What do mezzanine finance investors look for?
Like all lenders, mezzanine finance investors will need to assess the borrower’s ability to service the periodic interest payments and the loan repayment. However, as mezzanine finance investors are subordinated to senior debt lenders, they are less particular with collateral. Instead they tend to be more stringent in their due diligence and focus on the cash flow generation of the business. In a way, mezzanine finance investors look at similar criteria as equity investors. The most important factor is the management team; the team must have a credible track record to run the business. Unlike equity investors, since mezzanine finance investors require consistent interest payments, the business must have a compelling growth story: not only will it meet the consistent interest payments for the investment, but it will also provide the potential upside in the equity call option or the specific formula that is tied to the performance of the company. Mezzanine investors need to be convinced that both the industry and the company are promising winners for their investments.
As they require a steady stream of interest payments from the business, mezzanine investors usually steer clear of start-ups and turnaround situations.
Appeal to both entrepreneurs and investors
Being subordinated to senior debt, companies that employ mezzanine finance can avoid breaching their senior debt leverage for substantial investment, which commands a lower cost of borrowing. For entrepreneurs, the main attraction to mezzanine finance is that it requires less equity investment from equity investors, which means entrepreneurs can retain more shareholding ownership and management control.
For investors, following several high profile defaults in the high yield bond sector and some disappointing returns from private equity investments, the recurrent interest income from mezzanine finance and the potential upside in the equity kicker is a major attraction.
Mezzanine finance in the UK and Asia
Mezzanine finance has gained considerable ground in UK following several high profile defaults of high yield bonds and some dismayed results from private equity investments. The coupon rate of mezzanine finance has remained fairly stable, but mezzanine finance has evolved to more flexible structures: mezzanine finance investors have been successful in structuring their terms to tie in with a higher interest rate compared to equity call options.
In Asia, mezzanine finance is a relatively new concept. Companies are used to either senior debt/high yield bonds or private equity, but not a sandwich tool like mezzanine finance. However, investors have turned more cautious to protect their investments compared to private equity and high yield bonds, and banks have turned more stringent in their lending policies in the present economic gloom. For entrepreneurs who are unwilling to give up much of their equity stake, need a substantial amount of funding, do not want to be tied down by stringent loan covenants, and desire a lower senior debt leverage ratio, mezzanine finance may just be an ideal tool.