Funding options mezzanine finance

Mezzanine finance combines elements of debt financing and equity investment and can provide a relatively inexpensive alternative to private equity funding.

Business finance falls into two broad categories, namely ‘debt’ and ‘equity investment’.

Mezzanine finance is often described as a ‘hybrid’ or ‘halfway house’, combining elements of debt and equity funding. And while that combination may seem to introduce an unnecessary degree of complexity into the funding equation, mezzanine finance can be an effective and relatively cost-effective way to finance growth strategies that entail an element of risk.

The basics

Most businesses understand debt finance. A bank advances money that will be repaid with interest over an agreed term or through a rolling arrangement such as an overdraft. The bank makes its return by charging interest.

Equity investors, on the other hand, make their return from growth. They invest in a business that is seen to have growth potential. While they may receive a dividend on their shareholding, the real money is made when the success of the company allows the shares to be sold at a substantial profit. 

Equity investors, such as venture capitalists and business angels, are often seen as the primary source of growth capital. Expansion strategies, such as entering a new market or making an acquisition, are inherently risky. Equity investors are prepared to carry that risk because they see the potential of a high return. Bank lenders tend to be more cautious.

Many businesses, however, are reluctant to go down the private investor route. Angels and VCs will take large equity stakes in companies in return for their cash, and the cost of capital is typically above 30%.

Mezzanine finance provides an alternative. Essentially mezzanine finance providers lend money on the same basis as banks. However, typically (although not universally) they will also seek to share in growth by building an element of equity investment into the deal. Thus, if the business grows, the mezzanine provider will secure an additional return through the increased value of a limited amount of equity.

This equity component means that mezzanine providers are more comfortable with risk. As such, mezzanine finance is often used to fund strategies such as acquisitions and buyouts. 

Is it right for my business?

Mezzanine finance has certain advantages. It is certainly cheaper than private equity, with the cost of capital typically coming in the high teens or low twenties in percentage terms.

It can also be cashflow friendly. A term loan from a bank will require regular repayments, monthly or quarterly, creating a drain on the cash that is available to the business. Mezzanine loans are usually repaid at annual intervals. In addition, the loans are often structured with the bulk of the money repayable towards the end of the life of the loan agreement. This arrangement allows the business to implement its growth strategy with low repayments (and therefore a low drain on cash) at the front end of the agreement.

That can be a double-edged sword, as a company that fails to deliver on its growth projections will nevertheless be looking at large repayments towards the end of the term.

Mezzanine providers will take rights on a percentage of the company’s equity. However, this will be a much smaller percentage than would be the case in a conventional VC or angel investment. This factor makes mezzanine finance attractive to many owners.

There are variations on the theme. Santander’s Breakthrough Growth Capital offers mezzanine finance to qualifying businesses but without the equity element.

How available is it?

Most mezzanine finance providers operate at the larger end of the market and relatively few offer loans of less than £10 million. This means that supply to SMEs is limited. However, the Breakthrough programme does cater for SMEs with loans of up to £3 million.

When is it appropriate?  

Mezzanine providers are a useful source of growth finance in circumstances where bank finance is unavailable and when the existing owners are reluctant to see their own share holdings in the business diluted by new equity investors. It can be used to fund acquisitions, management buyouts or expansion plans.

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John Carroll - Helping businesses achieve International success. Head of Product Management & International Business, Santander UK