Mezzanine financing

Mezzanine financing is considered one of the most flexible and innovative ways to raise funds for large businesses.

Originated more than 40 years ago in the United States, this advanced concept is now widely used throughout the world, especially in countries with mature financial markets. Its scope covers a wide range of projects implemented on the basis of balance sheet and project finance.

Mezzanine financing is used for investments in energy, agriculture, industry, infrastructure, as well as in real estate, both residential and commercial.

Link Bridge Financial LTDA LBFL, an international finance company headquartered in Spain, offers a wide range of financial options for the implementation of investment projects around the world.

We provide financial advice and professional transaction support, organize project finance schemes, and issue long-term investment loans on flexible terms.

The essence of mezzanine financing

Mezzanine financing is an intermediary between debt financing (such as obtaining a loan) and equity financing (issuing shares).

It has traits for both debt and equity capital. In this case, the form of protection of the invested funds is the future cash flows of the investment project, but not the assets of the borrower. In fact, mezzanine is a hybrid form of financing, most suitable for the implementation of large capital-intensive projects.

The term "mezzanine" comes from the Italian language and means "half", "middle" or "area connecting the floors of the building."

Historically, the first use of mezzanine capital was recorded in the 1970s.

Mezzanine funds originated in the United States and were then a revolutionary way to finance business. In Europe, such funds appeared in the 1990s, and their capitalization reached several hundred million euros in the first years of their existence.

These funds, which operate mainly in Central European countries, were created with the assistance of the European Bank for Reconstruction and Development (EBRD), which provided approximately 25% of mezzanine funds to support business activities in the region.

Mezzanine remains the leading form of business financing, which is gaining popularity around the world. It is intended mainly for companies whose plans for the implementation of large investment projects exceed the possibilities of a "regular" bank loan.

The mezzanine is also widely used for legal entities that are planning takeover of other companies and therefore need significant funds to complete such an operation. This method of financing is currently widely used by companies in situations where there is a significant gap between the financial capabilities of the business and investment needs. Mezzanine instruments can be used to quickly raise capital in case of a fast growing business.

Depending on the financial instruments used, mezzanine financing can be classified:

• Debt mezzanine (instruments similar to debt capital): unsecured loans, subordinated loans or loans received from project partners. These can be different debt instruments in which the investor's income is based on a fixed or variable interest rate.

• Equity mezzanine (instruments closer to equity). In this form, the investor acquires a part of the business, including access to information about the company, the ability to control its activities and influence development. Thanks to warrants, an investor can obtain shares in order to profit from the increase in the value of the company.

Mezzanine financing has the features of the so-called subordinated debt.

This means that the borrowing company first undertakes to repay the priority loans (the so-called senior debt), and only then the so-called subordinated debt is repaid. It is worth remembering that the mezzanine is a way of financing, not a source of capital. Depending on the specific project, this form (method) of financing may include various financial instruments. This can be, for example, bonds, loans or preferred shares.

Mezzanine funding can be provided by specialized mezzanine funds, venture capital funds or private equity funds (high risk financing).

However, it can also be a commercial bank. As a rule, private equity funds are ready to bear a very high risk associated with the invested capital, while expecting a high return on investment. On the other hand, lending banks accept an average level of risk, but require large collateral from customers.

The financing period is usually 5-10 years, and the debt is repaid once at the end of the specified period.

During the term, the mezzanine fund or financial institution receives only interest in accordance with the agreement, similar to the interest on a traditional loan. Mezzanine capital is usually paid out in a lump sum at the end of the funding period.

This solution reduces the burden on the cash flow of the business during the financing period. Thus, the profit remains within the company, which significantly strengthens its financial position.

Mezzanine financing distinguishes the additional income of the investor, which is determined depending on the pace of development of the company. This income is secured by a warrant, which makes it possible to buy a certain number of shares of the enterprise at a reduced price in the future. Investors' high risk is closely related to the expectation of a high return on investment.

Distinctive features of mezzanine financing include the following:

• Investors take on a higher level of risk than in the case of bank loans in order to share in the profits from the completed project.

• Financing is carried out over a long period (about 6-12 years), but it involves the payment of debt at the end of the term, without regular servicing of monetary obligations.

• The borrower retains the freedom to manage cash flows during financing, which allows accelerating the development of the project by reducing the debt burden.

• High flexibility of financing, since the conditions are adapted to the type of project and agreed by the investors with the borrowing company.

• Investments usually do not require a backing of company assets.

Only companies that generate predictable and stable financial flows can take full advantage of mezzanine financing.



These should be businesses with good financial health, long operating history, and experienced management personnel. This approach is primarily focused on companies that have been successfully operating in the market for a longer period with the prospect of further growth.

