1. Introduction. 2. What is Mezzanine finance?

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1 MEZZANINE FINANCE: CLOSING THE GAP BETWEEN DEBT AND EQUITY Vasilescu Laura Giurcă Faculty of Economy and Business Administration, University of Craiova, 13, A.I. Cuza Street, , Craiova, Romania, Abstract: Present days the firms have to face the increasing competition, difficult economic conditions and an increasing need for major investments. In these circumstances, even the well managed and highly profitable businesses have limited options for financing growth or strengthening their equity resources. In these conditions, alternative forms of financing such as mezzanine finance are becoming more and more a supplement to the traditional forms of corporate financing. Mezzanine is a type of financing that combines elements of debt and equity financing, a hybrid construct that makes use of various longstanding instruments. The most important mezzanine financing instruments include: subordinated loans, participating loans, profit participation rights, convertible bonds and bonds with warrants. A common feature of the various instruments is that they can be structured flexibly in many different forms in order to provide solutions for the specific financing requirements of private and listed companies. Key words: mezzanine finance, debt, equity 1. Introduction In times when economic conditions are difficult, or when there is a need to make major investments, even well managed and highly profitable businesses have limited options for financing growth or strengthening their equity resources. A company s ability to raise equity and debt capital is largely determined by its profitability. But only a small number of companies have access to the capital markets, enabling them to issue large amounts of stock or corporate bonds. Consequently, bank loans are the most important source of external financing for many businesses. But companies often have insufficient equity backing compared with the risks of the business, and this reduces their ability to raise debt capital. Also, the new loans from traditional lenders are harder to obtain. Access to the public capital markets is virtually non-existent and the economic downturn has been financially challenging for many businesses. In these circumstances, many companies turn for capital using alternative forms of financing such as mezzanine finance. A hybrid form of capital, mezzanine financing is sandwiched between senior debt and equity on a company's balance sheet. Mezzanine capital typically is used to fund a growth opportunity, such as an acquisition, new product line, new distribution channel or plant expansion. Although it makes up a small percentage of a company's total available capital, mezzanine financing has become critical to middle-market companies. The term mezzanine (from the Italian mezzanino ) comes originally from architecture and denotes an intermediate floor between two main floors in a building. In corporate finance, it is used figuratively as a collective term for hybrid forms of financing that combine elements of debt and equity financing. Thanks to its hybrid nature, mezzanine capital has a range of advantages compared with traditional forms of corporate financing, which allow it to be put to effective use in the context of financing for SMEs, as well as for larger companies. 2. What is Mezzanine finance? From a balance sheet perspective, mezzanine capital is a hybrid instrument that acts as a flexible bridge between pure equity and pure debt. It is thus able to remedy financial shortfalls that cannot be made good using the classic forms of corporate financing. (Fig.1). Company balance sheet Financing instruments Assets Equity and liabilities Current assets Liabilities - Bank loans - Bonds - Supplier credits - Customer advances - Subordinanted loans 657

