M ezzanine F inance

June, 2010
Cor ry Silbernagel, P. E ng., M B A
Davis V aitkunas

With amendments to Capital Structures section with

Prof Ian G iddy , NYU Stern School of Business

Copyright © 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved.

940 - 1040 West Georgia Street Vancouver, BC Canada V6E 4H1 T 604.687.2663 F 604.688.6527
www.bondcapital.ca
Mezzanine F inance
Mezzanine finance is used by companies that are cash flow positive to fund: further growth through expansion projects;
acquisitions; recapitalizations; and, management and leveraged buyouts. Mezzanine finance comes in many forms. The
common features of all mezzanine instruments and products are that they offer a risk/return profile that lies above that of debt
and below that of equity. Mezzanine finance is used to increase the financial leverage of transactions where the senior bank
has no appetite to lend further senior debt but there is still more financial capacity to support long-term borrowings.

When mezzanine debt is used in conjunction with senior debt it reduces the amount of equity required in the business. As
equity is the most expensive and dilutive form of capital, it is logical for a majority equity holder to want to create an anti-
dilutive capital structure at the lowest cost in order to both maximize return on equity and fund the business plan.

W hat Is M ezzanine Debt?

Mezzanine debt is mezzanine finance. It is debt financed capital generall\UHIHUULQJWRWKDWOD\HURIDEDODQFHVKHHW¶VOLDELOLWLHV
between a company's senior debt and equity, filling the gap between the two. Structurally, it is subordinate in priority of
payment and security to senior debt, but senior in rank to common stock or equity (Exhibit #1). In a broader sense, mezzanine
debt may take the form of convertible preferred debt, junior debt, subordinated debt, private "mezzanine" securities (debt with
warrants or preferred equity), second lien debt, and is sometimes referred to as quasi-equity.

MEZZANINE FILLS THE GAP BETWEEN SENIOR DEBT AND

EQUITY

MEZZANINE  FINANCE
SENIOR DEBT & ASSET BACKED
(STRETCH) LENDING

SENIOR SUBORDINATED DEBT

CONVERTIBLE SUBORDINATED DEBT Mezzanine

REDEEMABLE PREFERRED STOCK

EQUITY

Source: FitchRatings Exhibit 1

Mezzanine capital is typically used to fund corporate growth opportunities, such as an acquisition, new product line, and new
distribution channel or plant expansion; or for company owners to take money out of the company for other uses, or to enable
management to buyout company owners for succession or exit purposes. Although it makes up only a portion of a company's
total available capital, mezzanine financing is critical to growing companies and in succession planning.

The gap in funding between senior debt and equity is common for the following 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;

2. senior lenders are reluctant to lend using goodwill or intangible assets as collateral,

3. senior lenders may wish to limit their exposure to any one company or industry, and,

Copyright © 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved Mezzanine F inance 2
 4. the availability and cost of equity may be limited and prohibitively expensive or highly dilutive.

However, with a gap in place the source of funds available are insufficient to finance the project. This leads to a search for
complementary capital that can be priced for risk and in partnership with the equity and senior debt capital that is already in
place or available. Mezzanine debt is complementary capital.

MEZZANINE IS A HYBRID WITH RISK PROFILE

TARGETED BETWEEN THAT OF SENIOR DEBT AND

MEZZANINE  FINANCE
EQUITY

Marginal Cost of Capital

(% Percent)
Equity
Cost of Capital

Mezzanine

Senior

Leverage

Source: Bond Capital Exhibit 2

A true mezzanine provider will generally seek a risk profile between that of senior debt and equity at a risk adjusted price.
Mezzanine can often be thought of as borrowing equity, as senior banks will treat it as such, while the cost of mezzanine will
be less than equity because of the interest paid and security preference it takes ahead of equity. While additional liquidity can
be obtained from equity investors to provide funding to the company, equity is the most expensive source of capital.
Moreover, existing shareholder dilution must also be considered. New equity will change the voting distribution which could
result in an unwanted change in control or shareholder coalition. Dilution with mezzanine is limited as the majority of the
mezzanine return is garnered through recurring interest payments. Additionally, it is common for a company to hold the right
to repurchase any equity issued to a mezzanine investor through the use of puts and calls.

