Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally after venture capital companies and other senior lenders are paid. Mezzanine financing tends to be completed with little due diligence on the part of the lender and little or no collateral on the part of the borrower. It is treated as equity on a company’s balance sheet.
Mezzanine financing is defined as a financial instrument which is a mix of debt & equity finance. It is a debt capital that gives the lender the rights to convert to an ownership or equity interest in the company. Mezzanine finance is listed as an asset on company’s balance sheet. As it is treated as equity in a company’s balance sheet, it allows the company to access other traditional sources of finance. In the hierarchy of creditors, mezzanine finance is subordinate to senior debt but ranks higher than equity. The return on mezzanine finance is higher in relation to debt finance but lower than equity finance. It is also available quickly to the borrower with little or no collateral. The concept of mezzanine financing is just catching up in India. Mezzanine financing is used mainly for small and medium enterprises, infrastructure and real estate. ICICI Venture’s Mezzanine Fund was the first fund in India to focus on mezzanine finance opportunities.
Need for Mezzanine Finance
Mezzanine capital fills the gap between equity and senior debt in the capital structure of a company, which may arise due to:
Discounting inventories, fixed assets and accounts receivable at a higher rate than before, for fear of them not realizing their value a high proportion of intangible assets in a balance sheet ceilings on debt that can be raised from a bank.
To raise mezzanine finance, a company must have a credible track record in the industry, consistent profitability, and a feasible plan for expansion through an initial public offering (IPO) or acquisition. Thus, mezzanine finance is used by companies that have a positive cash flow.
Maturity and Redemption
Mezzanine debt usually has a maturity period of 5 years or more. However, if the mezzanine debt is issued at the same time as bank debt, the mezzanine debt matures after the bank debt. Furthermore, given the high RoR offered on mezzanine finance vis-à-vis traditional finance, issuers often prefer shorter maturities. Mandatory redemption/prepayment is required in the event of asset sales or a change in control transactions.
Rate of Return (RoR)
Mezzanine investors receive a rate of return (RoR) of 15%-20%, which is higher than the RoR offered on traditional forms of debt financing (such as high-yield bonds and bank loans). This is because mezzanine capital is not as liquid as traditional debt finance and is subordinate to all other debt held by the company. The return on mezzanine finance becomes available through five sources:
- Cash interest: periodic cash payments which are a function of the percentage of the outstanding balance of mezzanine financing. The interest rate can be a fixed rate or a floating rate linked to base rates (such as LIBOR, CRR etc.).
- Payable in kind interest (PIK): a periodic payment where the interest is not paid in cash but through an increase in the principal amount in tune with the interest payment. (e.g., a $1,000 million bond having 9% PIK interest rate will pay out $109 million at maturity but without any cash interest)
- Ownership: like a convertible bond, mezzanine finance offers lenders the right to a stake in equity (in the form of a warrant) or a conversion to ownership, in the case of default.
- Participation payout: the lender may take a percentage claim in the company’s performance (as measured by EBITDA, total sales or profits)
- Mezzanine lenders also charge an arrangement fee (to cover administrative costs) which is payable upfront upon closing the transaction.
The Pros and Cons of Mezzanine Finance
- The owner rarely loses outright control of the company or its direction. Provided the company continues to grow and prosper, its owners are unlikely to encounter any interference from the mezzanine lender.
- The method offers a lot of flexibility in shaping amortization schedules and the rules of the borrowing itself, not least specifying special conditions for repayment.
- Lenders willing to enter into the world of mezzanine financing tend to be long-term investors rather than people looking to make a quick killing.
- Mezzanine lenders can provide valuable strategic assistance.
- Mezzanine financing increases the value of stock held by existing shareholders although mezzanine equity will dilute the value of the stock.
- Most importantly, mezzanine financing provides business owners with the capital they need to acquire another business or expand into another production or market area.
- Mezzanine financing may involve loss of control over the business particularly if projections do not work out as envision or if the equity portion of the borrowing is high enough to give the mezzanine lender a larger share.
- Subordinated debt agreements may include restrictive covenants. Mezzanine lenders frequently insist on restrictive covenants; these may include requirements that the borrower is not to borrow more money, refinance senior debt from traditional loans, or create additional security interests in the company’s assets; covenants may also force the borrower to meet certain financial ratios — e.g., cash flow to equity.
- Similarly, business owners who agree to mezzanine financing may be forced to accept restrictions in how they spend their money in certain areas, such as compensation of important personnel (in such instances, a business owner may not be able to offer above-market packages to current or prospective employees). In some cases, business owners have even been asked to take pay cuts themselves and/or limit dividend payouts.
- Mezzanine financing is more expensive than traditional or senior debt arrangements.
- Arranging for mezzanine financing can be an arduous, lengthy process. Most mezzanine deals will take at least three months to arrange, and many will take twice that long to complete.
How Mezzanine Financing Works?
- Mezzanine debt gets its name because it blurs the lines between what constitutes debt and equity. It is the highest-risk form of debt, but it offers some of the highest returns — a typical rate is in the range of 12% to 20% per year.
- A mezzanine lender is generally brought into a buyout to displace some of the capital that would usually be invested by an equity investor.
- In a mezzanine financing arrangement, the borrower negotiates an arrangement with a lender wherein the necessary capital is secured by combining a loan with a stock purchase to the lender.
- “As a rule, you pay only interest on the money you borrow (at prime plus two to four points) for five years or so,” explained Hovey. “At that point, you [the business owner] cash out your investors by going public or by recapitalizing your business in a new round of financing. Your investors, meanwhile, have earned interest on their loans, and if the value of your business has increased, they realize capital gains by selling their stock in your company.”
- Lenders that review mezzanine financing requests closely examine several facets of the prospective borrower’s business when weighing the deal. The most important consideration examined by a mezzanine lender is the company’s capacity to generate cash flow. As Levine stated, “Because the primary concern of a subordinated lender is a company’s ability to generate cash, if it is anticipated that the business’ cash flow is sufficient to repay the loan, it is quite likely subordinated debt can be used.” In addition to cash flow, lenders also examine ownership flexibility, company history, growth strategy, and acquisition targets (when applicable). Business owners in need of capital, meanwhile, should do some comparison shopping of their own. “In selecting a source for mezzanine financing, companies should pay attention to personnel turnover, commitment to the business, track record, and flexibility in structuring,” indicated Perille. “Low turnover and commitment to the business are key because businesses rarely perform exactly according to plan. Therefore, you need an investor who understands the business and will respond consistently and appropriately.”
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