Abstract: X Growth, a mezzanine fund, is considering an investment in a waste-hauling company called Y. Y is planning an industry consolidation. X and Y are in the negotiation process. X can purchase 1,168,333 shares of Class A common stock representing 25% of the fully diluted shares of Y if X provides financing in the form of a senior note worth $5 million in absolute value payments.
Mezzanine Financing: Mezzanine investing involves financing companies using securities that are in the “middle” of VCs and bank lending. Most securities in mezzanine investing have features similar to convertible debt, preferred stock, and warrants. In terms of capital structure, Mezzanine debt is usually still “safer” than common stock but more risky than less expensive forms of financing (e.g., senior loans). From a return perspective, mezzanine debt allows small firms access to capital while providing the debt issuer with greater returns than straight debt and lower risk than straight equity.
Transaction Valuation: A DCF was conducted to arrive at the equity value of Y after the acquisition, and then a logical analysis was made to suggest that warrants should command a premium price for being more senior to equity in capital structure. In other words, warrants are less risky than equity investments and but are risker than debt, so it should be priced in between these ranges. As such, we feel that a $5.55 per share price is reasonable, given that our implied value per share is around $11.
In calculating a DCF, the following assumptions were made.
Discount Rate: a discount rate of 16% was used to discount the cash flows. Historically, mezzanine debt financing requires 12%-20% discount rates. 16% is at the average of this selection because Y is relatively risky in that 1) industry consolidation of incumbents is likely to drive smaller players out, 2) projected lower profit margins due to regulatory forces, and 3) risky current ratio of 0.94 for Y, which means the company already has more current liabilities than current assets.
Exit multiple of 5X EBIT: This is a conservative estimate based on the historical multiples that other financial buyers are willing to make in the PE space. Y itself was willing to buy companies at 4X EBIT and it makes sense that strategic buyers might buy Y for more than 5X EBIT but we wanted to err on the conservative side.
We also included an IRR analysis for the loan payments in order to determine that the current deal will yield an 18% IRR, which is a good return for mezzanine debt. From our analysis, most of the upside of the transaction is from the added warrants. Without the warrants, the IRR of the debt alone will be around 6%.
DCF Analysis
- Gugnir and Partners