Private credit series: intercreditor issues for mezzanine finance

Introduction

There has been a notable growth in private credit in the Middle East market over recent years across a broad spectrum of sectors. Mezzanine debt is just one of the principal instruments through which private credit providers deploy capital in this market. Mezzanine debt is a hybrid form of financing that sits between senior secured debt and equity in a borrower's capital structure. It is typically secured by second-ranking security and subordinated to the senior debt, meaning that, in an enforcement or insolvency scenario, mezzanine lenders are repaid only after senior creditors have been satisfied in full.

The intercreditor agreement is the principal document which governs the contractual relationship between the senior lenders and the mezzanine lenders, and their respective rights as regards to priority of right to payment from the borrower and their enforcement rights in a distressed situation.

In this series, we examine the typical position of mezzanine lenders under an intercreditor agreement and some of the key negotiating points, starting first with a look at the permitted payments regime. 

Permitted Payments 

All payments by the borrower to the mezzanine lenders, including scheduled principal and interest payments, prepayments and default interest and costs, are typically subject to conditions agreed with the senior lenders under the intercreditor agreement. 

Default Blockers

The occurrence of a senior event of default would typically trigger a prohibition on mezzanine payments meaning that a key point for negotiation under any intercreditor agreement is the scope of the senior events of default which will trigger this mezzanine payment blocker. 

Whilst the senior lenders would typically push for all senior events of default (including potential events of default) to block mezzanine payments, the mezzanine lender should consider limiting the default blocker to actual (rather than potential) events of default that arise due to financial difficulties, and ideally those which are in the borrower’s control, and exclude minor technical or administrative breaches that do not prejudice the borrower’s ability to service the senior debt. 

In practical terms, negotiations should be focussed on misrepresentation, breach of information and general undertakings, MAC, unlawfulness and invalidity and creditor’s processes below a particular threshold which the mezzanine lender may argue are not necessarily indicative of the financial health of the borrower and so should not automatically on their own trigger a mezzanine payment block.

The duration of the mezzanine payment block should also be considered: if mezzanine payments are blocked until such time as the relevant senior default is remedied or waived, this may result in an indefinite freeze on mezzanine payments without the senior lenders taking action; a preferable negotiated position for the mezzanine lenders would be that any mezzanine payment block is lifted after an agreed defined period of time (commonly 120 to 180 days) even if the senior default remains, with mezzanine payments resuming automatically unless the senior lenders have accelerated and commenced enforcement. 

A mezzanine lender may also argue that a subsequent mezzanine payment block should not be triggered by the same or a substantially similar event of default within a specified period following the expiry of a prior blockage, and where a default is capable of remedy, the mezzanine lender may push for the right (but not the obligation) to cure that default on the borrower's behalf, with any amounts advanced being added to the mezzanine debt.

The mezzanine lender should ensure that its catch-up rights, following the expiry of a default-blocker, are incorporated robustly into the intercreditor agreement so that it is able to recover deferred interest and other amounts that accrued but were not paid during a blockage period rather than such amounts being permanently extinguished. 

In particular, from the mezzanine lender’s perspective, relevant issues to be considered include: (a) should the deferred amounts themselves bear interest (at the mezzanine rate, or at a default rate) from the date on which they originally fell due until the date of actual payment in order to compensate the mezzanine lender for the time value of money? (b) pushing back on any additional conditions preventing catch-up payments such as a fresh financial ratio test, the senior lenders’ consent (notwithstanding that the senior default is no longer continuing), instalment payments (rather than a lump sum catch-up payment) or any caps on recoveries; (c) an option for accrued but unpaid interest during any blockage period to accrue as PIK with such amount being paid as cash-interest or continuing as capitalised principal upon the resumption of mezzanine payments at the mezzanine lender’s option; and (d) ensuring that its catch-up payments sit outside, and in priority to, any cash-sweep mechanism under the senior facilities.

In practice, the parties will often settle on a framework that balances these competing interests of the mezzanine lender with the priority status of the senior lenders taking into account the interaction with the standstill and enforcement mechanics under the intercreditor agreement. 

Financial Condition Tests

In addition to a senior event of default triggering a block on mezzanine payments, the senior lenders may sometimes require mezzanine cash-pay interest (and, if applicable, principal repayments) to be conditional on the satisfaction of additional financial covenant tests. 

