This Article is written by Kahish Khattar, a 4th-year student at Amity Law School, Delhi. In this Article, he discusses the aspects related to mezzanine financing.

Introduction

Acquisition finance can be seen as a common trend in India and equity can be bought by purchasing an entity or through the way of mezzanine debt.

Mezzanine Financing is said to be a kind of hybrid security. It has the features of both equity and debt. A deal which involves mezzanine financing typically does include a number of structures which incorporate all kinds of debt, private placement transactions and equity investment. Compulsorily convertible instruments such as warrants, preference shares and debentures are now seen as a common trend for offshore mezzanine financing.

What is Mezzanine Financing?

Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in case of a default. It is paid after the senior lenders such as venture capital companies, private equity companies and others are paid.

It is usually listed as an asset on the company’s balance sheet. It is quickly available to the borrower without any collateral. A convenient loan without collateral only means one thing, a higher rate of interest. The rate of interest in relation to mezzanine financing can range anywhere from 12% – 20%. Typically, in India, it can range from 13-14%.

It is seen as a high risk, potentially high return kind of debt. It is said to have a tailor-made approach in mind. It is typically completed with not a lot of due diligence on the lender’s part and little or no collateral is needed from the borrower.

How does it work?

Mezzanine financing is a hybrid security, it can be said to be the highest risk form of debt. Highest risk means the highest rewards, that’s the reason why the lender gets a higher rate of return. Mezzanine finance lending is brought into the picture so as to reduce the capital being invested by equity investors.

A mezzanine finance lender is typically brought into the transaction to displace some capital that is usually paid by an equity firm. The borrower in this type of a transaction usually negotiates the terms with a lender where the capital required by the company is procured by mixing a loan and a stock purchase of the borrower company. The concept of mezzanine financing is typically used by MSMEs, infrastructure & real estate companies.

If we talk about a certain hierarchy, mezzanine financing can be seen as superior to equity and right below the senior debt. To raise mezzanine financing, the borrower company has to have a good track in the industry, a good amount of cash flow which shows profitability, and a well thought of expansion plan of the company through an initial public offering or through an acquisition.

The Rate of Return on Mezzanine financing (“RoR”)

So what exactly do mezzanine investors get in return for the monies invested? A good rate of return can range from 12-20%. This is way higher than RoR offered on all traditional forms of debt finance offered by banks.

How do they get it?

1. Interest in the form of cash: Periodic cash payments are the most common of the lot and are a function of the percentage of the remaining balance of mezzanine finance. The interest rate can be fixed or floating linked to the base rate.
2. Payable in kind interest: A periodic payment where the interest is not paid in cash but through an increase in wrt the interest payment. Payment at the time of redemption will be principal + redemption premium.
3. Ownership: Mezzanine financing offers a right to stake in equity, in the form of a warrant or conversion to ownership in case of default.
4. Participation payout: The mezzanine financing investor can always take a percentage claim in the company’s performance.
5. Fee: Mezzanine lenders can also charge a fee known as an arrangement fee to cover their administrative costs which have to be paid upfront.

Advantages of Mezzanine financing

1. Mezzanine financing is easy to procure and offers extreme flexibility.
2. No personal guarantees on the loan by the owner.
3. The borrower does not lose control of the company. Even though he may lose some amount of independence, the lender does not typically interfere in the day to day running of the business.
4. Mezzanine lenders are usually there for the long haul, instead of investors who are looking for a quick kill for their donors which gives the borrowers a sense of stability and security. The lenders are typically supportive of the management’s vision and plan for the business.
5. The said lenders usually bring a lot of valuable strategic advice to the business in terms of sophisticated and experienced insights that can open really new avenues for the business.

Disadvantages of Mezzanine financing

1. High-interest rates – Mezzanine financing is more expensive than traditional or other kinds of senior debt arrangements;
2. Restricts the borrower – Mezzanine financing usually involves the lenders to have restrictive covenants towards the borrowers. These covenants can range from borrower not being able to borrow more money, try to refinance senior debt; and
3. Loss of control – Mezzanine financing can involve a loss of control over the business if the projections do not work out as they were envisioned or the equity part of such a debt is high enough to give the mezzanine lender a bigger share of the pie.

Who all are involved in the raising process of a mezzanine debt?

To raise mezzanine debt, there are a few key people have to be involved in the process of mezzanine financing:

Investor: The money guy has to understand the business well before investing in it. He also has the responsibility to actually make the financing to be structured in a manner which helps the business to grow. This kind of responsibility would include looking at the investment size, the investment opportunity being a good fit for the business and the investor’s interest is aligned with that of the owners of the business. The typical list for  money guys would mainly include mezzanine funds and institutional investors; and

Consultants & Lawyers: These professionals are hired for their expertise on the various due diligence that is required before closing this transaction. The consultants look at the various financial statements of the company, figure out the specifics of the business they are in. Further, the consultants are made to look at alternate capital structures, advise on various financing structure and terms. The team of lawyers are hired to draft the specific clauses in this kind of an arrangement. They are expected to make it tight so that does not lead to an unnecessary dispute in the future.

