Subordinated debt, or “sub debt,” has all the characteristics of other debt instruments, but is structured junior in priority of payment and its claim on collateral to senior debt. Due to its subordinate position, sub debt presents a greater risk profile to the lender; and thus, warrants a higher rate of return. The total internal rate of return, or IRR, that a sub-debt/mezzanine investor would seek in an investment in a privately held lower to middle market company ranges from the low-teens to the mid-20s. Today, subordinated debt for a middle market company typically has an interest rate of between 12 and 14 percent, payable on a current basis. It is this current-pay aspect of the facility that makes it generally unavailable to early-stage companies that are typically cash constrained, preferring to use cash in their business rather than to service debt. The sub debt would typically have a maturity ranging from 4 to 7 years, call for modest amortization over its term, and have a large balloon payment at maturity. The remainder of the expected return over and above the interest rate charged on the sub debt must come from the equity-linked aspect of the investment, most often in the form of warrants.
The warrant position that accompanies the subordinated debt is known as the “equity kicker” and is structured to provide another 10 to 12 percent of IRR to the investor. Unlike the debt component, this portion of the total return to investors does not come in the form of periodic payments of interest, but through the projected increase in the equity value of a company. The company is valued at the inception of the transaction and the warrants carry a price based upon this initial valuation. It is important to note that the intent of the equity kicker is to enable the mezzanine investor to achieve its targeted return on the investment, not to take an ownership position in the company. The equity-related portion of the investment is realized by the investor selling the warrants upon an “exit event” to the company at some agreed upon date based upon a formula established at the initial closing of the deal. Some typical exit events are a sale, change in control of the company or a recapitalization.
A mezzanine investment is typically made in a company that is facing some sort of growth opportunity, e.g., the acquisition of another company, the acquisition of the company itself by new management, the establishment of a new product line or distribution channel or merely internal growth. This growth opportunity is expected to create top line revenue growth; bottom line growth in earnings, and most importantly, increased cash flow; which ultimately, increases the value of the company. The resulting increase in equity value translates into an increase in value of the warrants.