Mezzanine Finance

What is Mezzanine Finance?

Let’s move away from finance for a minute. Why is mezzanine finance called “mezzanine” finance? Mezzanine is basically used in reference to an intermittent floor sandwiched between two main floors of a building. It is neither exactly an extension of either of floors. Apply this concept to the source of funds and Bam! There you have “Mezzanine Finance”.

Mezzanine finance is fundamentally the bridge between equity and debt. While its structure and form are more inclined towards debt, it replicates equity in terms of performance and growth. Mezzanine finance sits between ownership funds and senior debt on the balance sheet. It is available on rates as high as 19% to 20% per annum while a conventional bank may only charge around 4%. However, borrowers find relief in the fact the stipulations governing the lending terms of a mezzanine finance are not very stringent. Moreover, it also does not lead to charge creation on the assets of the borrower.

The Mezzanine Effect

Consider an entrepreneur who has just started a venture with a total capital of $1,000,000.

Pre-Mezzanine Post Mezzanine
EBIT 3,00,000 3,00,000
Interest on Senior Debt @4.25% 21250 21250
Interest on Mezzanine Debt @ 20% 60000
EBT 2,78,750 2,18,750
Tax @ 35% 97562.5 76562.5
EAT 1,81,188 1,42,188
Earnings on Equity 36% 71%

In scenario 1, $500,000 are own funds and $500,000 are borrowed from bank at a rate of 4.25%.

In scenario 2, $500,000 is senior debt (as in the case above). However, $300,000 is borrowed as mezzanine debt @ 20% p.a and balance $200,000 are own funds.

Assuming an EBIT of $300,000 in the first year, watch how the numbers play out in both scenarios.

In Scenario 1, the take-home earnings for the entrepreneur is $181188 on an investment of $500,000. Thus, his ROI amounts to (181,188/500,000) 36%.

In Scenario 2, the take home in absolute terms has fallen standing at $142188. However, the investment on his part only amounted to $200,000. Therefore, his ROI drastically stands improved at (142,188 /200,000) 71%.

Advantages of Mezzanine Finance

To Borrower

Ease of Obtaining & Flexibility

Mezzanine finance is much easier to borrow than conventional loans. The mezzanine investors are often Venture Capitalists or Equity investors who share the entrepreneurial spirit of the borrower and are thus willing to take on some risk. Though very expensive, mezzanine finance can be sanctioned for 3x to 4x times to what a bank would do.
Another and most important benefit of a mezzanine investor on board is retention of ownership. Since the lender is charging hefty amounts of interest, he settles for little to no share in equity. This enables the management to function independently without any interference in strategic decision making.

Value Creation

Having a mezzanine investor on board is perceived as a positive signal by the shareholders. It validates and reinforces their conviction for the prospects of the company. Having a mezzanine investor is ideal for companies who are past their startup or inception phase and are now operating with steady cash flows. Companies in growth phase are more comfortable paying more (in terms of interest) for a new and potential project rather than diluting equity. Thus, the investor sense forthcoming projects or expansion plans in the pipeline with the onset of mezzanine finance. This consequently increases the share value.

Value is also created in terms of savings on operations. The interest rates, however high, are tax deductible and therefore save the company a considerable outflow of valuable cash. In the previously discussed example, the quoted interest rate was 20% and tax was collected at 35%. This renders the “effective” rate of interest to be (20-35%) 13%.

To Lender

Warrants

Mezzanine Finance is often structured to incorporate “kicks” for the lenders. Such kicks are nothing but warrants or convertible equity options the lenders can exercise and acquire a stake in the company. The options are exercisable at a specified date or in the event of a specific event occurring, subject to the agreement between the two parties. Such options compensate for the high risk taken on by the lenders. They can obtain a piece of the pie by converting their debt component into equity in case the company walks into windfall success.

Lucrative & Safe Investment

Mezzanine finance makes available the best of both worlds to the lender. He enjoys the benefits of an equity investment in form of high returns and a dynamic portfolio. In the case of a successful launch by the borrowing company, the lender can exercise equity option and partake in the enormous profits. On the other hand, the lender’s uncertainty component is also capped in the form of fixed interest rate payments. Even in the worst scenario, the lender receives at least, the interest. The interest earned by a mezzanine lender outperforms that earned by a conventional lender by a substantial amount. It is, therefore, a win-win situation for the lender.

Mezzanine Finance

Disadvantages of Mezzanine Finance

For Borrower

Backfire

As discussed, mezzanine finance is available rather easily but at very high rates of interest. This pro can quickly turn to a con in case the project does not take off. In such a scenario, not only will the borrower have to deal with the mess of a failed project but also be ready to pay off the incredibly expensive loan it had taken up in anticipation of success. Therefore, it will be a double whammy for the borrower leaving the borrower to fight an uphill battle.

Covenants

The loans are unsecured and subject to high risk. The lenders therefore often impose restrictive covenants to protect themselves. Some of them include equity warrants, restriction from borrowing additional debt and in some cases interference in management. The borrower jeopardizes ownership and independence by taking on mezzanine finance. Since there is always a chance of conversion to equity. Also, the value of the company may suffer greatly upon exercise of options. It leads to a dilution of EPS and generates negative sentiment among the shareholders.

For Lender

Long Gestation

Mezzanine finance is typically sought by companies in their growth or expansionary phase. The nature of investment is such that it cannot expect to generate returns immediately. Such projects have an incubation period and take a considerable time to finally start generating returns. Because of this, the mezzanine finance is not for investors wanting to make a quick kill or reap speedy profits. The lenders must have an appetite to stash away a sum and not expect anything a for a while. This is also the reason why several mezzanine finance agreements stipulate the commencement of interests after a period and not immediately.

High Risk

As if often the case, higher the upside equally deeper is the downside. So is the case of Mezzanine loans. Mezzanine finance is granted without any collateral and often the investment is made in high yielding but risky projects. The lender is always exposed to the odds of the venture tanking and losing his money. No extent of high interest may protect him from such an event. In case of a disastrous launch by the borrower, the company may go bankrupt. The lender shall then have to kiss both the principal and debt goodbye.

References

https://crowdfundup.com/blog/70/mezzanine-financing

CFA Curriculum L2

Last updated on : July 28th, 2018

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