| David Carson presents the essential guide to Mezzanine finance. |
by David Carson
Mezzanine finance can be classified as medium term subordinated debt finance that carries a medium-to-high level of credit risk, for which a premium is payable by the borrower. The premium is usually payable in the form of an interest rate in excess of that appropriate for senior secured debt, an up-front fee and/or an element of equity participation. Mezzanine finance is becoming increasingly popular as it allows for more precise matching of specific lender and borrower requirements.
Traditionally debt finance has been secured over assets, supported by guarantees. More sophisticated financial markets and a greater number of profitable, cash generating, companies that require funding but lack sufficient underlying tangible assets, has contributed to the increasing demand for mezzanine finance.
The relatively low cost of raising new mezzanine finance in comparison to a new issue of equity and the comparatively short timeframe within which new mezzanine finance can be raised are perceived as favourable factors by borrowers. In addition, the repayment of mezzanine finance on attainment of the medium term objective is easier to facilitate than equity finance.
Debt versus mezzanine finance
Whilst mezzanine finance is more expensive than senior debt, a reduced level of security is usually accepted by the lender. In most instances mezzanine finance is subordinated debt, which ranks after senior debt but before equity in priority of repayment. Whereas mezzanine finance is expensive from a borrower’s perspective, a provider of mezzanine finance can expect to derive superior returns in comparison to senior debt to compensate for the higher level of risk.
Equity versus mezzanine finance
Equity finance is long-term risk capital that, inter alia, provides a degree of security to providers of debt finance and trade creditors. In normal circumstances, a company has no legal obligation to repay ordinary equity finance. Although ranking after trade and senior debt, a company is obliged to repay mezzanine finance.
A provider of mezzanine finance enjoys regular returns and cash flow in the form of interest, whereas equity finance may yield periodic returns in the form of dividends and capital gains on realisation of an equity investment.
Key funding criteria
A provider of mezzanine finance will usually appraise the company’s management, commercial sector, operating performance, cash flow prospects and the extent of equity capital invested in the company.
In evaluating the lending risk and appropriate required rate of return, a provider of mezzanine finance will consider it imperative that a borrowing company generates, or is reasonably capable of generating, sufficient cash flows to comfortably service and repay senior debt.
Typical structure variables
Mezzanine finance is considered to be attractive by both borrowers and lenders as it can be extensively tailored to individual transactions.
The structure of mezzanine finance is tailored to address: the nature, extent and timing of finance; repayment terms; deferral or staging of capital repayments and interest; up-front fees; termination premiums; extent and means of any equity participation; in addition to the legal rights that will be conferred on the provider of mezzanine finance.
Cost of finance
Borrowers often consider mezzanine finance to be expensive. However, the cost of each mezzanine finance structure should be considered in conjunction with the underlying terms and conditions attaching to the particular transaction.
Generally, provided the borrower is reasonably capable of generating the required cash flow, mezzanine finance at a rate of 3 per cent to 5 per cent above money market rates (i.e. EURIBOR) is currently available in the Irish market. Interest on mezzanine finance can be fixed or floating. In addition to the interest charge, a lender may require equity participation and / or an up-front fee. The extent of equity participation and up-front fee is usually dependent on the extent of unsecured risk assumed by the lender.
The cost of mezzanine finance should be considered in conjunction with the cost of senior debt currently available in the Irish market at a rate of 2.25 per cent to 2.75 per cent above EURIBOR.
Whilst mezzanine finance may appear expensive in comparison to traditional debt finance, the cost of raising new equity finance and the flexibility of its structures have contributed to the increasing demand.
Typical uses of mezzanine finance
Mezzanine finance is frequently used to fund acquisitions, strategic developments, management-buy-outs and management buy-ins. Through mezzanine finance, the extent and timing of projected cash flows arising from a particular project or transaction can be matched against the capital and interest repayment terms.
As mezzanine finance can be raised quickly and discreetly, it is often raised to fund short-term cash requirements of a medium term project. The borrower will often repay the mezzanine finance from the subsequent proceeds of new senior debt or a bond issue.
It frequently arises, particularly in the funding of new projects, that senior debt, mezzanine finance and equity finance are all required.
Providers of mezzanine finance
Providers of mezzanine finance include banks, venture capitalists, pension funds, insurance companies and institutional investors. The nature and extent of mezzanine finance to be provided by the various parties will vary according to their respective risk-return parameters.
Forms of mezzanine finance
Various forms of mezzanine finance exist. The nature of risk and return associated with each varies significantly. Some of the basic forms of mezzanine finance: Senior debt, with deferred debt repayments; Discounted bonds; Debt with redemption premium and / or an up-front fee; Subordinated debt, together with warrants / equity options; Convertible debt; Convertible preference shares; Preference shares.
Transaction structuring
For various reasons an investor may wish to initially structure a transaction as debt finance and thereafter in terms of conversion rights take up an appropriate equity stake. This may be particularly suitable if the investor does not wish to consolidate losses into its financial results. Furthermore, in the event an investor has available taxation losses it may be advantageous to structure the investment as debt and thereafter convert to equity.
David Carson is a director at Deloitte & Touche Corporate Finance. |
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| Article appeared in the December 2000 issue.
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