When it comes to mezzanine financing, many people get confused for various reasons. Some people become skeptical about the whole thing while others lack ideas on how to go about it. In this article, we are going to explain clearly to you what mezzanine debt is and why you should consider spending on it.
Mezzanine financing is a hybrid between debt and equity. It is a form of a loan given to a person to enable financing of leveraged buyouts, recapitalizations and corporate acquisitions. It is also meant to finance companies that lack enough capital for growth. In most cases, it is presented in the form of unsecured senior subordinated notes.
If defined from an issuer’s perspective, mezzanine is a form of financial assistance given to a borrower to help reduce the cost of capital by providing additional financing that can be used to improve equity returns. When referring to financial planning for a business, the debt is entirely used to replace the high-yield bonds present in the business.
Why You Should Invest in Mezzanine Debt
High Yields on Total Return
Mezzanine investors usually demand high rates of return compared to unsecured debt investors. This is because most of them have subordinated position in an issuer’s capital composition. Returns are typically in form of fixed mezzanine debt rates charged on current coupons, commitments, arrangement charges and premium payments for call protection. Most debts come with opportunities that help boost equity. This leads to increase in potential returns beyond those stipulated in the agreement.
Provision for Downside Risk Management
Issuing of a mezzanine is practically based on privately negotiated transactions. This means that a decision made by a lender to extend the credit limit is influenced by the issuer’s ability to maintain free cash flow and prospective growth margins for the business. Mezzanine debtors can carry out private due diligence procedures that put them at a perfect position to understand the borrower and negotiate terms in ways that suit both parties.
After finalizing the deal with the borrower, mezzanine lender is entitled to get monthly financial statements of the business. Some of them negotiate with the borrower to secure a position on the board of directors with full permission to carry out director observations. This helps the issuer keep up to speed with the current situations and changes in the company that can affect its debt obligations.
In addition, most companies generally continue to have both incurrence and maintenance covenants in their loans. Such clauses may give mezzanine lenders additional tools and incentives to leverage whenever the business underperforms. They can also take various precautionary operational measures to put the business back to its feet whenever it crumbles.
Reduction in Financial Volatility
Mezzanine financing is commonly structured with a coupon, which means that it experiences low incidences of volatility in the system. The coupons act as a tool for compensation when the lender decides to subordinate their position in the capital structure. Mezzanine debt is attractive for investors who focus on investing in small businesses in a low-yield environment. Since the debts are paid quarterly, the heavy dose of current coupons becomes instruments in reducing the volatility of returns.
It is Highly Flexible
Mezzanine allows for flexibility in shaping up the amortization schedules in the business. It then harmonizes the rules followed during the borrowing process by streamlining them in favor of both parties.
As an investor, you must be vigilant enough to prevent putting your money into something that will make you regret. Most investors usually consider the following factors when evaluating the pros and cons of making a mezzanine investment;
• Mezzanine investor looks at the current returns which is much higher than returns on an equity investment. This is because returns from equity are calculated from the available cash flow that includes all debts. Therefore, the yields expected from mezzanine should be higher.
• Cash returns from mezzanine should not vary with the returns on equity. Equity returns are generally affected by the market demand and supply variations. The mezzanine return is fixed, and it is based on the contractual terms. The amount is usually paid in full before any other amount is given out for equity obligations.
• Mezzanine debtor must have a lower risk than that of equity investment. Since these debts are paid in full before any cash is channeled to equity investors, they are often exposed to fewer risks.
• Mezzanine investor does not participate in any profit turmoil like equity investors because they are paid in contractual terms. In most cases, equity investors have to participate in various financial challenges facing the company. They often participate in the profits and all the losses resulting from increased or reduced rents.
Mezzanine is already taking the Australian financial sector by storm. Many people resort to using it because it is highly flexible and saves a lot of time. Some big companies have already considered it as an important contributor towards an effective corporate financial planning process.