Any such tests over and above the usual suite of senior events of default would materially erode the mezzanine lender’s position, potentially making the mezzanine debt more of a quasi-equity instrument, with the return dependent upon the borrower’s financial performance at the time of payment, rather than a subordinated debt instrument. 

In practice, a commonly negotiated position would be that scheduled cash-pay interest under the mezzanine facility is paid provided no senior event of default or acceleration event is continuing (but there is no additional financial ratio test) whilst voluntary prepayments of mezzanine principal are subject to a pro forma financial ratio test in order to protect the senior lenders against cash leakage through voluntary prepayments in circumstances where the borrower's leverage position does not support it.

Mandatory prepayments – disposal, insurance and compensation proceeds

The starting point in most intercreditor agreements is a sequential waterfall under which mandatory prepayment proceeds are applied first to prepay outstanding senior debt, and second, to the extent of any surplus after the senior debt has been prepaid in full, to prepay the mezzanine debt.

However, a key negotiating point sometimes raised by the mezzanine lenders is that mandatory prepayment proceeds should be shared pro rata between the senior and mezzanine lenders in proportion to their respective outstanding principal amounts or, if not shared pro rata, there is a modified sequential waterfall with a mezzanine participation right. Such mezzanine participation right might operate to reduce the senior debt to a specified leverage target, with any excess above that target shared pro rata or released to the mezzanine lenders. Alternatively, the mezzanine lenders may receive a fixed percentage (e.g., 20–25%) of net proceeds, with the balance applied to the senior debt.

Cash Sweep, Cash Trap and Payments Waterfall under the Senior Facilities Agreement

Although contained in the senior facilities agreement rather than the intercreditor agreement, the payments waterfall, cash sweep and cash trap mechanisms are fundamental structural features that have significant intercreditor implications for the mezzanine lenders. 

As regards the payments waterfall, in order to protect the mezzanine lenders’ position, the mezzanine cash-pay interest should be a fixed step in the waterfall, payable immediately after senior debt service and senior mandatory prepayments, and, if subordinated to any reserves (such as a debt service reserve), such reserve should be fixed under the senior facilities agreement for a specified and measurable amount. 

A cash trap typically only blocks distributions to equity and subordinated debt service leaving mezzanine cash-pay interest to continue to be payable provided the permitted payment conditions are met. 

However, the senior lenders may on particular financings require a cash-trap to operate above mezzanine payments in the cash waterfall, and if so, the trigger should be set at a level that is meaningfully below the senior financial covenant levels, so that the trap only activates in genuine distress scenarios and does not routinely interfere with the mezzanine lender's income stream. 

The cash trap should operate only by reference to leverage or debt service ratios, not by reference to subjective triggers (such as a material adverse change) or operational triggers (such as loss of a key contract) that may not reflect the group's actual cash-generating capacity.

Trapped cash should not immediately be applied to prepay the senior debt, but instead it should be held in reserve for an initial period (e.g. two consecutive testing periods) and, if the cash trap trigger has not been cured by the end of that period, the trapped cash is applied to prepay the senior debt. If the trigger is cured within the period, the cash should be released back into the waterfall meaning that it remains available to resume mezzanine payments once the trigger is restored.

As with mandatory prepayments, the mezzanine lenders should consider whether they should push for a pro rata share (in proportion to the respective outstanding balances of the senior and mezzanine debt) of the trapped cash towards prepayment or otherwise based on meeting a specified senior leverage test or fixed percentage.

In addition, the cash trap should release automatically and immediately upon the financial ratio being restored to the required level at the next testing date with no additional senior lender consent being required for the release, and such released cash should flow through the waterfall in the ordinary course, with the mezzanine lenders receiving their share (including any catch-up of deferred amounts, if the trap blocked mezzanine payments).

As regards the excess cash sweep, again, the mezzanine lenders may want to push for a right to participate in the excess cash sweep together with the senior debt on the same basis as referred to above for mandatory prepayments and the cash trap. 

The mezzanine lenders should receive copies of all waterfall calculations, cash trap trigger calculations, and excess cash flow sweep calculations at each testing date, with the right to audit such calculations and to challenge them within a specified period.

Any amendment to the payment waterfall mechanics, the cash trap trigger levels, or the excess cash flow sweep percentages should require the mezzanine lenders’ consent under the intercreditor agreement.