C apital Structures
There are QR KDUG DQG IDVW UXOHV IRU RSWLPL]LQJ D FRPSDQ\¶V FDpital structure. However, return on equity (ROE) should be
commensurate to risk. Unfortunately, risk is in a constant state of recalibration. This means a FRPSDQ\¶V FDSLWDO VWUXFWXUH
policy being the assortment of capital employed to achieve the ROE target must also be dynamic. The combination of senior
debt, mezzanine debt, and equity capital in the balance sheet determineV WKH FRPSDQ\¶V weighted average cost of capital
(WACC). The combination of senior debt and mezzanine debt determines the companies weighted average cost of debt
(WACD). Where WACD exceeds target ROE, capital structure policy would be 100% equity, subject to availability of the
entire equity requirement. Determining target ROE is the cornerstone to making logical business decisions. In order to achieve
the profit objective investment in projects and transactions only need to be considered wherein the carrying cost is less than the
internal rate of return expected from that investment.

Mezzanine financings can be completed through a variety of different structures. Normally, the specific objectives of the
transaction are usually a primary driver. Unfortunately, the capital structure policy strategy in place at the company is usually
a secondary driver. Notwithstanding, this is likely backwards, it occurs because equity is usually dear and often timing cannot
be controlled and most businesses do not have such a policy. As such, a businessperson will often be happy to agree to a

Copyright © 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved Mezzanine F inance 3
mezzanine rate because they need nothing less than 100% project financing. Furthermore, the ability of a mezzanine lender to
make flexible capital available quickly is often the sole reason for a company to choose this form of financing. The good news
is that often and inadvertently the decision to include mezzanine debt actually leads to a more efficient capital structure. This is
especially true when the target ROE was non-existent, misunderstood, or incorrectly stated in the first place. For example,
return on average equity for the largest company in the world at the time of this white paper update was reported at 22.65%.
With this illustration in mind as a form of target ROE a business smaller than the largest company in the world would logically
consider an ROE adjusted upwards for smaller business risk, if nothing else. Our experience has guided us towards 25%+ as a
reasonable target ROE. Moreover, given tKDWXSZDUGVWRRIDFRPSDQ\¶VGHEWZLOOXVXDOO\FRVWOHVVWKDQDQGthe cash
cost of mezzanine is usually towards 15% a good CFO will be able to show the owners that when considered on a weighted
average cost basis the incremental increase in the overall cost of debt is most often de minimis. This means that mezzanine in
addition to being a good project financing tool is also a strategic risk aversion tool in the form of safety capital whether
immediately drawn down or available as a facility on standby terms.

COMPANIES WITH EFFICIENT CAPITAL STRUCTURES EMPLOY

A NUMBER OF CAPITAL SOURCES

MEZZANINE  FINANCE
Expected
Typical Private Equity Structure Returns
(% of total Assets) (% cost)

Senior Debt and Asset Backed (Stretch) Lending

5% - 12%
30% - 60%

Mezzanine 13% - 25%

20% - 30%

Equity
25%+
20% - 30%

Source: Management Magazine, Bond Capital Exhibit 3

In Exhibit 3, mezzanine debt is shown adding an intermediate tranche of capital that enables a company to grow by creating
and funding a new capital layer between senior secured debt and equity. On the positive side: the owners face little dilution
and maintain their control of the business; the companies total cost of capital is reduced; and the mezzanine debt has a flexible
payment term that LVVWUXFWXUHGDV³VHOIOLTXLGDWLQJ´ZKHQ paid off over time. On the negative side this is a debt structure that
requires certain recurring interest payments and there is less free cash available for growth and shareholder distributions.

Remember the objective of a capital structure policy is to bring discipline and risk aversion to business investment. Every
company should be interested in, and able to determine and state its proforma profit objective. With a transparent return on
equity objective in hand the logic of business math can be quickly applied for decision support. Where an individual project or
opportunity will provide an internal rate of return (IRR) WKDWLVJUHDWHUWKDQWKHFRPSDQ\¶VWACD management should want to
proceed and vice versa. An interesting and sometimes dangerous aspect of IRR is that it can be amplified with leverage.

This brings us to the next question what is an appropriate WACD? Risk aversion should govern the leverage limit in
consideration for the macroeconomic environment at the time the decision is made. Experience has shown that a long term

Copyright © 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved Mezzanine F inance 4
sustainable target WACD can be bank prime plus 9%. However, for certain golden opportunities WACD could be managed
strategically higher for short periods of time. Then in times of risk aversion and austerity WACD should be managed lower for
periods of time. This is often best managed by increasing and reducing the total amount of working capital in the business.
Risk aversion should be about the budgetary sacrifices and ongoing discipline required to create equity. Then in turn the use of
that equity can be considered to form a leverage base or pay down debt or as shareholder dividends until a growth opportunity
emerges in accordance with the capital structure policy.

