The traditional financing channels for small and medium-sized enterprises include bank loans or equity financing. However, because some enterprises are asset-light enterprises and have relatively large intangible assets, it is difficult to obtain bank loans due to the lack of qualified collateral, or because the enterprise’s credit limit is insufficient. For some companies, such as family-owned companies, since equity financing will cause dilution and affect control of the company, there is not a strong willingness to use equity financing. Therefore, mezzanine finance came into being.

What Is Mezzanine Financing

Mezzanine financing refers to a form of financing that is between senior debt and equity financing in terms of risk and return. For companies and stock promoters, mezzanine investing often provides a very flexible form of longer-term financing that is less dilutive than the stock market and can be adjusted to specific needs. The payment matters of mezzanine financing can also be determined based on the company’s cash flow situation.

Applicable Conditions for Mezzanine Financing

Financing companies can generally consider mezzanine financing under the following circumstances:

• Lack of sufficient cash for expansion and acquisitions.
• The existing bank credit lines are not enough to support the development of the enterprise.
• The business has had a history of steady growth for many years.
• Have positive cash flow and EBITDA (operating earnings before interest, income taxes, depreciation, and amortization) for at least one consecutive year (the past twelve months).
• The company is in a growing industry or has a large market share.
• Management firmly believes that the business will grow significantly in the next few years.
• It is estimated that the company can go public within two years and achieve a higher stock price, but the current IPO market conditions are not good or the company’s performance is not enough to achieve an ideal IPO, so a round of mezzanine financing first can reduce the company’s total financing costs.

Sources of Return on Mezzanine Financing

Returns from mezzanine financing are typically obtained from one or more of the following sources:

• Cash coupons, usually with a floating interest rate above the relevant interbank interest rate.
• Repay the premium.
• Equity incentives, like warrants, allow the holder to exercise redemption rights through equity sales or issuances. Not all mezzanine financing has the same functionality. For example, investment returns may come entirely in the form of accumulation options or call option premiums, with no cash coupons.

Advantages of Mezzanine Financing

Benefits to Borrowers and Their Shareholders

Mezzanine financing is a very flexible financing method that can be adjusted according to the special requirements of the funds raised. For borrowers and their shareholders, mezzanine financing has the following attractions:

• Long-term financing. Many mid-sized companies in Asia still find it difficult to obtain loans from banks for more than three years. Mezzanine financing usually provides funds with repayment terms of 5 to 7 years.
• Adjustable structure. Providers of mezzanine financing can tailor repayments to match the borrower’s cash flow requirements and other characteristics. Compared with financing through the public stock and bond markets, mezzanine financing can conduct smaller financings relatively discreetly and quickly. The equity character of mezzanine financing also allows companies to benefit from lower cash coupons and, in some cases, the option to defer interest, payment in kind, or waive coupon options.
• Less restrictive. Mezzanine financing has fewer restrictions on corporate control and financial covenants than bank loans. Although providers of mezzanine financing may require observer rights, they generally have little involvement in the borrower’s day-to-day operations and do not have voting rights on the board of directors.
• Lower cost than equity financing. It is generally accepted that mezzanine financing is less costly than equity financing because the provider of capital typically does not require access to a significant amount of the company’s equity capital. In some cases, the nature of payment-in-kind can reduce equity dilution.

Benefits for Mezzanine Finance Providers

Mezzanine financing providers benefit from the following key features that distinguish mezzanine investments from typical private equity investments:

• An investment method that is less risky than equity. Mezzanine investments are generally higher grade than equity investments and have relatively lower risks. In some cases, the provider of mezzanine financing may be well-positioned concerning, for example, cross-default provisions arising from a default by a senior debt borrower, or a first or second-priority lien on company assets and/or shares. The equity gains from “equity incentives” can also be very substantial, and can increase the rate of return to a level comparable to that of equity investments.
• The certainty of exit is greater. The debt component of mezzanine investments usually includes a predetermined repayment schedule, which can allow the debt to be repaid in installments over some time or in a lump sum. The repayment pattern will depend on the cash flow profile of the target company for the mezzanine investment. Therefore, mezzanine investments provide a clearer exit path than private equity investments (which generally rely on a more uncertain liquidation method).
• Current rate of return. Compared with most private equity funds, a large portion of the returns on mezzanine investments come from front-end fees and regular coupon or interest income. This characteristic makes mezzanine investments more liquid than traditional private equity investments.

Mezzanine Financing and Financing Development

Mezzanine financing should be considered as part of the overall financing development strategy. Although the cost of mezzanine financing is relatively not cheap, sometimes it is the most appropriate financing method. Mezzanine financing is most suitable for MBOs, companies that have merger and acquisition plans can grow rapidly and are about to go public.

Most U.S. investment bankers believe that companies must issue more than 500,000 to 1 million outstanding shares to maintain active stock trading and support higher stock prices. At the same time, the stock price must be above $10-$20 to attract large institutional investors, while stocks below $5 are generally not attractive. Since the number of shares can easily be changed through splits and reverse splits, the price of the stock depends primarily on the market value of the business.

Conclusion

Since the market value of a company depends on the size of the company, that is, the company’s historical performance and expected performance, if mezzanine financing can greatly increase the company’s turnover within one year and also give the public confidence in the company’s profitability, That would put the company in a more favorable position for its IPO. Under such conditions, companies can use mezzanine financing to complete the transition until their market value is realized and proven, rather than conducting an IPO or private placement of equity at an undervalued value now.

If the company can IPO at a higher stock price in the future, it will reduce the company’s overall financing costs, which is why companies are willing to pay higher interest for a round of mezzanine financing before the IPO.