine lender, which will depend on numerous factors including their role in enabling the transaction and their connection with the borrower or sponsors, will steer negotiations and which concessions (if any) a senior lender will agree to. The final outcome is deal contingent, and consequently, engaging an experienced legal adviser is essential to ensure a suitable outcome is reached for the senior lender.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.