Structured and mezzanine finance

Structured finance and mezzanine finance facilities can be used exclusively or in conjunction with each other to help companies to fund management buyouts (MBOs), acquisitions or ambitious growth plans and provide a real alternative to private equity investment.

In brief

• Structured finance explained
• Is structured finance right for you?
• Mezzanine finance explained
• How does mezzanine finance work?
• Mezzanine finance pros and cons
• What to do next

Structured finance is a relatively new concept but the idea behind it is a simple one. At any one time, a company might draw on a number of loan agreements: a term loan to fund investment; invoice discounting or an overdraft to cover the ups and downs of cashflow; or an asset-finance solution such as leasing, to free up cash. Often these arrangements are agreed independently of each other, perhaps with different lenders and at different times.

With structured finance, the various loans are worked out and agreed as part of a single package based on the needs of a company at a given point in its development.

There are several advantages to this approach. Rather than entering into loan/debt agreements on a piecemeal basis, the company and its lenders look at the strategic requirements of the business over a period of years and then tailor a unique financial support package. Typically, the various loans within the package will be repayable on a different timescale.

Structured finance packages are suitable for companies with a large and complex funding requirement.

For instance, it may be that a business requires cash to fund a particular project, such as the purchase of new equipment, while also needing credit to smooth over peaks and troughs in cashflow, or pay wages before revenue from a new order comes in.

In circumstances where a business owner may have had to surrender shares in return for cash from a private investor, structured finance provides a borrowing alternative. For some businesses, this can be perceived as an expensive price to pay for unlocking cash investment.

However, structured finance is not for everyone. As it is a bespoke service, it generally isn’t available to very small businesses and each bank will have its own turnover requirements. The best way to find out more is to contact your prospective lender.

It’s also worth remembering that securing a structured loan package will mean the bank taking a detailed look at your business plan, especially in cases where an unsecured loan is part of the package. The bank is also likely to look at factors such as the quality of the management team, although this can be seen as positive. For instance, if there is a hole in your line-up, the bank can help you identify your requirement and recruit accordingly.

Negotiating a structured finance arrangement doesn’t usually involve the kind of intense due diligence process that private investors carry out before parting with their cash. It will, however, be thorough and the bank may require financial due diligence to be evidenced and in some cases management and commercial due diligence may be required.

Charges will depend on the nature of the loan components and the lender’s perception of risk. The costs will be agreed on a case-by-case basis.

Mezzanine finance has grown more popular in recent years. It provides businesses with an opportunity to raise money in order to fund strategies that are seen as a risk. For instance, mezzanine finance often provides a source of funding for management buyouts or acquisitions.

As stated, mezzanine finance can form part of a structured finance package but again, it generally isn’t available to small businesses. Banks can provide mezzanine finance although venture capital funds are a key provider in the market.

From the bank’s point of view, mezzanine finance provides the lender with a higher than normal interest rate (in line with the risk), plus an arrangement that will allow it to share the success of the company.

Mezzanine finance can take a number of forms including subordinated debt, preference shares or convertible instruments.

It is something of a hybrid, combining conventional debt with a component that provides the lender with an additional payment when the borrower achieves certain performance targets.

Think of it this way: under normal circumstances, banks lend money and make a profit by charging interest. This is in contrast to “equity” investors, who make a return when a company does well and then sell their shares at a profit. Under a mezzanine arrangement, the lender charges interest but also profits from the company’s growth.

Mezzanine finance is often described as a hybrid of debt and equity and in a simple approach to investment solutions, is considered to rank after normal credit but before equity.

The mezzanine debt provider may sometimes wish to participate in board meetings or appoint a non-executive director, which can be viewed as both a positive and a negative by the business owners. Here are some other pros and cons of structured and mezzanine finance:

PROS

• It provides access to bank funding that might not otherwise have been available
• This kind of arrangement does not involve issuing conventional shares to the lender, so the value of any existing shareholdings in the company is not diluted
• Debt associated with a mezzanine finance arrangement is generally redeemed in a one-off payment rather than paid monthly over a period of years
• The repayment requirement does not put a strain on cashflow
• It is often payable after or over a longer period of time than normal credit terms.

CONS

• Mezzanine loans can be expensive, for example, if the bank is providing unsecured senior debt
• The single redeeming payout will involve a significant sum of money
• The exit payment could put significant strain on businesses that fail to fulfil their growth plans.