On first impression, this conclusion may seem surprising: How can giving up warrants increase IRR or reduce the risk of financial distress? The answer lies in the recently restored availability of cash flow senior debt for LBO's. In the past six months, the credit cycle has matured from recessionary tight money to looser money typically found in the "middle age" of a cycle. Debt service coverage levels and cash interest rates now set the limits on total debt, not artificially low total debt leverage multiples.

When senior lenders required sponsors to keep total leverage ratios at unusually low levels, debt service coverage ratios were automatically strong as a result. During this tight money period, senior lenders (especially cash flow senior lenders) often limited the ratio of total debt to EBITDA to 3.5x or lower. With such low leverage, the higher interest costs of all coupon subordinated debt deals did not limit total debt availability. And the absence of warrants left sponsors with greater flexibility to refinance. Therefore, all coupon structures worked particularly well for LBO's with plenty of free cash flow. Although sponsors still had to put up extra equity, a quick refinancing allowed many of them to cut interest costs and make dividend distributions, all with no equity dilution.

In today's improved credit market, the advantages and disadvantages of warrant versus no-warrant deals are reversing. With amazing swiftness, the limiting factor on total leverage in many deals has become the fixed charge coverage ratio, rather than the total debt to EBITDA ratio. "Cash interest rates matter again," said William Kosis, president and chief executive officer of PNC Business Credit, a unit of Pittsburgh's PNC Financial Services Group Inc. "Most recently, lenders have relaxed the total debt to EBITDA ratio as long as the borrowers have good fixed charge coverage," he said.

This change provides sponsors with compelling reasons to prefer warrant deals to all-coupon structures in many instances. Sponsors can get higher IRR's with more total debt at lower average interest rates. Lower cash coupons in warrant deals encourage cash flow senior lenders to advance a greater amount of low cost senior debt. Even asset based lenders can increase the size of their "air ball" term loans since amortization can be higher, lowering the average interest rate on the deal. Lower cash interest also leads to better debt service coverage ratios in warrant deals, which in turn enables senior lenders to allow more subordinated debt and higher total debt to EBITDA levels.

What Will It Take To Create A New Gold Standard for Subordinated Debt for Middle Market LBO's? Benefits That Sponsors Want: Senior lenders able to advance more proceeds at low senior rates; Senior lenders allowing an extra 0.25 to 0.50 turns of sub debt; Higher free cash flow, even with higher leverage; Lower risk of financial distress; Shared pain with junior lenders if the deal goes sideways.  The lower total interest rate avoids an equity trap where enterprise value grows a little, but equity value is destroyed by compounding high coupon debt.

Structural Elements to Deliver These Benefits: Lower cash coupon to improve debt service coverage; Lower total coupon to reflect market conditions; More pay in kind (PIK) interest to provide post-closing flexibility; Warrants to create alignment of interests between subordinated lenders and sponsors; Partnership approach with lenders and sponsors who work together on a series of deals over time.     Who is Well Positioned to Deliver These Benefits: Privately funded, sponsor driven subordinated debt lenders, especially those who use some leverage in their funding sources, are best suited to provide financing that meets these goals.  These firms have a cost structure that allows competitive pricing and a philosophy that makes them reliable partners.

"We can usually provide some additional senior debt and some relief on the total leverage covenant in transactions where the subordinated debt has a meaningfully lower cash pay rate," said Steve Robinson, a director of Antares Capital Corp., a Chicago-based provider of leveraged finance capital to equity sponsors and middle market companies.

More debt availability allows the sponsor to reduce the amount of equity required for the deal. Together, the lower blended interest rates and lower equity investments create higher IRR's.

As an example, take a typical LBO where expected post-closing performance is achieved and where a warrant structure allows senior and subordinated debt to be increased by 0.25 to 0.50 times EBITDA. The added leverage can improve the sponsor's IRR by 300 basis points or more. The improvement can be even more important if the target company's post closing results are somewhat disappointing. The lower total coupon in a warrant deal can be the difference between the sponsor achieving an adequate return on equity and virtually no profit at all.

