Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally after venture capital companies and other senior lenders are paid. Mezzanine financing tends to be completed with little due diligence on the part of the lender and little or no collateral on the part of the borrower. It is treated as equity on a company’s balance sheet.
Mezzanine financing is defined as a financial instrument which is a mix of debt & equity finance. It is a debt capital that gives the lender the rights to convert to an ownership or equity interest in the company. Mezzanine finance is listed as an asset on company’s balance sheet. As it is treated as equity in a company’s balance sheet, it allows the company to access other traditional sources of finance. In the hierarchy of creditors, mezzanine finance is subordinate to senior debt but ranks higher than equity. The return on mezzanine finance is higher in relation to debt finance but lower than equity finance. It is also available quickly to the borrower with little or no collateral. The concept of mezzanine financing is just catching up in India. Mezzanine financing is used mainly for small and medium enterprises, infrastructure and real estate.
Need for Mezzanine Finance
Mezzanine capital fills the gap between equity and senior debt in the capital structure of a company, which may arise due to:
Discounting inventories, fixed assets and accounts receivable at a higher rate than before, for fear of them not realizing their value a high proportion of intangible assets in a balance sheet ceilings on debt that can be raised from a bank.
To raise mezzanine finance, a company must have a credible track record in the industry, consistent profitability, and a feasible plan for expansion through an initial public offering (IPO) or acquisition. Thus, mezzanine finance is used by companies that have a positive cash flow.
Maturity and Redemption
Mezzanine debt usually has a maturity period of 5 years or more. However, if the mezzanine debt is issued at the same time as bank debt, the mezzanine debt matures after the bank debt. Furthermore, given the high RoR offered on mezzanine finance vis-à-vis traditional finance, issuers often prefer shorter maturities. Mandatory redemption/prepayment is required in the event of asset sales or a change in control transactions.
Rate of Return (RoR)
Mezzanine investors receive a rate of return (RoR) of 15%-20%, which is higher than the RoR offered on traditional forms of debt financing (such as high-yield bonds and bank loans). This is because mezzanine capital is not as liquid as traditional debt finance and is subordinate to all other debt held by the company. The return on mezzanine finance becomes available through five sources:
How Mezzanine Financing Works?
Mezzanine debt gets its name because it blurs the lines between what constitutes debt and equity. It is the highest-risk form of debt, but it offers some of the highest returns — a typical rate is in the range of 12% to 20% per year.
A mezzanine lender is generally brought into a buyout to displace some of the capital that would usually be invested by an equity investor.
In a mezzanine financing arrangement, the borrower negotiates an arrangement with a lender wherein the necessary capital is secured by combining a loan with a stock purchase to the lender.
Lenders that review mezzanine financing requests closely examine several facets of the prospective borrower’s business when weighing the deal. The most important consideration examined by a mezzanine lender is the company’s capacity to generate cash flow, if it is anticipated that the business’ cash flow is sufficient to repay the loan, it is quite likely subordinated debt can be used. In addition to cash flow, lenders also examine ownership flexibility, company history, growth strategy, and acquisition targets (when applicable). Business owners in need of capital, meanwhile, should do some comparison shopping of their own. In selecting a source for mezzanine financing, companies should pay attention to personnel turnover, commitment to the business, track record, and flexibility in structuring.