Mezzanine financing

Mezzanine financing generally takes the form of a medium-term subordinated loan and involves two parties: an investor (the lender) and a business (which takes out the loan under certain conditions). Mezzanine financing represents an alternative to traditional borrowing methods, and the borrowed capital may be structured as either equity capital or loan capital. In general, this form of financing is obtained for a term of 7 to 10 years. It is usually repaid in full at the end of the contractual period.

As it is becoming increasingly difficult to obtain credit from banks, which must comply with ever-stricter risk evaluation requirements, this form of fund-raising is attracting renewed interest in the business world.

It is particularly suited to businesses seeking a source of financing which:

  • bypasses traditional lenders such as banks;
  • does not give investors a right of inspection over how the business is managed;
  • allows for relative freedom in terms of the return on capital;
  • does not need to be repaid immediately.

Who is concerned

Mezzanine financing may be of particular interest to:

  • businesses that:
    • plan to form a company;
    • expect their borrowing requirements to increase in the near future (e.g. major investments);
    • already have high debt levels;
    • are having difficulty raising loan capital via the traditional channels, i.e. via banks.
  • investors who:
    • wish to acquire a stake in a company without taking on any responsibility for its management;
    • are prepared to hold a long-term stake in a business by investing their capital.

Prerequisites

Businesses planning to raise funds via mezzanine financing may seek assistance from a bank in order to establish contact with potential investors. Mezzanine capital is frequently provided by the following types of investor:

  • venture capital companies;
  • holding companies;
  • insurance companies;
  • private investors;
  • mezzanine investment funds.

Businesses with lower funding requirements may make use of crowdfunding, a sub-form of mezzanine financing.

In general, prior to contributing any funds, potential investors carry out an in-depth audit of the business either themselves or via a rating agency. In return for their investment, investors look for a share in the business' profits.

However, if the business fails to generate a profit, the lender does not receive any remuneration.

It is important to note that in general, if the borrowing business defaults, the invested capital will be lost. However, in most cases, this risk is offset by an appropriate share of the profits.

How to proceed

Mezzanine capital structured as equity capital

Where mezzanine capital is structured as equity capital, it is recognised as such in the balance sheet, thereby reducing the business' debt levels and improving its solvency. Mezzanine capital structured as equity capital may be raised:

  • by issuing profit-sharing certificates;
  • by issuing warrants;
  • through contributions of funds from sleeping partners.

Advantages for the borrower

By using an equity capital structure, the business' total debt does not increase and, as a result, its solvency is not adversely impacted.
The business does not have to grant lenders any right of inspection over its management.
This form of investment is generally perceived as a long-term commitment on the part of the investor and the business is not under pressure to produce immediate results.
As a general rule, lenders do not require guarantees in exchange for their contribution.

Disadvantages for the borrower

The in-depth audit of the business required by the mezzanine lender may incur considerable expense. Most of the time, this audit is carried out by external rating agencies.
The lender often charges higher interest rates so as to compensate for the greater risk.

Advantages for the investor

If the business thrives, the proportional share of the profits leads to significant returns.

Disadvantages for the investor

If the business defaults, the invested capital is treated as equity capital and is not protected, so to speak.
The investor is only entitled to a share in the business' profits. If the business does not generate sufficient profit, the investment will not provide a return.

Mezzanine capital structured as loan capital

Where mezzanine capital is structured as loan capital, i.e. as a debt, it must be recognised as such on the balance sheet.  If the business funded by the investor defaults, this type of mezzanine financing enjoys better protection. In this case, the mezzanine capital is considered to be unsecured third-party capital, enabling lenders to assert their rights vis-à-vis the general body of creditors. However, in terms of protection, it is subordinate to traditional third-party capital. Mezzanine financing structured as loan capital may be raised:

  • via a subordinated loan at a higher rate of interest;
  • by taking out a loan from shareholders (or partners).

Advantages for the borrower

As contributions structured as loan capital benefit from greater protection in the event of default, they generally require a lower rate of return.
The business does not have to grant lenders any right of inspection over its management.
This form of investment is generally perceived as a long-term commitment on the part of the investor and the business is not under pressure to produce immediate results.
As a general rule, lenders do not require guarantees in exchange for their contribution.

Disadvantages for the borrower

The funds are recognised as loan capital in the balance sheet and therefore increase the business' debt levels.
Treating the funds as a debt leads to a deterioration in the business' solvency.

Advantages for the investor

Greater capital protection in the event of default compared with financing structured as equity capital.
Returns are frequently higher than on other long-term capital investments.

Disadvantages for the investor

If the business defaults, the invested capital is not treated as equity capital, but it nevertheless is less protected than traditional loan capital due to the lack of guarantees.
The investor is only entitled to a share in the business' profits. If the business does not generate sufficient profit, the investment will not provide a return.

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