What is Mezzanine finance?

Q. What do promising companies do when they have already exhausted standard bank finance and are already listed on the exchange, but still have some inadequacy of finance to fund their expansion or attractive acquisition venture in a very short period of time ?

Ans: Such companies need some quick money to adjust their cash flows and fill that important gap to pursue their growth strategies and goals. At such times, mezzanine finance comes in as a handy option. Let's take a look at this increasingly useful finance option, study its structure and understand its features from the lender's as well as the borrower's perspective.

Mezzanine finance has the characteristics of both debt and equity capital and is essentially a mix of both. This type of financing is usually availed by companies which have either expansion or restructuring plans and acquisition goals. It can be in the form of subordinated debt which is referred to as mezzanine debt or in the form of equity preferred shares referred to as mezzanine equity finance. Mezzanine finance is subordinate to senior debt and venture capital finance but has preference over equity stockholders. This means that if the company that has availed the finance, defaults or is liquidated, the mezzanine finance lenders will be paid only after senior debt lenders and venture capitalists charges are satisfied but will be treated superior to equity holders.

If the borrower fails to repay back the loan as per the schedule or in its entirety, the debt can be converted to equity and the lenders will then hold an equity interest in the company. Mezzanine finance therefore will be issued in the form of convertible debt with attached warrants that entitles the lenders to crystallize an equity interest (ownership interest) in the company if repayment terms are not adhered to. There is also a provision for the borrower to buyback this equity interest at a pre-specified price from the lender.

Why do borrowers seek Mezzanine finance?

Seekers of mezzanine finance are usually companies with an established reputation and having a sound track record. When the balance sheet of such fundamentally strong companies do not allow for any more traditional bank lending and which have already gone public, they look for mezzanine lenders for making good the shortfall in funding for a growth plan which primarily would have already been funded. To fill in this gap is very critical for the company to achieve its strategy. Also, the company would require these funds at a very short notice and generally, they would try to repay back these loans very quickly. This is why mezzanine financiers lend the funds without conducting much due diligence and in many cases even collateral would not be obtained. However, lenders have recourse by way of conversion of debt into equity ownership of the company in case borrower defaults. This right works as a substitute in lieu of collateral.

Also, when companies opt for mezzanine finance, it is treated as equity in accounting perspective. This provides room for availing more usual bank finance for the company. Another motivation for borrowers to seek mezzanine finance is to partner their risk with a financial institution.

What motivates institutions to lend mezzanine funds?

Mezzanine lenders provide finance only to companies that have strong cash flows, profitability and other fundamentals. The company should have a respectable track record and a robust reputation. Also, the finance is provided to companies which have expansion or acquisition (management/leveraged buyouts) plans which would help the company to generate more profit in future. The lending institutions have complete confidence in the company's ability to pursue profits which is why they do not demand collateral or very negligible collateral. Mezzanine lenders do have board observation rights.

Mezzanine lenders hunt for returns ranging between 20 to 30% as the loans are riskier than the usual bank loans. Usually the requirement of borrowers would be short term and temporary in nature. However, the tenure of mezzanine finance could range from 2 to 7 years i.e. it could be medium or long term. The lenders hedge the risk of default by structuring warrants in the loan. If loan is not repaid in time, the lenders can convert the debt into equity by invoking these warrants.

How is mezzanine finance different from a bridge loan?

Many a times, the term 'bridge loan' is used synonymously with 'Mezzanine Finance'. However, bridge loans are very short term in nature (usually 12 months). Sometimes, the borrower institution would have an immediate requirement of funds to meet its present liabilities and in situations like these; it would be difficult for the institution to arrange quick finance through its permanent sources. In such cases, bridge loan serves as an apt way out. The high risk associated with a bridge loan is compensated to the lender by way of high interest. Unlike in mezzanine finance, a bridge loan lender demands collateral to attenuate his risk position. As compared to bridge loan, mezzanine finance could be medium or long term in nature ranging anywhere between 2 to 7 years.

An example

When Tata-Jaguar deal was struck in 2008, Tata Motors availed bridge loan for financing of the acquisition. Unfortunately, due to the financial crisis of 2007-2009, the bridge loan had to be restructured. When the deal materialized, there was a lot of criticism by the business community regarding the success of the deal due to non-visibility of the synergies as well as due to encompassing recession which was expected to dampen the sales. However, the enormous success of this deal is now evident in the fact that Tata Motors derives its maximum profit from the JLR segment. This is a classic example of the usefulness of a bridge loan.

In normal investment and business parlance, bridge loans and mezzanine finance are considered identical as they serve the purpose of bridging the gap for achievement of an entity's financial objective.