Mezzanine debt can be a lower-risk alternative to equity

Hotel & Motel Management, July 5, 2004 by James T. Merkel

Why does the mention of mezzanine debt cause a hotel owner-operator to pause?

While mezzanine debt is perceived as higher risk than equity, it can actually be lower risk for hotel owner-operators. Lower risk comes through, among other things, geographic diversification, increased management fees and control of major decisions regarding the hotel and its operations, when compared to having an equity partner.

Mezzanine debt is the portion of the capital structure that lies between the senior debt and the hotel owner-operator's cash investment. The leverage of such mezzanine debt tends to dictate its pricing more than classification as debt or equity.

* Increased cash flow: Mezzanine debt provides for retention of more ownership and consequently more upside. Over a 10-year hold period, the economics can be dramatically better than with an equity partner in terms of yield and in terms of aggregate dollars.

In a value-added transaction, the hotel owner-operator often can refinance the mezzanine debt with senior debt after five years, retaining 100 percent of the cash flow and upside in the remaining five years. However, in a traditional equity investment, the equity investor is your partner not only for the first five years, but also for the next five years even after you refinance.

Further, while equity partners might not require a current payment on their equity, they often require a preferred return on their investment that accrues over time and is senior to the hotel owner-operator's return of equity. Often, this preferred return accrues and compounds. So, while with mezzanine debt you pay now, with an equity investor you pay later, and often significantly more.

* Diversification: Increased cash flow generates additional cash to invest in additional projects. Mezzanine debt can lever the owner-operator's existing cash as well as this additional cash, and facilitate spreading it across multiple properties, resulting in less risk and more reward.

Through multiple transactions, a hotel owner-operator increases relationships with sellers, intermediaries, lenders, franchises and other vendors, further diversify and growing its platform for future opportunities.

* Control retention: Mezzanine debt provides leverage on the hotel owner-operator's equity, requiring less cash equity in the capitalization and often resulting in the hotel owner-operator's lack of need for any significant number of equity partners.

The lack of a significant equity partner means that the owner-operator retains control of the hotel, control of all major decisions including sale or refinancing of the hotel and control of the management contract.

Obviously, control by definition is stabilizing. However, many owner-operators do not consider a loss of control particularly destabilizing. A loss of management contracts at an inopportune time, when outside your control, can impact operations, human resources, corporate infrastructure and morale. Often, this leads to a tailspin that cannot be recovered.

* Tax benefits: Mezzanine debt can provide substantial tax benefits such as deductions for the additional interest expense. All tax benefits are retained by the owner-operator and often enables additional growth.

hmm@advanstar.com

James T. Merkel is managing director of Columbus-based RockBridge Capital LLC. He can be reached at (614) 246-2505.