Mezzanine financing may be used both as a way of raising expansion capital for an enterprise or for financing the acquisition of an enterprise. As the name implies, in the financial mix of a firm, mezzanine financing is located between the “ground floor” of equity and the “first floor” of debt (e.g. mezzanine finance is a hybrid instrument containing features of both debt and equity). In this article we will take a look at some of the issues it involves.
1. What is mezzanine financing?
There is no single formula for this hybrid instrument: it could be preferred equity with a guaranteed level of dividend, convertible to straight equity at the option of the preferred equity holder, or some form of debt, also convertible into straight equity. The conversion option gives the owner of the mezzanine instrument a higher degree of security than if he were a straight equity holder (e.g. higher priority in the event of the liquidation of the firm and priority in payment of dividends or interest compared to straight equity holders), while allowing the investor access to the benefits that an equity holder has (e.g. conversion of debt or preferred shares into straight equity prior to a liquidity event). A mezzanine holder will typically rank subsequent to secured or even to unsecured debt holders, often holding the shares of the common shareholders as security.
A mezzanine financier will typically negotiate various put or call options in order to help ensure the liquidity of his holding, help acquire control in case the company dramatically underperforms and help ensure an eventual exit.
2. What kind of returns are typical for mezzanine financing in Central Europe today?
Given that the degree of risk for a mezzanine holder is lower than for the owner of plain equity, yet higher than for a holder of plain debt, it stands to reason that the rate of return is usually also somewhere between that of straight debt and equity. For example, if holders of straight equity in a particular venture would expect returns of 25% or more and holders of debt would expect 6-12%, then a holder of a mezzanine interest might expect a return in the range of 15-20%. The precise yield would depend obviously on the debt/equity mix and the degree of risk absorbed by the mezzanine holder (e.g. whether the preferred dividends, if any, are 5% or 10% of the value of the mezzanine instrument, the precise nature of the put or call options, the strike price at which the instrument might be convertible into straight equity and the overall leverage level).
3. Why is mezzanine financing so much more expensive than straight debt?
Mezzanine lenders typically do not have a registered security interest in the assets of a company. This means that, in the event of default, repayment of the mezzanine may commence after all senior obligations have been satisfied.
Another factor, and one of the difficulties faced by companies issuing mezzanine instruments, is the financial sophistication required in pricing the value of the embedded put or call options, or other aspects of the mezzanine financing, where the provider of mezzanine financing is typically much better equipped than the company making use of such financing.
4. When should the owner of a business consider mezzanine financing?
Mezzanine financing allows business owners to obtain financing or growth capital that permits higher leverage (e.g. an additional level of financing to straight debt), without burdening the company with extremely high debt service obligations (e.g. mezzanine holders may be paid by preferred dividends, payable only when the company is profitable). Such high leverage financing will either not require collateral against the company’s assets or, if so, the collateral will be subordinated to more senior debt holders.
Mezzanine financing may require less cash payment of interest or dividend than junk bond financing, as the mezzanine financier may rely on his equity conversion option to boost his overall return, thus conserving cash flow for the company.
Mezzanine financing might be more appropriate than straight debt where there is a considerable degree of volatility in expected cash flows (cheaper debt might be available if the company and lenders foresee steadily increasing cash flows).
5. When should the buyer of a business consider mezzanine financing?
Private equity funds, management buyouts and other types of acquisitions that like to use leverage are frequent users of mezzanine financing. Mezzanine financiers are typically comfortable piggy backing on the due diligence of a private equity purchaser on a business and allowing the private equity firm to take the driver’s seat in managing the acquired company, at least while the business plan is being met.
In conclusion, mezzanine financing is not for everyone. It requires considerable financial sophistication in order to correctly price returns. However, for the financially sophisticated, it opens up a new source of financing and is a creative way of allocating risks and returns between the different stakeholders of a company.