Autor: Administrador Vinca Capital

What is Mezzanine debt?

Mezzanine debt is a hybrid financing instrument, that is, it has the characteristics of a loan (fixed term, interest, and guarantees), and capital (subordinated to bank financing, and the possibility of have property rights and participation in profits). Some examples of mezzanine debt are: senior subordinated debt, and debt convertible into shares.

Mezzanine debt incorporates a series of clauses that allow debt to be exchanged for capital through options. Generally, this type of debt is presented in the form of a bond with a defined interest and maturity to which is added some form of leveraged or bonus share. This type of leveraged or bonus action can be options, warrants or any type of financial asset with the same characteristics. In practice, mezzanine debt behaves more like equity than debt, because the built-in options make converting debt into equity very attractive.

Mezzanine debt is frequently associated with acquisitions and buyouts, for which it can be used to prioritize new owners over existing owners in the event of bankruptcy.

In the order of priority, it is above the Senior debt, and below the Capital, that is, in case of bankruptcy the company will repay the Mezzanine debt with the available resources (if any) after repaying the Senior debt. However, this carries higher returns compared to other types of debt, as it often receives rates between 12% and 20% per year.

What role does mezzanine debt play in corporate operations?

It is common for Venture Capital funds to use Mezzanine debt to complete the financing needs in Leverage Buy Out operations.

For example, a Venture Capital firm wants to acquire a company with debt worth 100 million euros, and obtains a loan that covers 75% of the operation. The Venture Capital firm does not want to put up the remaining 25 million euros of its own capital, so it seeks to finance itself through Mezzanine debt amounting to 15 million euros. In this way, the firm only has to invest 10 million euros of its own capital to be able to carry out the 100 million euro operation. The investor will have the possibility of converting the debt into equity if the previously established requirements are met. If the investment is unsuccessful, the investor will remain as a creditor of the company, and if, on the contrary, it is successful, he will be able to exercise the option and receive shares in the company.

Mezzanine Debt Advantages and Disadvantages

The main advantage for the investor is the possibility of obtaining shares of a company in exchange for the borrowed debt. On the other hand, the current shareholders will lose control within the company when the determined requirements are met, and therefore they will sacrifice potential growth performance.
One of the key aspects to be taken into account by both parties is the interest generated by the Mezzanine debt, which is higher than the senior debt since it has a higher risk.
In this sense, if the company in question goes bankrupt, the lenders of the Senior debt will be paid first, so if there are no more assets remaining after repaying the senior debt, the Mezzanine debt will not be repaid.

Finally, Mezzanine debt investors take the same risks as shareholders, but receive a recurring benefit in the form of interest, while shareholders are not guaranteed the benefit through dividends.

In short, Mezzanine debt is a widely used instrument to complete the debt portion of leveraged corporate transactions. The Venture Capital firm will allow you to undertake the acquisition without having to put up all the necessary capital, and the lender will obtain higher interest rates than those of a Senior debt, having the possibility of converting the debt into company shares.

Carlos Navarro, analyst at Vinca Capital.

During the early days of the coronavirus pandemic, the focus for forecasters was not so much whether the economy would recover, but how which way would you do it.

The most optimistic analysts expected a «V» shaped recovery, while others foresaw a «swoosh» shaped recovery with a slower.

Those who believed that the pain was here to stay believed that a long «U» was most likely, and the more bearish were betting long-term bearish trends as of “L”. However, what appears to have occurred is none of the above, but rather a “K” shaped recovery, in which some traditional sectors are in a structural downtrend, as well as consequence of Covid-19 or for any specific reason of the Company.

The sectors that recover most quickly are technology, pharmaceuticals, online commerce, agriculture and food (which have been essential activities and very resilient to crises). On the other hand, the sectors that will take longer to recover are those related to tourism, travel, hotels, restaurants, small businesses, etc. The real estate sector will also be affected as the trend to work from home will reduce the demand for office space in cities. 25% of shops and bars are going to close their doors permanently, so many commercial premises will be empty. Likewise, the demand for residences with gardens and terraces on the outskirts of cities will increase, while the value of real estate in the center of cities will depreciate as it is less attractive as a habitual residence and as international tourism is reduced.

For some, the pandemic may have been a great opportunity to power the transformation of the world economy, precipitating the disruptive transformations that were unfolding. They see the pandemic as a catalyst that has accelerated in 5 or 6 years the technological changes that the economy needed, attracting the strong investments that are necessary and in a scenario of abundant cheap money. We have this money because of the action of the Central Banks, which have injected huge amounts of money at a cost close to zero and because of the financial facilities that the Governments have offered to companies and individuals.

