Elephant Bar Mezzanine Finance Case

Executive Summary
TEAM: Yuliya Matnenko, Pouya Yousef

The owner of Elephant Bar is seeking a loan from Allied investment group for the

purpose of expanding their restaurant chain. Elephant bar is bar restaurant business

headquartered out of Santa Barbara, CA. Their restaurant chain spreads from California to

Arizona. From 1997 to 2003, Elephant Bar opened 8 additional restaurants. Elephant Bar is now

looking to expand and will seek an additional funding of 20 million from Allied Investment

group to grow the chain.

Key Aspects of the Business

Elephant Bar is a high end casual dining restaurant that is known for their African

themed restaurants and elephant sized portions. Their target market is on the diners that look

to spend between $13-$17. Historical data shows that this segment of the market proves to be

the most profitable as chains such as Cheesecake factory have had large growth and revenues

within this category. Elephant Bars focused more on the lunch segment than other restaurants.

Elephant Bars average check was $14.55. Food costs comprised of 29% of total revenues. A

number that is perceived to be low given the small scale of which they purchase from different

vendors. Additionally, labor costs for Elephant Bar are among the highest at approx. 36%,

mainly due to expansion costs.

E.B. Objective
 Elephant Bar is seeking a loan of $20 million in an effort to expand their business model

into new states. Among the states that E.B. has targeted are Colorado, Texas, Kansas, and

Missouri. The total number of restaurants that E.B. will be adding will be 49 from September

2003-2008, totaling 72 restaurants. The addition of the new stores will allow E.B. to generate

enough revenue that the interest payments and principal of the loan will be paid in year 5.

Nature, Role and Structure of Mezzanine Financing

Start-up and Early Stage companies will often raise capital through angel investors and

venture capitalist. Once these investors have funded the early growth of a company, a company

may look to raise money through different avenues. Typically the Angel and VC will require

equity. Equity often times is a more expensive form of capital. Debt is more difficult to acquire

when no consistency or cash flows have been exhibited in past years, but when going concern is

less of an issue, debt is easier to obtain. Mezzanine financing was developed to provide

companies with a more flexible method for raising capital through debt and equity. It helps

facilitate the growth of a company considering expansion or acquisition. The typical Mezzanine

deal has two parts. The bulk of the financing come from the debt portion of the deal and the

smaller added bonus, equity. Because there is still considerable risk for the company and

therefore the provider of funds, lenders require an incentive or kicker beyond the interest of

the loan. These are the warrants issued. The warrants issued allow the lender to participate in

the success of the financed company. With the addition of these equity derived investments,

the lender is now able to achieve higher returns for successful investments and likewise

possibly lower the debt burden placed on the borrowing company.

Specific Terms of Elephant Bar Proposal

Elephant Bar is looking raise $20,000,000 for the expansion of the restaurants. SKM

suggests that Elephant Bar structures a deal that allows them to draw money at different times

considering their investments occurs in different years. Therefore, the Mezzanine financing is

structured over 5 years. The initial draw can be no less than 5 million dollars. Subsequent

draws can be no less that 2.5 million dollars. The terms of the loan require 13% interest and 2%

PIK (paid in kind). The interest of 13% will be paid in its respected year, while, the PIK interest

will be added to the balance of the loan throughout the term of the loan annually. The loan will

also require equity distribution of 2.5% issued after drawing $5 million. There is no amortization

of this loan, the entire balance will be due in 5 years. Prepayment penalties will be 4% year 1,

2% in year, and 1% in Year 3. The fee’s will be 2.5% (1% commitment dee and 1.5% drawdown

fee).

Managers & Sponsors

SKM is the majority stakeholder in Elephant Bar and invested $15.5 million in E.B. in

2000. Currently, SKM holds 53.8% of the Elephant Bar. SKM has made other investments in

restaurant related companies. SKM supports Elephant Bars plan for expansion.

Chris Nancarrow is the CEO of elephant bar. Nancarrow owns 25% of the company while

other management owns 14.8% of the company.

Deal Risks

A major risk concern for this deal is centered around the business model being effective

in different states. While the business model has shown to be effective in the western region,
different states and subcultures may provide different results. The African style theme may be

more effective in a diverse cultural geographical setting such as California, however, the lack of

diversity in other states may provide for additional risk.

Additionally, the deal carries risks from a damaging public relations incident that

purportedly involved Hepatitis A at the Elephant Bar’s Arden Restaurant. This incident could

affect potential future revenues.

The risk of the loan repayment is also a concern for Elephant Bar and Allied Capital.

Allied Capital will have a claims priority with regard to new stores, but as a Private Equity

mezzanine financing company a primary risk is the risk of default. The principal payment is due

in year five of $22,027,000. It is possible that E.B. will have difficulty paying $22,027,000 at the

end of year five. Most likely they would need to either raise additional funds with a large bank

to pay Allied Capital the entire principle, thereby refinancing the loan, use cash on hand, or

raise capital through an issuance of stock which would be dilutive.

Estimate of Expected Credit Metrics

CAPM 0.1309
WACC using yr ending 2002 0.1278
WACC using current rate for borrowing 0.1294

We used the WACC to discount the cash flows to realize NPV for EB over the 5 year run.

Analysis of Expected Returns/Conclusion

Allied would possibly accept the project if IRR is greater than 18% and the ratio of total

cash received to total cash received is between 1.5 to 2x. However, given the type of business
Elephant Bar is in, we believe a higher risk premium is required when looking at the prospects

of growth outside of California, where the demographics can be far different. Further, the

expected IRR from the Base Case shows that the Elephant Bar would only satisfy 1 of the 2

conditions for the loan, as IRR<18%.