Mezzanine Fund Essay
How can growth companies afford hybrid debt facilities, which are riskier and more expensive than senior loans obtained by mature value companies? The Paradox: “Growth companies” notoriously generate lower Cash Flows than “Mature companies”, but at the same time Growth companies have to finance their business through more expensive instruments (mezzanine finance) as the information available to the public, i. e. the investors, are much less than those released by big and mature companies.Therefore Growth Companies have difficulties to finance their growth through “cheap” financial sources as “senior loans” and the only way to boost their activity is to rely on more “expensive” and structured instruments. How come? First of all Growth Companies are in the “second stage” of the Business Life-cycle which means that are entering into an “Expansion phase”, i. e. those companies are expected to generate high cash flows in the near future. That said it’s intuitive to understand how a so-called “grace period” could be a viable feature that hybrid instruments provides to SMEs.
While for most of the start-ups 1 or 2 years of “grace period” is not enough to reach the ability of generate enough cash flows in order to pay back the loans it may be the contrary for Growth Companies. Moreover there are some advantages of mezzanine finance that justify the “paradox” previously discussed: * The total yield of all versions of mezzanine capital can ultimately be broken down into an interest and a kicker element: one lower (relatively safe) interest element which is compensated by a very much higher (relatively unsafe) kicker element.The company and lender work together to avoid burdening the borrower with the full interest cost of such a loan. Because mezzanine lenders will seek a high return, this return must be achieved through means other than simply cash interest payments. As a result, by using equity ownership and PIK (payable in kind) interest, the mezzanine lender effectively defers its compensation. In other words those companies will be heavily charge from the moment that they will be able to pay. * Mezzanine finance is subordinated to senior loans and is easy to combine ith other finance products.
This results in an improved balance sheet structure and better access to additional loans or equity (Leverage Effect).* By choosing the appropriate form of mezzanine finance SMEs can retain control over the company and avoid surrendering ownership rights. (No Capital Dilution) * Interest payments on some types of mezzanine finance are tax-deductible. (Tax Optimization) * The confidence of a mezzanine capital provider increases the image of the company. Banks will invest more easily in a company that has the trust of a risk taking investor. Smart Money) * Providers of mezzanine finance are often more willing to offer advice and valuable strategic assistance than providers of debt finance, especially when the return on the investment is partly dependent on the performance of the company (Equity Kicker) B. Design an innovative loan contract joining the “mezzanine finance” category particularly well suited for a small family business with high growth potential.
Type of Mezzanine Product| | Target Group| Small Family-Owned Enterprises (SFOE)| Mezzanine Investment range| Up to 1M€|Duration of investment| 3 to 9 years| Rights of mezzanine Investor| * No decision rights 1 * Covenants 2 * Outside Collaterals 2 * Convertible option| Conditions| * CIR (4% – 6%) 3 * Grace period 3-4 years 3 * PIK (12% – 15%) 4 * PBF (2% – 4%) 5| SFOE needs: “patient capital” and “keep the control”. Hybrid product features: 1. Many SFOE are reluctant to share the control, i.
e. diluting the ownership. Mezzanine finance provide a solution here: no decision can be taken by the fund providers even though in most situations the financing is upplied in combination with advice and mentoring in order to stimulate the development of these companies and to create leverage effects. 2. We strongly believe that positive/negative/financial covenants (commitment of the company to provide timely and qualitative financial information; restriction from selling core assets or firing key employees; company commitment of maintaining predefined financial ratios, such as D/E) and above all outside collateral (family wealth) are essential to get the family (the owner) involved and careful.
Some “skin in the game” stimulates the commitment of the family and works as a warranty for both the success of the business and the repayment of the fund. 3. Low fixed Cash Interest Rate (CIR) which implies, along with the grace period, a very much PATIENT capital. Although we believe that the grace period is viable for the company to “breath” the fixed cash interests has to be paid monthly regardless the duration of the grace period.
The rationale behind is that the company’s fulfillment of the monthly payment in a timely fashion works both as a positive signal for the fund providers (which could otherwise exercise is convertible option or stop the funding) and as an operating fee – still leaving oxygen for the company being the CIR very low. 4. High Payable In Kind (PIK) interest rate which compensates (from the fund provider perspective) the lower CIR, once again the rationale is to leave oxygen for the company during the early stage and charge the major cost at maturity date when the company is supposed to be profitable and cash generator. .
Profit Based Fee (PBF) should be charged at the end of each quarter or semester starting from the third year, here the rationale is to increase the return (fund provider perspective) once the company start making profit. The bigger the profit the bigger the return for the fund provider, still not a very high rate in order to keep low the family incentive to hide profits.