Mezzanine financing — an alternative solution to traditional credit

Mezzanine financing — an alternative solution to traditional credit

Simone Hudson

Wednesday, November 25, 2020

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Access to finance is often highlighted as a major challenge for businesses within the region, especially those without the 'blue chip' on their shoulders. Before, and especially now with COVID-19, businesses looking for capital to recapitalise, retool or expand their operations may require longer repayment and grace periods, additional flexibility on the requirement for collateral and, of course, attractive rates. However, structurally, and given regulatory constraints, the business models of commercial banks tend to favour seniority in ranking of payments, earlier amortisations (repayment of principal) and shorter arrangements. These dynamics have left some small and medium-sized enterprises (SMEs), and even some larger firms, without a wide range of bank financing options.

Fortunately, the agility of the capital markets has given rise to mezzanine financing solutions, which effectively bridge the gap between what traditional financiers can afford to offer and the need for added flexibility by business owners.

Specifically, mezzanine financing through an alternative investments structure — such as a mezzanine fund, facilitates a better alignment of interests between entrepreneurs and the investors who can supply this type of capital. Let's explore mezzanine financing further.

DEFINING MEZZAnINE FINANCING

Mezzanine financing is a type of capital that has some of the characteristics of bank loans as well as some of the owners' share capital. If you were to visualise it on a balance sheet, it would be that level of financing that sits above equity and below senior debt in the capital structure. In the event of a default, mezzanine financiers stand in line behind all senior lenders, but in front of equity holders, and the transaction is priced according to its position in the line. Mezzanine financing can take various forms including secured subordinated debt, convertible subordinated debt and preferred shares. Through a combination of various instruments, it can be structured to look more like debt at one end of the spectrum or more like equity on the other end, to meet the needs of various businesses and achieve a desired risk/return profile for the lenders.

BENEFITS TO BUSINESSES

The benefits of mezzanine financing to companies are significant. Importantly, it provides business owners with an alternative source of capital to grow and or retool especially in crises when credit conditions tighten. Owners can utilise this funding to support their current operations, strengthen their balance sheet and position the company to take advantage of the opportunities that are present during and post crisis. In addition, mezzanine can provide an alternative to private equity when the owner is reluctant to cede control of his or her business. Owners may opt for a more debt-like solution in this instance, and in honouring the obligation can ensure that they maintain full control of their businesses. The primary benefit of mezzanine financing however, is the flexibility in structuring which helps to mitigate balance sheet risks. Mezzanine financiers take a keen interest in working with owners to find a solution that matches the repayment schedule to the cash flow profile of the company.

This could mean an allowance for greater flexibility in servicing during the early years of the financing. In essence, through negotiations and structuring, the financier and business owner can tailor a bespoke financing package with terms and instruments aligned with the company's operations and long-term strategy.

BENEFITS TO THE INVESTORS (MEZZANINE FINANCIER)

Relative to other investment opportunities, mezzanine credit can offer higher risk-adjusted returns to investors who are willing to participate as suppliers of capital. The average annualised return on mezzanine strategies from 2008 to 2018 was just under 10 per cent, which compares favourably to the returns on other fixed income investments such as bonds (four to seven per cent, with high risk, non-investment grade bonds on the higher end of this range) . In addition, the sub-asset class is designed to offer investors a less risky option than pure equity through the reliance on several tools to mitigate risk, including: the ability to employ covenants to exert a level of control, amortisation features and security packages. In some instances, the investor may have the ability to exert influence in certain key decisions to be made by the principals at the strategic level. Further, the dearth of senior lenders in many emerging markets has resulted in mezzanine investors sometimes being the only debt providers in a deal, giving them the ability to secure first rights to collateral.

The launch and expansion of several alternative investment funds dedicated to mezzanine financing strategies support the view that this credit arrangement will become mainstream in the Caribbean. For example, the Caribbean Mezzanine Fund (CMF), launched in 2016 and co-managed by NCB Capital Markets Limited and Eppley Limited, has deployed its committed capital of US$16m ahead of schedule, highlighting the strong demand for patient, flexible funding. On the supply side, investors would have been pleased with the returns generated from the strategy. Since its inception, CMF has delivered annual cash dividends of eight per cent in US dollars and is expected to deliver 14 to 16 per cent net compounded annual returns in US dollars to its investors over the life of the fund. That said, given the benefits to businesses and investors, expectations are that mezzanine financing will continue to gain in popularity throughout the region.

Simone Hudson — Assistant Vice President, Alternatives and Fund Management


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