Unlike venture capital, mezzanine capital typically does not fund early stage startups, focusing on relatively mature projects.

The table below summarizes the most important differences between mezzanine financing versus traditional bank lending.

Criterion	Bank lending	Mezzanine financing
Economic criterion	Debt	Equity
Legal criterion	Debt	Debt
Expected return on invested capital	5-10%	15-25%
Acceptable level of risk	Low	High risk
Debt security requirement	Real estate or movable property	Cash flow of a project or shares
Return terms	Regular payments throughout the financing period	Payment at the end of the funding period
Tax effects	Interest as expenses	Interest as expenses
Possibility of changing conditions	Flexibility limited by contract	Very high flexibility of conditions

When to use mezzanine funding

Equity and debt are the two traditional pillars on which enterprise finance is based.

The providers of equity capital are the owners of the company (shareholders), while the providers of equity capital are usually banks, international financial institutions or other entities outside the circle of business owners.

The main ways of financing investment projects, in addition to equity capital, are various types of investment loans provided by banks. Companies are often unable to obtain a loan in the full requested amount on acceptable terms. This happens most often for two reasons. First, the company's creditworthiness is insufficient. Second, the company simply does not have enough assets to use as collateral for a loan.

In the event of these restrictions, the company faces a real problem: where to get financial resources if banks refused a loan?

The first answer may be the corporate bond market, which is underdeveloped in many countries, and therefore may not meet the needs of a particular business.

Capital injection by owners is not always in line with their plans or capabilities. In addition, the latter solution may be subject to a number of stringent requirements and restrictions.

Raising funds through the stock exchange is time-consuming, expensive and does not guarantee a satisfactory valuation of the company. In addition, it can be difficult for the company and its owners to accept new obligations associated with the company's listing on the stock exchange (for example, information obligations) or even the possibility of a business takeover by competitors.

In such a situation, an enterprise cannot implement the selected investment project, conduct and implement the results of its own research without informing other market participants, including competitors.

Lack of the required financial resources at the right time can lead to an irreversible loss of unique business opportunities.

Mezzanine financing will be a valuable solution for companies in good financial health.

The main task of this mechanism is to accelerate business development without additional risks. When choosing this method of financing a company, it is important to have experienced management and a well-defined company development strategy.

As long as the company's need for capital does not exceed its creditworthiness, mezzanine financing can be unprofitable due to higher costs compared to bank loans.

Mezzanine financing is ideal for:

• Expansion and growth of the company through mergers or acquisitions. The value of this company increases before the sale of its shares on the stock exchange.

• Financing the purchase of shares from a shareholder who decides to leave the company. Then the financial structure and ownership structure of the given enterprise changes.

• Implementation of large investment projects in situations where commercial banks refuse to finance the cost of the project in full.

• Long-term financing for the buyout of the company by a team of managers from the current owners.



Banks often assess a company's creditworthiness in terms of EBITDA and do not provide loans if the company's total debt to EBITDA ratio (Debt / EBITDA ratio) exceeds 4.

Of course, a financial institution's decision largely depends on the quality of collateral that the borrower can offer.

In the case of mezzanine financing, the ratio can reach 6, and sometimes even higher.

This actually means that the company can receive 50-70% more funds for the implementation of the project than in the case of traditional bank lending. However, the value of this criterion depends on many factors, including the following: the company's business reputation, its operating history, business plans and prospects, as well as the state of the industry and the current market situation.

Mezzanine capital is not suitable for newly established businesses.

These business entities are much more sensitive to all kinds of market risks. These companies have much smaller and, above all, less regular cash flows, so they cannot provide adequate collateral. They are viewed as risky partners for potential investors.

Debt capital in newly created companies is, of course, necessary for faster development, but this is also associated with an increase in financial risk.

Organization of mezzanine financing: procedures, tools, participants

The whole process of obtaining mezzanine financing consists of several stages.

The first stage is a preliminary analysis of an investment project, during which the main assumptions and the feasibility of such an investment are carefully checked. If it turns out that the project does make sense, the company begins to work more closely with the mezzanine fund. An initial analysis of the applicant company's financial condition and its market environment is performed.

Often this analysis is confirmed by due diligence carried out by external companies. The list of possible activities includes detailed legal, financial and tax due diligence and sometimes technical due diligence on complex projects.

Then the bank or fund offering mezzanine financing enters into a preliminary agreement with the company applying for this type of financing.

The preliminary agreement specifies the obligations of both parties, the conditions for the implementation of the project, the structure of the enterprise, as well as all the formal procedures associated with the implementation of the transaction. This document is not binding, but rather serves as a kind of basis for further negotiations between the parties.

