Click here for printer friendly page

Mezzanine as expansion finance

Mezzanine needs to be demystified if investors are to commit time and energy to this sector of the asset class. This paper, from Adrian Lurie at Indigo Capital, provides an introduction to mezzanine and the crucial role it can play in the capital structure of a company. It gives a description of its role as a financial product that bridges the funding gap that can occur between equity and bank debt, and provides investors with an understanding of this emerging investment opportunity.

Introduction

As a hybrid product, mezzanine shares characteristics with both bank debt and equity. It is used to bridge the funding gap that occasionally occurs between the two. This gap is created where the risks preclude the use of conventional debt and where recourse to equity is constrained. In these cases, mezzanine can provide the solution.

Mezzanine is well suited to financing expansion. In whatever form it occurs (corporate acquisition, additional manufacturing facilities, new product development or launch into a new geographical market), expansion contains inherent risks. This can often preclude the use of bank debt to finance the expansion. Mezzanine can be used in these circumstances as a better value alternative to a pure equity investment.

Mezzanine: what it is and how it's used

Mezzanine is a hybrid product best described as a layer of financing between equity and bank debt. As such, it can be seen as ‘middle-risk - middle-return financing', and shares characteristics with both debt and equity.

Mezzanine is typically used to fill a funding gap that occasionally occurs between equity and bank debt. This can occur for a number of reasons. One principal cause can be that the business lacks sufficient security against which a bank can lend. This is often the case with service businesses, where both fixed and current assets can be of minimal value. The business may also be highly leveraged, with standard lending ratios, such as interest cover or debt as a multiple of operating profit, already reaching acceptable maxima. Additionally, the business may be unable to meet the repayment profile required by a bank, because, for instance, of a cash-intensive investment programme.

Shareholders are also sometimes unable or unwilling to advance additional capital to fill the funding gap themselves. The resources of the shareholder group may be limited, which can be the case where it comprises individuals rather than an institution with ‘deep pockets'. Follow-on investment from private equity funds is also sometimes problematic if, for example, the fund, which made the original investment, has reached or is nearing the end of its active life.

Mezzanine is a flexible product, which has a number of applications. The classic use of mezzanine is in the financing of buyouts. It is often the case that in these situations, mezzanine is perceived to be a ‘necessary evil'. This can apply in competitive auctions, where the equity investor's internal return requirements preclude them from financing the entire difference between the purchase price required to win the bid and the amount that the bank is willing to lend. In such cases, mezzanine is used to reduce the effective ‘price per share' to the equity provider.

This is a very narrow view of the role of mezzanine and demonstrates a lack of appreciation of the circumstances of individual companies. A business is unique (if it weren't, its future has to be brought into question), and its financial structure needs to reflect this. There are varying shades of grey in the spectrum, and it is in this middle ground that mezzanine is used. This fact, combined with increasing competition among mezzanine providers themselves, is resulting in more varied and imaginative applications of mezzanine.

Shareholder restructuring is an example. Mezzanine can be used where, for instance, one shareholder wishes to realise his equity stake. This can provide the other investors with the opportunity to increase their own shareholdings with little or even no recourse to additional equity. It can also be used to the opposite end in recapitalisations, where mezzanine investment strengthens the balance sheet by reducing leverage and the short-term debt repayment burden on the business. It can be tailored to meet specific requirements and may range in characteristics from ‘junior debt' to ‘senior equity'.

Its flexibility also makes mezzanine a good source of pre-flotation financing, or where a tight timetable requires a company to attain swift certainty of funds, which may not be possible when raising bank debt or capital via the public markets.

A mezzanine investment can be structured in various forms. Although typically a subordinated loan, it may also comprise preference shares or convertible bonds.

Mezzanine pricing typically comprises two distinct elements. The first is a current yield that the mezzanine contractually receives and so is similar to interest on bank debt. The interest margin is typically higher than bank debt, however (the margin may be 3 to 4 per cent or higher), and the overall rate can be either fixed or floating. It will usually be paid in cash on specified payment dates, or may be rolled up and paid at some future point.

The current yield is united with a back-ended payment made upon repayment of the mezzanine or sale of the business. This can take two possible forms. The first is a redemption premium, where the amount payable upon exit or repayment of the facility is specified at the point of investment effectively in the form of additional interest. The second and more usual mechanism provides the mezzanine investor with a form of equity ownership. This can be a warrant or option in to the ordinary shares, or some other mechanism that provides an interest in the equity of the business. Unlike the redemption premium, the second mechanism does not contractually bind the business in to paying a pre-determined amount to the mezzanine investor and its value (or cost) is only meaningful if the business thrives.

Providing an equity interest to the mezzanine investor has two principal advantages over the use of an exit premium. Firstly, its value is dependent upon the success of the business and therefore aligns the interests of the mezzanine investor more closely with those of the shareholders. Secondly, an exit premium is payable irrespective of the future trading of the business. It is not success-related and the premium is still payable even in the event of the business not meeting its plan.

The equity interest usually required by a mezzanine investor is a key characteristic that distinguishes it from other forms of subordinated debt finance, such as ‘stretch senior', ‘B notes' and other debt instruments occasionally offered by the banks. Such offers can appear attractive to the shareholders, which are keen to minimise the cost of capital to the business and maximise equity returns. A ‘package offer' from a single finance provider can also be more attractive than having to deal with two parties. Such forms of financing, however, share the motivational disadvantage of the mezzanine provider who relies purely on a redemption premium. What can begin as a seemingly cheap form of finance can ultimately become very expensive indeed.

