Mezzanine financing
When using subordinated financing pays off
Mezzanine capital and mezzanine financing are particularly in demand in the area of large-scale project financing. Often, the high purchase sums required for the acquisition of commercial properties cannot be raised profitably without mezzanine capital. But what exactly is mezzanine capital? How do you raise mezzanine capital? And what are the advantages and disadvantages of mezzanine capital? We shed light on this in this article. If you would prefer to listen to the whole thing in audio form, you can do so here
Definition & Types
In architecture, mezzanine floors or half-storeys in a multi-storey building are termed mezzanines. A mezzanine floor does not count as a full storey but is included in the floor area calculation. Mezzanine capital also follows this concept. It can be counted as both equity and debt capital.
There are various forms of mezzanine financing, including silent partnerships, subordinated loans, convertible bonds and bonds with warrants.
Subordinated loans
Subordinated loans are so-called because they are subordinated in the hierarchy compared to traditional financing. This means that they only receive money when the loan is repaid once the senior loan has been repaid. This term is often equated with mezzanine financing.
Silent partnerships
A silent partnership is when a company deposits assets in a company and thereby participates in the profits, but does not have to be mentioned externally, not even in the commercial register. There are typical and atypical silent partnerships. In the case of atypical silent partnerships, the company has more rights but also more risks because it also participates in losses and hidden reserves.
Convertible bonds and bonds with warrants
Corporate bonds that can be converted into shares at a predetermined conversion price are also known as convertible bonds.
Benefits
There are several reasons why it can be worthwhile to raise mezzanine capital. As banks are now often less willing to provide more than 70 percent of the financing, the equity capital must be increased. No matter which form of mezzanine financing you choose: Due to the fact that mezzanine capital is attributed to equity, the conditions with mezzanine can be significantly better than without. This gives you more leeway, especially when it comes to implementing large-scale projects. It also gives you the opportunity to significantly increase your own income.
This is best explained with an exemplary calculation based on the following factors:
Equity investment (EI): 3 million
Mezzanine financing (MF): 6 million (double the amount of equity)
Mezzanine interest: 12.5 % (e.g. with Exporo)
Financing by senior financing banks: max. 70 %
Average profit margin in relation to total investment costs: 15%
A mezzanine financier wants to contribute twice the amount of the investor's existing equity, which is EUR 3 million.
Without mezzanine | With mezzanine |
|---|---|
3M EI + 70% loan (7M) | 3M EI + 6M MF + 70% loan |
= 10M project volume | = 21M project volume |
1.5M profit margin | 4.5M profit margin - Mezzanine cost |
= 50% capital increase | = 100% capital increase |
As you can see, you can achieve a good leverage effect with mezzanine capital. In other words, you can maximize profits or diversify risk with the same amount of equity with mezzanine financing - even though mezzanine financing is expensive compared to senior financing.
In return, however, mezzanine capital providers often do not require any collateral and have no direct influence on company decisions. And as long as the project overview and breakdown of the financing is transparent and easy to understand, banks are not going to be reluctant to approve a financing request when a mezzanine investor is involved.
Costs of mezzanine financing
While the interest costs of senior financing are in the single-digit range, double-digit interest rates are the norm for mezzanine financing. Between 10 and 20 percent are common. And then there is the profit participation. This naturally results in relatively high costs, which should always be taken into account in the calculation. The reasons for this are that the risk for mezzanine capital providers is high and that in the event of insolvency they are only serviced after the senior lenders.
In order to keep the costs of mezzanine capital in check, the financing should therefore be used towards the end of the project phase and fulfill a very specific purpose. Examples of this include
Expansion plans, such as the establishment of new branches or expansion of production capacities
Management buyouts (MBOs)
Technical innovations, digitization measures, etc.
Who is mezzanine financing suitable for?
Mezzanine financing is suitable for investors in various scenarios. Start-ups that require an equity-friendly entry can secure the right boost for the start-up phase with mezzanine capital. But established companies also benefit from mezzanine financing. Here's a more detailed list of possible target groups:
Middle Market Companies
Mezzanine financing is well-suited for middle-market companies looking to fuel growth initiatives such as expansions, acquisitions, or product development. These companies often have established operations and cash flows but may lack the collateral or credit profile required for traditional bank loans or prefer not to dilute existing equity by seeking additional equity investments.
Private Equity Firms
Private equity firms frequently utilize mezzanine financing to structure leveraged buyouts (LBOs) or recapitalizations. Mezzanine debt allows these firms to increase their purchasing power and amplify returns on their investments while providing them with the flexibility to tailor the capital structure to meet specific deal parameters.
Real Estate Developers
Mezzanine financing is commonly employed by real estate developers to fund the construction, acquisition, or redevelopment of properties. This form of financing can supplement senior debt and equity, enabling developers to optimize their capital stack and enhance returns on investment without sacrificing significant ownership stakes.
Startups and Growth-stage Companies
Although less common, mezzanine financing can also benefit startups and growth-stage companies with proven business models and robust revenue streams. For these entities, mezzanine financing offers an alternative to traditional venture capital or bank loans, allowing them to access capital without relinquishing substantial equity or providing hard assets as collateral.
Companies in Transition or Restructuring
Companies undergoing transitions, such as ownership changes, corporate restructurings, or strategic repositioning, can benefit from mezzanine financing to navigate transitional periods and capitalize on growth opportunities. Mezzanine debt offers flexibility in structuring repayment terms and may accommodate fluctuating cash flows or uncertain operating environments.
Management Teams in Buyouts
Mezzanine financing often appeals to management teams participating in management buyouts (MBOs) or management buy-ins (MBIs). By leveraging mezzanine debt alongside equity contributions, management teams can acquire ownership stakes in their companies or facilitate ownership transitions while preserving operational autonomy and incentivizing alignment with financial sponsors.
Summary
Mezzanine capital and financing play a crucial role in large-scale project financing, especially in commercial real estate acquisitions where high purchase sums are involved. Mezzanine capital blends elements of equity and debt, offering flexibility and attractive terms compared to traditional financing options. Subordinated loans, silent partnerships, and convertible bonds are common forms of mezzanine financing, each with its advantages and costs. While mezzanine financing can increase leverage and support diverse projects like expansions, management buyouts, or innovations, it comes with higher interest rates and profit participation. However, its flexibility and ability to enhance returns make it appealing to middle-market companies, private equity firms, real estate developers, startups, companies in transition, and management teams seeking strategic capital solutions.
Urbyo Professional can help you secure mezzanine financing and help you find the right loan structure for your project. Create a profile by signing up for an account or simply contact us for more information and we will get you started.