Then, on the basis of this document, a corresponding financial agreement is prepared.

At a later stage, a detailed analysis of the situation of the company and the industry in which it operates is carried out. In this case, a detailed business plan for the project based on the most likely assumptions is critical.

The company must also be prepared to accurately articulate the planned strategy and convince the funding party that the forecasts are realistic. Legal documentation is being prepared for the entire transaction, a corresponding financing agreement specifying detailed terms of cooperation.

Mezzanine contracts are drawn up separately for each transaction, therefore they require detailed negotiations between the financing organization and the company. The capital provider is often given broad rights, such as a seat for a representative on the company's supervisory board.

Therefore, it is important that the decision to attract this type of financing is made with the approval of shareholders.

The agreements reached are coordinated with the so-called investment committee.

At the last stage, contracts are signed between the parties, after which the company is actually provided with mezzanine capital.

The instruments used in mezzanine financing are selected in such a way that the cost of financing clearly depends on the results of the planned investment project. In addition, these instruments should ensure that the debt is repaid at the end of the financing period and minimize costs.

The most commonly used mezzanine instruments include:

• Loan with equity participation rights. This is an option for financing investment projects, in which the company incurs expenses in the form of interest. The rest of the costs are borne by the owners only when the project is successful. The capital provider gets the right to buy a certain number of shares at a fixed price at a specified time. This right (or guarantee) in the case of mezzanine financing usually extends to a small block of shares, not exceeding a few percent of the capital. The price and number of shares is determined prior to the start.

• A profit share loan gives the lender the right to a share of the profit from the implemented investment project. The profit share can, for example, be set as a percentage of the annual net profit for a predetermined period of time. The actual cost of such financing may turn out to be too high given the strong financial flows of some investment projects.

• Bonds with zero coupon / discount. These are bonds for which the issuer pays off the entire amount of the debt, together with interest, on a one-off basis when the bond matures.

• Bonds with a warrant are designed to raise financing in which the company pays a portion of the amount in the form of an interest coupon on the bond.

• Convertible bonds are securities for which the coupon is paid by the issuing company of the bond.

An important feature of mezzanine financing is the ability to adapt conditions to the needs of a particular borrower.

There is no strictly defined documentation and conditions, which in the case of bank loans often make it impossible to provide funds. Each case is considered individually, and financing is selected taking into account the needs of a particular company. It's like a "tailor-made loan".

Mezzanine financing: advantages and disadvantages for large businesses

Despite the many advantages that follow from the above, mezzanine financing has some disadvantages for the parties.

The potential advantages and disadvantages of this method of financing should be carefully weighed when choosing a source of raising funds for a specific investment project. In many cases, the correct solution requires a combination of different tools.

The main advantages of mezzanine financing include the following:

• Detailed check of the business plan of the enterprise before starting investment. Before making a financing decision, the mezzanine fund subjects the business project to a detailed and comprehensive assessment. This helps investors validate their business assumptions and pinpoint potential threats in order to maximize the value and safety of their investment.

• Possibility of obtaining financing, despite the lack of sufficient collateral and low creditworthiness, which effectively closes the path to obtaining bank loans.

• Payment of principal only at the end of the contract. This makes it easier for the funded company to maintain liquidity for the entire period of the investment project.

• Flexibility in terms of financing and debt repayment. The solutions are tailored to the needs of the funded company, its capabilities and development strategy.

• Lower cost for company owners compared to issuing shares on the stock exchange or raising capital from a private equity fund.

• Maintaining full control over the company by the previous owners.

Mezzanine financing has more advantages than disadvantages, although two significant disadvantages should be noted:

• Relatively high cost of capital compared to the cost of a bank loan, which can be explained by the high risk for investors. In order for capital providers to achieve the expected rate of return of 15-25%, they must receive from the issuer a few percent of the company's shares (usually the contract provides for the possibility of buying 2-5% of the shares). Participation in the capital of the borrower is based on an assessment of the value of the company and financial projections.

• Necessity to conclude an agreement with many conditions that the financed company must meet. This could be, for example, provisions regarding the company's refusal to take on further bank loans, or a provision allowing the mezzanine capital provider to block the company's ability to make certain (risky) investments.

Mezzanine financing costs are associated with several types of payments.

They include the initial contribution of the proponent of the project, expressed as a percentage of the total funding. The company also needs to pay capitalized interest at the end of the funding period.

Thanks to this, the company is less burdened with financial costs during the entire term of the contract.

So, mezzanine finance perfectly bridges the gap between debt and equity financing, providing a high degree of business flexibility when implementing large capital-intensive investment projects.

To find out more about project financing, contact Link Bridge Financial LTDA LBFL experts.