The table in Exhibit 4 outlines differences between capital sources:

CAPITAL SOURCES OFFER VARYING LEVELS OF

FLEXIBILITY

MEZZANINE  FINANCE
Senior Stretch Mezzanine Equity
Security Secured Partial Subordinated none

Ranking Senior First on Specific Assets Second Third

Covenants Tight Tight Flexible none

Term Demand Term Term / Patient Patient

Coupon Coupon - Floating Coupon - Fixed Coupon - Fixed Dividend

Amortization ~ 5 years or less Tied to asset life Flexible / Engineered Indefinite

Rate Prime Prime Adjusted Risk Adjusted Market Adjusted

Equity Kicker none Success Fee Warrants Shares

Prepayment
Yes Yes Fixed Period No
Penalties
Private Capital /
Capital Providers Bank Bank / secondary lender Private Capital
Capital Markets
Recovery % High medium Low Low
Right of Sale /
Liquidity High medium Low
Shotgun

Source: FitchRatings, Bond Capital Exhibit 4

Secure More Total C apital

Some closely held companies, particularly those that are family controlled, are reluctant to consider mezzanine financing
because it requires relinquishing a certain amount of ownership. However, a mezzanine investor's goal isn't to be a shareholder,
but rather to achieve a target return rate by some specified time. In fact, a typical mezzanine transaction has the mezzanine
fund as a minority equity holder, with buyout terms to payout the mezzanine fund at the appropriate time. It's also important
for a business owner to analyze the difference in value between an ownership interest in a stagnant or underperforming
business and an ownership interest in a growing company. What's more, having mezzanine debt in place actually can help a
company secure more total capital and avoid the cumbersome business pitfall of being under capitalized.

For example, a business owner approaches a bank to provide a $10 million senior debt facility for the purchase of a company
with a purchase price of $20 million. A conservative bank may discount the request and offer 75% of funding requested ($7.5
million) leaving the business owner to fund the balance of $12.5 million with equity. In this situation a mezzanine lender
might offer to fund $5 million in mezzanine and work with the business owner to secure more senior debt through its own
deeper rooted relationships. With a mezzanine componentWKHEDQNVHH¶VWKHPH]]DQLQHDVHTXLW\ and in certain cases as a
reputable risk reducing partner. As a result of a perceived change in risk profile the bank is willing to lend the original request
of $10 million. The total amount raised through external sources is now $15 million with the mezzanine layer compared with
$7.5 million without. Ultimately this reduces the equity requirement from the owner from $12.5 million to $5 million.

Banks often look more favorably on companies that are backed by institutional investors such as mezzanine lenders and may
extend more credit under more attractive terms. This is a result of the mezzanine lenders' reputation and the increased
involvement of the mezzanine lender with the company as compared to with a bank alone. Simply put, the risk to the banks
investment is reduced because of their knowledge that the mezzanine lender through a more active role (often with a board

Copyright © 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved Mezzanine F inance 5
seat) may enhance the success of the business. Additionally, mezzanine lenders are a source of reserve capital for a business
owner helping to GLYHUVLI\DFRPSDQ\¶VEDQNLQJUHODWLRQVKLSVthus reducing dependence on any one lender.

Lowering the Cost of Capital and Improving E quity Returns

In addition to securing more capital a mezzanine structure also allows a business to reduce its cost of capital, and boost both
return on equity and absolute profits. The following three cases illustrate a traditional all equity company (Case 1: Mature)
transitioning to a more efficient capital structure through a small recapitalization into a typical company with debt (Case 2:
Growing), and then recapitalizing again to a final optimized structure using a higher degree of leverage (Case 3: Event
Driven). The result of the transition from traditional lower growth or mature company into a more efficient capital structure
lowers WKHFRPSDQ\¶Vcost of capital, improves the return on equityDQGUHOHDVHVVLJQLILFDQWFDSLWDOWRDFRPSDQ\¶VH[LVWLQJ
owners for an event driven transaction as demonstrated in Exhibit 5.