2 Fixed assets Mezzanine Equity - Silent participations - Participating loans - Profit participation rights - Convertible bonds - Bonds with warrants - Retained profits - Stock - Capital contributions from equity holders - Private equity Figure 1. Mezzanine Capital versus Debt and Equity The most important mezzanine financing instruments include private placement instruments (private mezzanine) and capital market instruments (public mezzanine). The private placement instruments are the followings: subordinated loans (junior debt) are the most common form of mezzanine financing and they are unsecured loans where the lender s claim for repayment in the event of bankruptcy ranks behind that of providers of normal loans (senior debt); participating loans are normal loans, but rather than being fixed, their remuneration is contingent upon the results of the business. Despite sharing in profits, participating loans do not give rise to an ownership relationship; the silent participation is closer in legal form to a stockholding than are subordinated or participating loans. The distinguishing feature of this form of financing is that one or more persons take an equity stake in a company, but without assuming any liability to the company s creditors. The typical silent participation affects only the company s internal affairs and is not apparent to outside observers. The capital market instruments (public mezzanine) are the followings: profit participation rights are equity investments under company law that entitle the holder to rights over the company s assets (e.g. participation in profits or in the surplus on liquidation, subscription for new stock), but not to the right to be consulted on business decisions; convertible Bonds/Bonds with Warrants give the holder, in addition to the usual right to fixed interest payments and repayment of principal, the right to acquire shares or other equity instruments of the company instead of accepting repayment of the bond. A common feature of the various instruments is that they can be structured flexibly in many different forms, and combined in almost any way desired, in order to provide tailor-made solutions for the specific financing requirements of private and listed companies. The specific form of a mezzanine financing instrument is classified first by its position between equity and debt in the balance sheet (equity vs. debt mezzanine), and second, by its tradability, which ranges from book instruments (private mezzanine) to those which can be traded on the capital markets (public mezzanine). The latter may be issued publicly or placed privately. Different risk-return profiles for the mezzanine investor can arise depending on how close the instrument is to pure debt or equity. So, taking into account the risk exposure and the return, the classification scale of the mezzanine instruments should start with pure equity capital, bonds with warrants, convertible bonds, profit participation rights, participation loans and end with the silent participation, subordinated loans and pure debt capital. The central feature of mezzanine capital is that mezzanine investors have a subordinated status in relation to other loan creditors in the event of bankruptcy, arrangements with creditors, or liquidation. This means that in the event of bankruptcy, the higher-ranking debt providers are generally paid first, followed by the mezzanine creditors. For this reason, mezzanine funds although classified as debt for legal and tax purposes are also described as economic equity or quasi-equity, because they represent liable equity capital from the point of view of the higher-ranking lenders. However, mezzanine investors are classified as higher-ranking in comparison with pure equity investors. In contrast to equity capital, mezzanine funds are generally made available for a limited period of time, until the business can generate sufficient genuine equity capital from retained profits. A corollary of the subordinated status of mezzanine capital is that security in the form of property, equipment, etc. does not normally have to be provided as would be the case with classic loan financing, and call rights are limited. 658

3 3. Advantages and Disadvantages of Mezzanine Financing Mezzanine financing is associated with a number of advantages for companies in comparison with the traditional forms of financing. Among the advantages of mezzanine financing are the followings: remedies financial shortfalls and provides capital backing for implementing corporate projects; improves the balance sheet structure and thus creditworthiness, which can have a positive effect on the company s rating and can widen the room for maneuver as regards financing; strengthens economic equity capital without the need to dilute equity holdings or surrender ownership rights. Moreover, by raising mezzanine capital, stockholders can continue to act with greater independence than would be the case with the introduction of an additional equity investor, because mezzanine investors do not usually seek the right to be consulted and to participate in the management of the investee company.; tax-deductible interest payments and flexible remuneration structure; the flexible remuneration of a mezzanine instrument. Thus, the standard arrangement includes, in addition to an interest component, a performance-related bonus in the form of a share in the performance of the company, or an option to acquire or receive equity interests; greater entrepreneurial freedom for the company and limited right of mezzanine investor to be consulted. There are also few disadvantages of the mezzanine finance: more expensive than conventional loan financing. Mezzanine capital should therefore be seen as complementary to traditional debt capital and appropriate only in cases where the funding requirement is larger than the amount that can be raised using conventional debt financing and equity resources; capital provided for a limited term only, in contrast to pure equity capital; more stringent transparency requirements as regards accounting, controlling, and information policies. this form of financing is not appropriate for particular types of company and business phases. This applies first of all to the financing of start-ups or early-stage companies (fig. 2). Growth and expansion financing 60% Early-stage financing 7% Refinancing 33% Fig. 2. Reasons for mezzanine financing The mezzanine is unsuitable for financing restructurings or turnarounds, as cash flows are usually volatile during these phases and difficult to forecast; the companies with a weak market position and negative development prospects; with inadequate finance and accounting function, with high leverage or low equity resources. Because mezzanine capital is subordinated and unsecured, the mezzanine provider cannot rely on real security in making an investment decision. The ability of a company to repay capital raised therefore depends largely on the total cash flows it will be able to generate in the future. Consequently, it is an important precondition for raising mezzanine capital that the earning power and market position of the existing business should be well established and stable. But qualitative factors such as the track record and quality of the management, as well as appropriate accounting systems, also play an important part in the investment decision. As a result, established businesses with stable, healthy cash flows and the prospect of long-term positive business development are the prime candidates for mezzanine financing. The requirements for mezzanine financing are the followings: possibilities for funding from own resources have been exhausted and loan financing is either insufficient or not available; 659