Further, subordinated lenders who hold warrants have dramatically better alignment of economic interests with sponsors. Warrant holders care about growth and enterprise value. This alignment plays out everywhere from fewer documentation issues on intercreditor agreements to an improved sense of partnership at board meetings. Alignment of interests can be especially critical if a deal requires an amendment or waiver due to an acquisition or a performance bump. Lenders who hold warrants are likely to be more flexible and to make changes at a lower cost. Some all coupon subordinated lenders who get no tangible benefit from improved enterprise values have developed a reputation for high consent fees and big interest rate increases when changes are needed.

As an added benefit, lower cash interest costs increase financial flexibility and reduce the chances of financial distress. In good times, higher free cash flow can be used for capital expenditures, working capital or amortization of restrictive senior debt. In weak performance periods, the large cushion against fixed charges makes a liquidity crunch less likely.

Modestly leveraged, sponsor-driven mezzanine providers are best suited to provide sponsors with highly flexible subordinated debt structures with warrants. Such lenders specialize in underwriting enterprise value and have a track record of working well with equity investors and senior lenders. Partnership minded subordinated debt providers can provide flexibility for the companies, even in tough times, in return for a long term relationship with like-minded sponsors.

How Have All Coupon   Deals Evolved?     The Recent Past: 1999-2000          It was subordinated debt lenders, not borrowers, who first moved away from warrants.  In the late 1990s, many weak LBO's generated no warrant gains.  Therefore, many subordinated lenders started asking for higher coupons and offered to take fewer warrants in return.  Expected lender IRR's stayed level, but coupon levels rose from 12 or 13 percent to 16 percent or higher.   2000-2001           All coupon subordinated debt structures attracted sponsors because of the refinancing potential.  Higher cash and PIK coupons did not reduce total available leverage (which was set by senior lenders as a multiple of EBITDA, not free cash flow.)  Sponsors saw that these structures could allow low cost refinancings of high cost debt without permanent equity dilution if company performance improved (which it generally did) or if availability of senior debt improved, which in fact it did.                     Fast growing publicly traded mezzanine providers, like the Business Development Companies (BDCs), promoted all coupon structures and used low prepayment premiums as an additional tool to gain market share.  Since traditional mezzanine funds can only put money to work once before

returning it to investors, early prepayment is a big disadvantage for those funds.  Meanwhile, shareholders of publicly traded subordinated debt lenders focus almost exclusively on current yield, so capital gains from warrants and average duration of portfolio investments are less important.  The more flexible providers (especially those who could recycle investments that were repaid early) used low prepayment premiums to make it much harder for traditional funds to compete.          This was a major shift.  Private mezzanine providers typically speak with great pride about the superior protections that they get over holders of public high yield bonds.  Yet for the first time, prepayment protection became dramatically stronger for investors in public high yield bonds than for investors in private subordinated debt or for the public shareholders of the subordinated debt oriented BDC's!           Importantly, all-in costs of subordinated debt dropped from 19-21% to 15-18% for middle market deals.   The Present:          Lower cash coupon warrant deals seem to be regaining lost marketshare.  More sponsors are recognizing that all coupon subordinated debt transactions sometimes reduce total leverage available, lower potential sponsor IRR's and hurt  post-closing  flexibility.  Many sponsors and junior lenders are  returning  to  a  partnership

mentality.  Subordinated debt BDC's and other all coupon subordinated lenders are fighting to keep market share, but more and more sponsors are seeing the benefits of the lower cash coupons of subordinated debt with warrants.                                             The Future: Late 2004           The massive wave of prepayments of deals done in 2001, 2002 and early 2003 will probably convince even the most yield hungry publicly traded subordinated debt lenders (or their shareholders) that it is hard to replace good assets fast enough.  Without higher prepayment premiums and/or warrant gains, it will be hard for all coupon investors to earn enough dollars of profits from good deals to maintain their returns.   2005+            As the cycle matures, credit losses on subordinated debt investments will start to rise.  Some major subordinated debt lenders who have relied on all coupon structures might have serious performance problems from credit losses on a relatively small number of deals.  Their gains from the good deals-with no warrants and little prepayment protection-may not provide enough dollars of profit to offset the credit losses.  Sponsors may choose to avoid these lenders out of concerns over lender stability.