Whether a business is a suitable candidate for mezzanine depends on a number of factors. As with all forms of finance of this nature, this will be determined by a review of the business, its market and its management. The latter not only includes an assessment of the team but will also seek to establish that they share the same objectives for the business as the shareholders. This is crucial to maximising the value of the business upon exit.

Such a business review will aim to identify both the key business risks as well as the opportunities in its business plan. The results will be taken account of in determining the degree of financial risk that can be placed on the business and, consequently, the degree of leverage that can reasonably be applied. It will also be instrumental in shaping whether a mezzanine investment takes the form of ‘junior debt' or ‘senior equity'.

Mezzanine as expansion finance

Mezzanine is ideally suited to financing expansion in the various forms it takes. This can be via corporate acquisition, an expansion of manufacturing facilities or products, or a move into new markets. Expansion of sufficient magnitude may not be affordable from the resources of the business alone, generating the requirement for third party investment.

Expansion financing can represent an unattractive opportunity for bank debt. Corporate acquisitions contain inherent risks for a bank that at worst are insurmountable and at best time-consuming to get comfortable with. New product development, as with an expansion of facilities, involves both the risk of cost over-run and the fact that there is often a considerable time lag between the investment being made and the eventual cash flow. This may make it difficult for a company to meet the repayment profile required by a bank.

For much the same reasons as discussed in the previous section, the equity providers for their part will wish to maximise shareholder returns by avoiding unnecessary dilution of their stake in the business, and can use mezzanine as a less dilutive form of junior finance than equity.

The role of mezzanine in expansion finance can best be illustrated with an example.

Case Study: ‘Globalise GmbH'

Globalise GmbH (“Globalise”) is a German Mittelstand company providing globalisation services to industry. Globalisation involves the authoring, translation, layout and publication (in either printed or electronic format) of technical documentation. These services are used extensively by, for example, the automotive industry, where all the documentation associated with a new model needs to be accurately translated into many languages. Considering the amount of documentation that typically accompanies a new vehicle launch (purchaser manuals, service handbooks, repair guides and part descriptions, to name but a few) and the number of countries that they are sold into, this can represent an enormous task.

Globalise is an independent full service provider of globalisation services, with capability of translating into all principal languages using native-speaking technical experts. It has also developed a proprietary ‘block-editing system' designed to automatically translate blocks of text which it recognises from previous translation tasks, thereby significantly reducing duplication of translation that has already been carried out by the company. Although a relatively small business with sales of some DM50 million, it has grown rapidly and achieves high operating profit margins.

Some months previously, the one founder manager, wishing to reduce his involvement in the business, had accepted an offer from a professional management team to acquire a majority stake in the company. Their aim was to expand the business and either float it or achieve a trade sale. Key to this strategy was strengthening of the customer base and its geographic reach. The management team had identified a suitable acquisition candidate in a UK technical authoring business, with sales of some £20 million, that was being sold by a large engineering conglomerate. The management team agreed an acquisition price of DM20 million, and began seeking both financing for the acquisition and a further DM20 million to support the continuing growth of the business.

To finance the acquisition with bank debt was not feasible. Leverage was already above 60 percent and, because of the nature of the business, it had few assets to offer as security. Additional debt would also have been inappropriate for the risks relating to the acquisition. Equally, the management team was not supported by an institutional investor with ‘deep pockets' and a pure equity investment from a new investor would have been very dilutive to the current shareholders. Mezzanine was the best form of finance.

The management raised a mezzanine investment which was provided to the company in two tranches: one of £7m (DM20m equivalent at the time) to fund the acquisition in the UK, together with growth capital of DM20m. The loans were subordinated to the existing bank debt and secured on the shares of the holding company. Both attracted a fixed rate of interest. The equity interest was in the form of an option, exercisable into the business at a pre-agreed price.

In this case, mezzanine had a number of advantages over alternative funding sources. In an already leveraged company, the facility was structured as ‘senior equity' to strengthen the balance sheet. It was less dilutive to the existing shareholders than conventional equity and provided the company with a financial investor with substantial resources, placing the business in a strong position to be able to respond quickly to future acquisition opportunities. Furthermore, the investment was structured in a manner best suited to the circumstances of the acquisition and the cash flow profile of the business.

Adrian Lurie is an Investment Manager at Indigo Capital, a dedicated provider of mezzanine capital to growth-oriented businesses across Europe, where he has focused on UK and German investments. Indigo Capital was founded in 1999 by the former principals of Kleinwort Benson Mezzanine Capital, an established mezzanine provider, with experience of investing more than Euro 300 million across a broad range of industry sectors throughout Europe. Prior to this, Lurie was a member of the Acquisition Finance team of NatWest Markets, where he focused on lending to management buyouts. He has a degree in Economics & Politics from the University of Warwick and the University of Konstanz, Germany.

Adrian Lurie, Indigo Capital Limited, 25 Watling Street, London, EC4M 9BR, Tel: +44 (0)207 710 7890, Fax: +44 (0)207 710 7777, E-mail: adrian.lurie@indigo-capital.com