Ordinarily, entrepreneurs turn to debt or equity funding to fund their business. Alex Canham, a partner at Herrington Carmichael LLP, explains the concept of a hybrid between the two - mezzanine finance.
Mezzanine finance is a sum lent or invested into a business on a junior basis that ranks in priority behind senior debt, but ahead of standard equity.
By virtue of being subordinated to senior debt, which in itself often secures the main banking facility, the returns reflecting the risk are likely to be higher, proving the old adage: “a greater return for greater risk”.
In the UK, mezzanine finance can be made available through several different structures based on the specific objectives of the transaction. Mezzanine lenders look for a certain rate of return. This can come from cash or “payment in kind” (PIK) interest, but also from an equity stake in the borrower.
As the mezzanine debt is subordinated behind the senior debt, the mezzanine lender will usually require a significantly higher rate of return on their advance. The higher rate of return acts as compensation for the increased risk of not being repaid on their advance.
Mezzanine lenders may seek returns in the region of 12-20pc, or even higher.
Mezzanine lenders may also seek what is known as an “equity kicker” from the borrower – for example, a mezzanine lender may have discretion as to whether or not the debt it is owed converts into an equity stake in the borrower. This provides the mezzanine lender with the ability to recover its advances and accruals through owning shares in the borrower.
Mezzanine finance could also take the form of preference shares (preferred equity), or a combination of pure debt and preferred equity. Considerations by a provider are based upon its own model, market forces or the position a borrower can actually offer. It may also be attractive to the provider, who is looking to maximise returns on investment, but it can have the impact of locking away an investment, so careful consideration should be given when looking at the rules surrounding it.
A debt/equity solution can be attractive when considering a senior funder’s financial covenant requirements. Rules surrounding equity would be set out in the constitution of a company and the articles of association and rules on interest payment and/or conversion to full equity would be governed by the mezzanine facility.
Dedicated mezzanine lenders would typically expect to see the mezzanine finance used for capital expansion and growth. For example, mezzanine finance may be used to finance the acquisition of a target company.
Other mezzanine lenders may view the use of the mezzanine funds as immaterial, so long as they obtain their required levels of return.
Why use mezzanine finance?
Mezzanine finance is appealing to borrowers for a number of reasons when compared with standard debt and equity financing. Notably, these benefits include:
• Mezzanine lenders do not typically seek to get involved with the management of the borrower.
• The borrower may have the benefit of flexible repayment mechanisms to the mezzanine lender.
• It represents a viable option for companies which have moved beyond start-up but are not yet in a position to finance further growth from their own funds.
• Typically, mezzanine lenders are also prepared to fund higher amounts of money than standard bank loans. Some mezzanine lenders have been known to lend three to four times the cash flow of a borrowing company.
• It usually comes at a lower cost in comparison with raising equity or selling shares to an investor.
Mezzanine finance is an attractive proposition to a borrower due to its flexibility. Whilst a borrower may naturally be concerned and put off by the rates of return – where the commercial terms and legal protections are sound, another old adage comes to mind – “with great risk, comes great reward”.