OPTIMIZING CAPITAL STRUCTURES CAN SIGNIFICANTLY

IMPROVE RETURN ON EQUITY

MEZZANINE  FINANCE
Company Capital Structures
(% of Company Value) Bank  Debt
Mezzanine  (non-­‐bank  Debt)
Equity

50%
60%
Equity Capital
Replaced by
other sources 100%

20%
50%

20%

Case 3: Case 2: Case 1:

High Growth Typical Debt Debt Free
Weighted Average
11% 19% 35%
Cost of Capital

Return on Equity 40% 21% 12%

Source: Bond Capital Exhibit 5

Mezzanine T erms
Mezzanine investors include pension funds, hedge funds, leveraged public funds, business development companies, private
equity funds, and insurance companies, as well as banks that have established mezzanine departments (also known as
captives). Traditional mezzanine lenders are book-and-hold investors, generally focused on cash-flow lending, looking for a
minimum term (call protection) and equity participation to generate longer term results. Mezzanine lenders will also look at
the value of the enterprise as an investment consideration. Unlike traded equity, high-yield debt, and interest rates which
fluctuate with economic conditions, traditional mezzanine finance has been a fairly consistent and stable market.

Copyright © 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved Mezzanine F inance 6
The coupon rate on mezzanine notes and targeted returns of mezzanine investments have remained relatively constant as
shown in Exhibit 6.

TARGETED MEZZANINE RETURNS HAVE REMAINED

RELATIVELY CONSTANT AT ABOUT 20%1)

MEZZANINE  FINANCE
Mezzanine Targeted Returns
(Internal Rate of Return IRR %)

30% 35% 2008

2009
30% 2010
Internal  Rate  of  Return

25%
%  Occurrence
25%

20%
IRR  %

20%
15%

10%
15%
Low Median High 5%

10% 0%
<16% 16-­‐1 7.9% 18-­‐1 9.9% 20-­‐2 1.9% 22-­‐2 3.9% 24-­‐2 5.9%
06 07 08 09
IRR  %

Source: Fleet Securities Inc., PNC Mezzanine Capital, Bond Capital Exhibit 6

Typically, mezzanine lending includes both subordinated debt and an equity component. The debt is usually issued with a
cash pay interest rate of less than fourteen percent and a maturity ranging from four to seven years with the ability of the
borrower to buy out the debt earlier and repurchase any equity. The biggest benefit mezzanine debt provides is reducing the
amount of equity required in the transaction. As illustrated in Exhibit 6 mezzanine investors are looking for a risk adjusted
return (target 16% IRR) without dilution compared to an IRR of 22%+ with dilution for equity investors. In addition,
mezzanine is more cost effective in absolute terms because of a tax shield benefit from the tax deductibility of interest. The
basic forms used in most mezzanine financings are subordinated notes and preferred stock with warrants for private companies
and high yield debt (junk bonds) or convertible debt for public companies. Specialized mezzanine investment funds, look for a
certain rate of return which can be made up through a variety of securities (each individual security can be made up of any of
the following or a combination thereof) including:

x C ash interest ² a periodic payment of cash based on a percentage of the outstanding balance of the mezzanine
financing. The interest rate can be either fixed or floating and with or without a floor and or ceiling.
x PI K interest ² payable in kind interest is a periodic form of payment in which the interest payment is not paid in
cash but rather by capitalization of interest (increasing the principal amount by the amount of PIK interest).
x O wnership ² along with the typical interest payment associated with debt, mezzanine capital will often include an
equity stake in the form of warrants or a debt conversion feature, similar to that of a convertible bond.

Other sources can include royalty payments, bonus interest payments and other derivative like mechanisms. Mezzanine
lenders will also often charge an arrangement fee, payable upfront at the closing of the transaction and ongoing administration
fees to cover administrative costs, opportunity costs, management time, and as consideration for capital structure policy advice.

Copyright © 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved Mezzanine F inance 7
In structuring a mezzanine security, the company and lender work together to avoid burdening the borrower with the full
interest cost of such a loan. Because mezzanine lenders will seek a return range of 13% to 25%, this return must be achieved
through means other than simply cash interest payments. As a result, by using equity ownership and PIK interest, the
mezzanine lender effectively defers its compensation until the due date of the security or a corporate liquidity event

Exhibit 7 is an example of a mezzanine facility that is back end loaded, meaning that payments (interest, principal and equity)
are deferred until later in the facility term, and further demonstrates reward for delayed payment risk for the mezzanine
investor.

