Mezzanine debt as a financing instrument
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.