Often regarded as the CEO’s dilemma, debt or equity is the one indispensable question which has enthralled extensive discussions for centuries now. Keeping aside the for and against of this celebrated discussion of the financial world, what if we tell you about the road that exists between debt and equity? Yes, a hybrid fashion of financing! Encompassing the features of both debt and equity financing, mezzanine financing allows the lender to convert its loan into equity in case of default upon repayment of senior debt i.e. the debt that takes priority over other unsecured debts or otherwise more ‘junior’ debt owed by the issuer. Commonly used to finance large amounts that are intended to repay through profits earned in the due course of business, these loans are offered as cash with portions transforming into equity after an agreed time has elapsed. To put it in a nutshell, the companies are effectively using their own equity as loan security while cashing in on the interest payments!
A form of ‘junior capital’ sitting right in between of senior debt with less risk and equity with high risk, mezzanine financing is used by companies to achieve goals that require capital beyond what senior lenders will extend. This type of funding allows lenders to provide a potential for equity in addition to a subordinate loan, should the loan extend a certain period. Subordinate loan refers to that this loan will fall below other debts in the event of liquidation of the company. Ones with the first lien or first charge would be paid off before the owners of subrogated loans. Customarily, mezzanine finance lenders would be paid off after ‘senior debt’ holders, but before common equity holders.
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A funds’ crunch within a company or a business, significantly tampers with its stability ultimately proving to be detrimental to its growth. That’s where financing steps in. Every business and company at least once take a page from the book of financing to facilitate activities paramount to its growth (say acquisition or taking up new large capital projects under its sleeves) and stability ( say shareholder activities- dividend distribution, shareholder buyouts, etc). But what happens if the companies maximize their senior debt borrowing capacity or simply wish to preserve senior debt capacity and need additional capital? What if small new businesses are unable to raise funds through traditional methods?
Well, they usually have two-way outs; either raise outside equity or opt for mezzanine financing. The market gurus advocate mezzanine financing as their go-to choice. They believe mezzanine is by large the patient capital (final maturity up to 7-8 years) that allows companies to act in line with their long term strategies of pursuing growth and expansion. This element of “patience” affords a business time to process the growth event or shareholder activity as well as build senior capacity (via increased retained cash flow) to refinance the mezzanine capital over time
A typical mezzanine financing deal incorporates an interest rate ranging between 10% and 30%. Pretty high-interest rates, no? Well, this is primarily because equity is offered in lieu of cash. Though this seems fairly safe for the lender, in reality, it takes fairly long for the lender to translate into cash in case the worse occurs. Hence the high-interest rates. Lenders in a way try to cover themselves from the unexpected.
Even though some view mezzanine as an expensive debt despite the higher coupon payments (fixed rate of interest paid by bond issuers to holders) because of the higher interest rates it carries in comparison to the senior debts that the companies can obtain through their banks, thereby reflecting more risk than senior debt, it is still substantially less than equity in terms of the overall cost of capital. Moreover, it is less dilutive as compared to equity and allows the owners to maintain their controlling power.
While some argue that mezzanine financing creates its own impediments, in the form of slumping management control and increased debt, if the borrower defaults, there are others who favor because of the immediate access to capital and leverage along with tax concessions it provides and hence used widely. Mezzanine financing apart from for growth financing, shareholder financing/buyouts, and acquisitions, as discussed previously, is also used leveraged buyouts, management buyouts, recapitalization, and refinancing. For many businesses, the mezzanine is not viewed as permanent capital, but instead solution-oriented capital that serves a specific purpose, and can later be replaced with lower-cost capital, i.e. senior debt. Mezzanine financing is ultimately a way for companies to grow faster and also execute an ownership or management transition in a way that allows existing stakeholders to increase their ownership interest.
But are mezzanine financing loans safe? The answer to this question is one of the trickiest ones which can’t be stated in a concrete fashion. Owing to the markets that are constantly changing with the broader economic forces, no finance is completely safe. Often unsecured and bearing higher interest rates than senior debt, it may not be suitable for companies and businesses with not such high-risk appetite and deeper pockets.
To summarize, mezzanine financing is a supplementary role for a more traditional senior loan. The risk associated with a Mezzanine loan is higher, but if you are secured after performing a review of the loan and the investment opportunity, it can be a highly worthwhile investment.
This article has been written by Neha Haldia pursuing B.Com. Honours from Shri Ram College of Commerce.