SME Financing – Mezzanine Finance
Our previous article, SME Financing – Debt or Equity?, discussed the two basic options that Business Finance Professionals and their SME clients have when looking to secure funding. As well as these two options, a third type of financing that combines the elements of debt and equity is available – Mezzanine Finance.
Business Finance Professionals would typically consider Mezzanine finance for their SME clients when funds are required for expansion, project development or acquisition and traditional lenders are unwilling to provide all of the capital required. And, like other forms of financing, a proven track record and well-documented business plan are highly preferable for Mezzanine lenders.
How Mezzanine Loans Work
Mezzanine loans are considered a hybrid of debt and equity finance. As per a traditional loan, the lender will provide funds to an SME and require repayment of the debt amount plus interest. However, an additional condition of the loan would be that if the SME defaults on the loan, the lender may convert the debt to equity.
Mezzanine debt is categorised as sub-ordinated debt, placing it at a lower priority than senior debt (traditional loans from banks and other lenders). For example, in the case of liquidation or bankruptcy, a SME would need to sell assets (equipment and buildings) for cash to repay creditors, and those creditors have a ‘pecking order’. Senior debt lenders are first in line with mezzanine lenders further back. Equity investors are at the bottom of the order.
Because of this lower priority, the interest rates applicable to mezzanine loans are higher than senior debt. Usually much higher! Sometime to reduce the interest rate lenders will include an equity instrument that entitles them to a small piece of ownership in addition to that available through default of repayment.
When compared to senior debt, Mezzanine loans have more flexibility, normally in the form of options for repayment. When cash flow is tight, or reinvestment into the business is pertinent, SMEs can take an option of capitalising interest (adding it to the loan amount). Other options may be simply deferring a portion of the interest repayment. Obviously, this additional flexibility is in recognition of the higher interest rate and the possibility of equity transfer.
Advantages of Mezzanine Loans
The following are reasons that Business Finance Professionals and SMEs would consider Mezzanine Loans.
The main advantage for SMEs is access to funding – attaining the capital they require for growth, expansion or acquisition.
In most cases, the interest payable on loans is a deductible expense to the SME.
From a financial perspective, any lending affords the SME an opportunity to leverage their investment. If borrowed funds are used wisely and astutely, and the growth, expansion or acquisition plans go well, the return on the SME owners’ equity is multiplied.
Mezzanine loans can be used in conjunction with traditional senior debt to borrow more than banks are willing to lend.
Because the SME is not swapping capital for equity (unless they default on their loan) they are not diluting their share in the SME, nor are they giving away any control.
When a SME secures Mezzanine finance, they are able to treat it as equity on their balance sheet. This shows lower debt levels than would be the case though debt finance and can assist with future debt financing applications.
Disadvantages of Mezzanine Loans
SMEs and Business Finance Professionals need to be mindful of several risks that come with Mezzanine finance. These include: -
The main disadvantage of Mezzanine finance is the high-interest rate, which from the lender’s perspective compensates for the higher level of risk they are taking on.
Leverage is a double-edged sword. Borrowing funds with the intention of generating a return that pays the money back plus provides an investment return is great as long as things go to plan. If things don’t work out, the SME can be left with significant debts, possibly a black mark on their credit history and not much to show for it.
Where the SME defaults on repayments or another condition of the loan is the trigger of an equity instrument, there will be a dilution of shareholding or equity in the business.
Even where there is no equity transfer and dilution, Mezzanine lenders may require specific criteria be met and reporting provided. For example, they may place parameters on certain financial ratios such as Return on Assets (ROI) or Debt-Service Coverage Ratio (DSCR).
When Mezzanine Finance is Appropriate
Mezzanine finance is a great fit for SMEs that can’t access venture capital or attract angel investors or are not willing to give up equity and control in the business. Specific reasons and situations where Mezzanine finance is appropriate for SMEs include: -
1. Pre Going Public
SMEs on a strong upward trajectory need to consider how to take on and fund their next growth phase. If going public, via an Initial Public Offering (IPO), is not feasible because the SME is not quite at that stage of development or maturity. Or, simply because the owners are not comfortable with giving up equity at this stage, Mezzanine finance is a good option.
The SME will still need to demonstrate a sound track record, stable cash-flows, liquid assets and an experienced management team. But, securing a Mezzanine loan should be relatively straight forward.
2. Improved Credit Rating
For SMEs whose plans include rapid expansion and growth and who will require or prefer traditional senior debt finance can use Mezzanine finance to assist with future lending. Because Mezzanine debt is subordinated debt and treated as equity on the Balance sheet, it leads to a lower debt-to-equity ratio.
Banks and traditional lenders look favourably on this because it results in an improved credit rating. This can make the difference when it comes time to apply for pure debt finance via a large traditional loan.
3. Institutional Backing
When SMEs take on Mezzanine lenders, it is recognised they have the backing of an institutional investor. Again, this can be highly beneficial when negotiating terms on future loans with banks and traditional lenders. More credit may be extended, or attractive conditions offered because of the Mezzanine lender’s presence and relationship with the SME.
4. Additional Funding
SME can diversify the lenders they use by introducing Mezzanine finance and reduce the dependence they have on one lender. This can provide them with either an alternative source of investment or as a top-up to a traditional loan.
5. Lower Costs
While Mezzanine finance comes at a higher interest rate than debt finance, when compared to equity finance, it can be considerably cheaper. Venture capitalists and Angel investors normally target a 20-25% return on investment, compared to Mezzanine finance lenders who might sit at 15-20%.
6. Flexibility
In many respects, Mezzanine loans are similar to bank loans, except for the added flexibility they afford. SMEs with a level of uncertainty around cash flow and revenue timing may benefit from the added flexibility of capitalising interest or deferring payments.
Mezzanine Loan Example
As a Business Finance Professional, you work with a SME who runs a few coffee shops in your town. Your SME client has the opportunity to buy a complementary business – a local bakery. The bakery generates $100,000 per annum in operating income, and the owners have it up for sale for $500,000. Your SME client doesn’t have $500,000 available, and you are discussing the options with them.
Financing with Senior Debt and Equity
You have found a bank who will finance $300,000 of the purchase price at a rate of 7% per annum.
Under this scenario the capital structure would be:
The bank contributes $300,000 at 7%
Your SME contributes $200,000 in equity
And the return on equity calculations are as follows: -
Operating Income from Bakery $100,000
Interest Expense (7% x $300,000) ($ 21,000)
Pre-Tax Income $ 79,000
After-Tax Income (30% tax rate) $ 55,300
Return on Equity ($55,300/$200,000) 27.65%
Financing with Senior Debt, Mezzanine Debt and Equity
Your second consideration is to find another lender to provide funds in addition to the senior debt, thus adding more leverage. You secure a Mezzanine debt of $100,000 at a rate of 14% per annum
Now the capital structure becomes
The bank contributes $300,000 at 7%
The Mezzanine lender contributes $100,000 at 14%
Your SME contributes $100,000 in equity
And the return on equity calculation is: -
Operating Income from Bakery $100,000
Interest Expense (7% x $300,000) ($21,000)
Interest Expense (14% x $100,000) ($14,000)
Pre-Tax Income $ 65,000
After-Tax Income (30% tax rate) $ 45,500
Return on Equity ($45,500/$100,000) 45.55%
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