4 strong market position based on products/technology and market shares; healthy financial position and good earning power with steady profit growth where possible; focused business strategy and positive long-term development prospects; positive, stable cash flows that can be forecasted reliably; appropriate finance and accounting function, and open information policy; quality and continuity of corporate management. Mezzanine capital can be used in a wide range of situations, particularly given the fact that the purpose is not specified in the financing agreement. In terms of a company s development phase, the focus of mezzanine finance is on financing growth and expansion projects, and in particular management buyouts (MBOs) or management buyins (MBIs) in the context of company succession arrangements or spin-offs of parts of the business. Mezzanine capital is a particularly suitable financing solution for such cases, since the management team normally does not have sufficient security available to satisfy the requirements for traditional loan financing. But hybrid forms of financing can also be employed in less dynamic periods (maturity phase) in order to optimize the financing mix. Bridge loans and refinancing are also suitable for the use of mezzanine capital. In these business phases, mezzanine financing constitutes a valuable addition to classic debt and equity financing, and represents an attractive option for companies with appropriate cash flows and growth prospects to raise funds in larger amounts. From the investors perspective, mezzanine forms of financing have some advantages as follows: access to a new investment segment; returns similar to those on equity; investment platform independent of stock and bond markets; optimal opportunities for diversification; lower exit risk and better protection of capital compared with private equity investments because in the case of mezzanine finance the contract usually provides for the repayment of the principal, and the remuneration of the instrument is covered by the company s cash flows. There are also few disadvantages of mezzanine finance for investors, such as: the difficulty to exit early; the wrong assessment of creditworthiness leads to lower returns. 4. Conclusions Mezzanine financing increases the range of financing options available to companies. In particular, companies with a good credit rating, but whose funding requirement is not large enough for a financing on the capital markets, can acquire greater room for maneuver by using this instrument. In this context, mezzanine should be understood as being complementary to traditional loan financing, and not a substitute for it. The use of mezzanine financing solutions can be especially appropriate in cases where the capital requirement exceeds the amount that can be raised with conventional financing instruments (equity and loans) for example because of a lack of borrowing capacity or insufficient equity resources. Thanks to their hybrid qualities, mezzanine funds are able to make good financing shortfalls between the maximum amount of debt capital available and the funding requirement as a complement to equity and loans. Nevertheless, mezzanine financing must not be seen as a cure-all in cases of financial difficulties, for example if a loan has been refused as a result of an inadequate credit rating or if the poor performance of the business has led to financial difficulties. Mezzanine capital is a riskier form of finance than classic debt capital, because the risks it bears are in some respects similar to those of equity capital. As a result, the criteria that companies must meet in order to qualify for mezzanine funding are also considerably more stringent than those for loan financing. The target group consists primarily of stable businesses with high growth potential and healthy, sustainable cash flows. In terms of a company s stage of development, mezzanine financing is suitable for investments intended for growth and expansion, and also for management buyouts in the context of succession arrangements and changes in ownership. Compared with classic loan financing, mezzanine capital is still little used at the moment. But, against a background of rapidly changing markets in which survival will require substantial amounts of funding, this form of financing is set to acquire increasing significance. REFERENCES 1. Brokamp, J., Hollasch, K., Lehmann, G., Meyer, L. Mezzanine-Financing, Bridging the Gap, published by Deloitte, 2nd Edition, Giurca Vasilescu, L., Popa, A. Mezzanine Finance - an alternative for the firms financing, International Conference Competitiveness and Stability in the Knowledge-based Economy, Craiova, October Incisive Financial Publishing - The Europe Mezzanine Review 2004, London 660

5 4. Jensen M. Corporate Control and the Politics of Finance, Journal of Applied Corporate Finance, Vol.4, n 2, 1991, pp Müller-Känel, O. Mezzanine Finance, SECA (Swiss Private Equity & Corporate Finance Association), Volume 1, 2nd Edition, Rajan, R. G., Zingales, L. Banks and Markets: The Changing Character of European Finance, NBER Working Paper No. 9595,