How are they regulated?

Let us try to understand how they are regulated by the RBI. Subordinated debt is to be included as Tier II capital. As given in Annex 5 of the  Master Circular concerning  Prudential Norms on Capital Adequacy – Basel I Framework, terms of the issue of the bond to be eligible for inclusion in Tier-II Capital, terms of the issue of bonds should be in compliance with the various terms:

1. The amount of such a subordinated debt to be raised will be decided by the Board of Directors of the bank;
2. The maturity period of these instruments which is less than 5 years or with a remaining maturity of one year should not be included as Tier II capital. The subordinated debt with a remaining maturity of the instrument being more than four years and less than five years is discounted at 20%;
3. The bonds should have a minimum maturity of five years;
4. The rate of interest shall be decided by the Board of the Directors of Banks;
5. The subordinated debt instruments are not expected to have a ‘put’ option or a ‘step up’ option. Call option may be exercised after the instrument has run for at least five years;
6. The instruments should be fully paid-up, unsecured, subordinated to the claims of other creditors and free of any restrictive clauses; and
7. Subordinated debt instruments will be limited to 50 per cent of Tier-I Capital of the bank. These instruments, together with other components of Tier II capital, should not exceed 100% of Tier I capital.

Deal structure

The mezzanine financing can be achieved through a variety of deal structures which will be based on the specific objectives of what the lender and the borrower are trying to achieve. The most common forms used are subordinated notes and preferred stock. Mezzanine lenders generally look at an RoR from these sources:

1. Cash interest – A periodic payment of cash is based on a percentage of the outstanding balance. The interest rate can either be fixed or floating along with LIBOR or other base rates;
2. PIK interest – A payable in kind interest is not paid in cash but chooses to add to the principal amount of the security in the amount of the interest;
3. Ownership – Along with interest payments, the terms include an equity stake in the business or a conversion feature to achieve the same end; and
4. Participation payout – Instead of an equity stake, the lender may also take out an equity-like percentage from a company’s performance which is usually measured in total sales, EBITDA as a measure of cash flows or profits.

Lenders also take out an arrangement fee which is to be paid upfront at the closing of the transaction. This kind of fee mainly includes an administrative fee and an added incentive to complete the transaction.

Why do investors love to invest through mezzanine debt?

The following transactions are in typical need of mezzanine financing, the mezzanine debt can be seen as a stop-gap solution which will later be replaced by a more permanent solution:

1. Recapitalisations – This mainly involves raising of new capital to restructure the debt and equity in a company’s balance sheet. It is said to be an ideal use of this kind of financing where the owners are looking to gain partial liquidity are not willing to let go of the control of their business;
2. LBOs – Leveraged buyouts are mainly used by PE funds to maximize their borrowing limit at the time of purchase. LBOs, as they are commonly called, can be taken by companies to support their long term objectives for the company;
3. Management buyouts – Mezzanine finance is used by the management team of a company to typically buy out the owners and gain control of the business in the process;
4. Growth capital – This is used by companies to achieve organic growth. These events can include a significant capital expenditure or constructing a large group of facilities required by the business. Further, the capital by mezzanine can be used for diversification of the product or an introduction in a new market;
5. Acquisitions – Mezzanine financing can also be used to finance acquisitions where companies can acquire other businesses to help enhance offerings under their banner to their customers;
6. Shareholder buyouts – This can be typically used by a family run business who wants to repurchase the share of their company, it can be done through the help of mezzanine financing; and
7. Refinancings – Refinancing is commonly done to take advantage of the lower RoR or better terms being offered by mezzanine finance. Further, it can add flexibility to a company’s capital structure.

Mezzanine financing v. PE funding

1. PE funds are mainly looking for riskier investments and higher returns, mezzanine finance on the other hand look for sustained growth with a lower rate of return.
2. PE funds make sure to changes to the governance and controls of the company. However, mezzanine works on the principles laid by traditional bank loan covenants.
3. PE funds even give out funds to a business with negative cash flow but that is not the case with mezzanine finance which is preferred after the business has matured and shows signs of profitability.

Conclusion

The demand for corporate debts has risen quite a lot in the last few years. Corporate debt has become the go-to option for quite a lot of PE firms where promoters are preferring debt over equity for their companies. The simple reason for choosing debt over equity is the premium on equity, which is really high.

PE transactions give out a much higher rate of returns whereas mezzanine financing can generate lesser returns, they typically are on a  low-risk basis when it comes to debt. The mezzanine structure is increasingly being preferred in structured deals.

PE firms have set up their own individual debt funds or NBFCs to fill this particular void. Mezzanine finance is surely going to be used a lot in the coming years by the way of particular structured deals between companies and investors.