Last week Fed Chairman Jerome Powell announced his intention to maintain zero rates, also reiterating the strategy of linking zero rates to the goals of maximizing employment and allowing inflation higher than 2% in order to compensate for periods of low inflation such as those of recent years. Investors took Powell’s message as an anticipation of more stimulus, so the message was more powerful than any new tool Powell might have announced.

In some cases things have changed drastically and some companies are realizing that it is not going to be like before. Some examples of areas that are changing drastically: use and demand for Cloud services, growth of telemedicine reserving the physical visit to the doctor for diagnosis and operations, streaming entertainment instead of going to the cinema or theater, etc.

It is time to reflect on how the environment has changed and adapt our strategy to be able to take advantage of the opportunities and even more, to avoid succumbing to the changes that lie ahead. As Bill Gates says, «We always overestimate the changes that will happen in the next two years, but we underestimate the changes that will come in the next 10 years.»

Carlos Navarro Enguídanos, analyst at Vinca Capital Corporate Finance

Javier Navarro, managing partner of Vinca Capital Corporate Finance, is the guest in the new installment that this newspaper launched two months ago, in order to to find out how Valencian financiers have lived through the state of alarm.

Navarro kindly answered the call from Valencia Plaza to address other aspects such as the performance of the financial markets, the economic recovery and his vision of the so-called ‘new normality’. Here is the talk:

-How have you been during these months of confinement?
We have experienced an unusual and complex situation. At first you go into shock, trying to understand the problem; then we go to a phase of adaptation to the limitation of movements; and for a few weeks we have been in the reconstruction phase, as we recover freedoms.

-And how have you organized yourself to continue at the foot of the canyon?
-Following very specific guidelines for schedules, food, sports… A little daily self-discipline that has allowed us, despite being confined, to clearly differentiate working time from spending time with family and leisure.

-How has Vinca Capital responded to the health crisis?
-We have tried to keep in continuous contact with our customers and partners. Fortunately, today, new technologies allow teleworking and undertaking most tasks in the financial area. In addition, we have taken the opportunity to become part of the team, taking an online course at ESADE on Agile Business, which has allowed us to review our strategic commitment.

-Have you received many calls during this time, especially after the first weeks with the market crashes?
-In general, customers have understood the situation and have remained calm. We have issued several analyzes with our opinion on the market situation, which in addition to communicating it to our clients, we have made them public and shared on our website and on social networks.

-What recommendations have you given them?
-The measures adopted have been varied: we have increased liquidity a little, we have increased exposure to sectors with little exposure to covid-19, such as the technology sector and the pharmaceutical sector; We have sold futures on the Ibex to partially cover the portfolios. At no time have we made crazy sales, because we trust the quality of our analysis system. We have also taken advantage of some opportunities, for example, we doubled our bet on MásMóvil a couple of weeks before the takeover bid for KKR, Providence and Cinven was announced. We have also modified the prospectus of the investment fund Fundamental Approach Spain to make it international.

-Where are the declines in the stock market going to stop after the measures adopted by the big central banks?
-The declines have already stopped weeks ago. In the case of the S&P 500 we have experienced the fastest decline in history, followed by the fastest recovery. It is the first time since the crash of 29 that 85% of the drop has been recovered in less than 80 days. The Nasdaq offers positive returns of +10% for the year and the S&P 500 is positive. The European markets, somewhat lagging behind, offer very good opportunities.

-Do you see a strong economic recovery once the ‘coronavirus effect’ passes?
-Depends on countries. In the United States the recovery is being brilliant: a ‘V’ clearly. The published macroeconomic data has surprised positively, with the creation of 2.5 million jobs in the month of May, the rebound in manufacturing production and an increase of 18% in retail sales.

-And the economic recovery in Europe?
-It will be quite fast in the form of a ‘U’ to put a simile), but we have to say that Spain will be one of the countries that will find it hardest to recover. We expect Spanish GDP in 2020 to be -9.6%, unemployment to reach 21% and the public deficit 11.1%. We will not fully recover until the end of 2022 and much depends on the measures taken by the Government.

-What awaits us in the ‘new normal’?
-In Spain, unfortunately, we are going to find a greater intervention of the public sector, more regulation of economic activity, greater social conflict and an increase in all kinds of taxes. Fortunately, the financial sector is being part of the solution, unlike the 2008 crisis.

-And