Loh Peck Kuan
Contributing Author
February 2003

What is mezzanine financing?
Mezzanine financing has long been a useful tool in investment; however, its profile has increased in recent years. More investors are turning back to mezzanine finance as they have sought refuge from the meltdown in equity and high yield bond investments. Likewise, entrepreneurs are realizing that it offers relative lower give-up in equity control compared to pure private equity or venture capital.

Simply put, mezzanine finance is a cross between a loan and equity in the form of a call option or convertible that allows the investor to convert the loan into an equity investment at a previously agreed price. It is usually subordinated to senior debt but ranks higher than common equity. Some mezzanine finance investors may not incorporate an equity component. Instead, they may accept a higher stepped-up interest rate towards the end of the loan or incorporate some type of formula tied to the performance of the company (e.g. a percentage of the sales or profit). The borrower will have to pay a higher interest rate or coupon rate than senior debt, usually at 10-12% p.a., but suffers less dilutive effect in shareholding compared to pure equity investments. Moreover, as mezzanine finance is usually a subordinated loan, its loan covenants are usually less stringent than senior debt. Mezzanine finance has traditionally been perceived as a bridging loan, but it is increasingly used as a stand-alone investment in buyouts or as a substantial investment to further expand a business.

Key comparisons among different classes of investment

	Senior Debt	High Yield Bond	Mezzanine Finance	Private Equity Venture Capital
Nature	Loan, ranks highest in times of liquidation	Loan, subordinated to senior debt but ranks higher than common equity	Loan, subordinated to senior loan and usually bonds but ranks higher than common equity	Usually common equity, however may be in the form of convertible bond with a low coupon rate
Convents/ undertakings	Stringent	Less stringent than senior debt	Less stringent than senior debt	Least stringent
Equity component	Absent	Absent	Call option/convertible bond to convert into common equity	Common equity. Option to convert to common equity if it is a convertible bond
Shareholding dilutive effect	Absent	Absent	Less dilutive than private equity/venture capital	More dilutive than mezzanine finance
Return expected from investors	Market lending rate	12-14% p.a.	18-20% p.a., inclusive of 10-12% p.a. coupon rate, with the remaining return from the equity portion or higher stepped up interest rate/other formula tied to the performance of the company	30%-35% p.a.

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.

Presently residing in London, Peck Kuan has 8 years of investment experience, more than 3 years in the stockbroking research industry and 5 years in the private equity industry. Peck Kuan was previously with PrimePartners Asset Management in Singapore, and she also worked in Hong Kong in 1999. She has invested in several leveraged buy-outs and expansion capital deals in Asia, where she was actively involved in corporate governance issues in monitoring the investments. She is familiar with the investment environment both in Southeast and Northeast Asia.