MEZZANINE RETURN CAN BE MADE UP OF SEVERAL

COMPONENTS

MEZZANINE  FINANCE
Example Simplified Mezzanine Facility Components and Return

($000's) Initial Year  1 Year  2 Year  3 Year  4 Year  5 Ending

Opening  Principal                          -­‐              10,000              10,300              10,609              10,927                  8,255                  5,503
Closing  Principal              10,000              10,300              10,609              10,927                  8,255                  5,503                          -­‐

Principal  Repayment                          -­‐                          -­‐                          -­‐                          -­‐                  3,000                  3,000                  5,503

Interest                  1,523                  1,568                  1,615                  1,439                  1,032                          -­‐
Less  PIK  Component                      (300)                      (309)                      (318)                      (328)                      (248)                          -­‐
Bonus  /  Equity  Participation                  2,500
Mezz  Cash  Flow          (10,000)                  1,223                  1,259                  1,297                  4,111                  3,784                  8,003

Faility  Assumptions
Loan  Size  ($000's)              10,000
Maturity  (Years)                                  5
Interest  Rate 15.0%
PIK  component 3.0%
Simple  Annual  IRR 16.5%

Source: Bond Capital Exhibit 7

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 or five. Mezzanine facilities are often customized or
³(QJLQHHUHG´WRPDWFKWKHFDVKIlow profile of each company by changing the timing and amounts of interest, PIK, principal
and equity portions of its return. Exhibit 8 depicts average debt multiples of leveraged companies and differentiates between
bank debt as a multiple of EBITDA, and non-bank debt (often mezzanine debt) as a multiple of EBITDA. For example, an
average US highly leveraged company with EBITDA of $10 million per year in 2004 would have had 3.2 time EBITDA or
$32 million in bank debt, with 1.0 times EBITDA or $10 million in non-bank debt. In general, smaller businesses (less than
$50 million EBITDA) and companies operating in more volatile industries may have reduced access to financing and thus the
leverage levels of these companies may be less than the averages shown. An experienced advisor is critical to successfully
reaching the upper end of the range. Exhibit 8 also depicts macro economic factors at work and ties the availability of capital
in general to the amount of growth and sentiment on growth in the economy at a given point in time.

Copyright © 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved Mezzanine F inance 8
 MEZZANINE DEBT IS OFTEN A SIGNIFICANT DRAFT
COMPONENT OF A COMPANY¶S CAPITAL STRUCTURE

MEZZANINE  FINANCE
US Average Debt Multiples of Highly Leveraged Loans
(multiple of EBITDA1))
Non-­‐Bank  Debt  /  EBITDA
Bank  Debt  /  EBITDA

1.1

1.7
2.3 2.1 1.8
1.9 1.7
1.2
1.0
1.2 0.8
1.4 1.7 1.3
1.5
5.1
4.0
3.3 3.5 3.6 3.5 3.3 3.6
2.9 3.2 3.0
2.2 2.4 2.3 2.5

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

1) EBITDA = Earnings before interest, taxes, depreciation and amortization

Source: S&P LCD, Bond Capital Exhibit 8

Mezzanine E xit
Most mezzanine investments are repaid through cash generated by the business, a change-of-control sale or recapitalization of
the company. Many mezzanine capital providers believe the IPO "home run" is a rarity. Furthermore, mezzanine investors
also hold the view that cash streams with a high quality of earnings are managed for pace of growth rather than to generate a
specific shorter term liquidity event. While some mezzanine providers may look to invest in companies that represent strong
IPO candidates, more frequently the mezzanine capital provider is looking for longer term capital deployment which receives a
return commensurate with the risk being taken. The useful incorporation of mezzanine debt into both strong and less strong
balance sheets results in a wide range of risk adjusted pricing. It also shows that a majority of companies are continually
seeking access to customizable capital. It is very common that mezzanine investors are bought out by the initial owner. Other
exits occur through recapitalizations, the accumulated profits generated by the business, initial public offerings, or an
acquisition of the company by a competitor, consolidator, or other control equity investor.

About Bond ± Bond Capital provides capital for growth, succession and equity withdrawal strategies to sm all and medium
sized enterprises. Bond Capital IRFXVHVRQPH]]DQLQHOHQGLQJIRUH[SDQVLRQ0 $0%2DQG/%2¶V .

Copyright © 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved.

940 - 1040 West Georgia Street Vancouver, BC Canada V6E 4H1 T 604.687.2663 F 604.688.6527
www.bondcapital.ca

Copyright © 2003-2010 Bond Capital Mezzanine Inc. - All rights reserved Mezzanine F inance 9