Mezzanine deals have always been regarded as one of the top-notch forms of financing, mainly because of their complexity. Historically they have been (and still are) associated with M&A activity, especially leveraged buyouts, which is indeed a form of financial art. Thus mezzanine financing is often viewed as boutique, hand-crafted magic, which it basically is at the moment. But that is about to change. Economic turmoil, rising interest rates and the ever toughening bank regulation pushes more businesses of smaller size to revert to mezzanine financing as a vital way to expand, grow and survive. In order to meet the booming demand, lenders must reinvent their approach to mezzanine deals. Scaling this segment seems viable only through employing technology at each and every step of the process.
This article delves into the transformational potential of automating financial reporting within the realm of mezzanine firms. Authored by Alexander Koptelov, Head of Merchant Banking Innovations and Managing Director, Founder p2p lending platform, this piece offers unique insights shaped by years of experience at the forefront of banking innovation.
Quick glance at mezzanine finance
Mezzanine financing sits between senior debt (like conventional bank loans) and equity capital. It is a hybrid way of financing, as it often embeds an equity or payment in kind (PIK) option. Combining some features of loans and equity, mezzanine covers the gap between them and often comes handy. Let’s say company A wants to make an acquisition or launch a new business project worth $100 mln. But A only has $15 mln of its own capital that it is willing (or able) to commit to this deal. Banks are reluctant to lend the remaining $85 mln to fund 85% of the project or acquisition and are only comfortable with 70%. It is here when a mezzanine lender comes to help, providing A with another $15 mln. Now, the remaining $70 mln can be obtained from a bank and the project can get rolling.
For the lender, mezzanine debt provides a stable and predictable cash flow as it typically employs monthly payments. The interest a typical mezzanine deal usually generates for the investor is anywhere between 12% and 20% and sometimes even more. This is a risky investment, as mezzanine debt is subordinate to senior debt like bank loans. But in case of a default it usually provides for an option to convert part of the debt into borrower’s equity. For the borrower, such instruments come pricier than conventional loans, but potentially cheaper than equity capital. Also, mezzanine financing can be available in situations when bank loans are out of reach or insufficient. At the same time, the borrower can be more comfortable as mezzanine financing does not dilute control over the business, at least not until the equity option is exercised.
The exact terms and execution of mezzanine deals can vary greatly. They can include the following elements in different combinations:
- Cash interest — A periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing. The interest rate can be either fixed throughout the term of the loan or can fluctuate (i.e., float) along with LIBOR or other base rates.
- PIK interest — Payable in kind interest is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the principal amount of the security in the amount of the interest (e.g., a $100 million bond with an 8% PIK interest rate will have a balance of $108 million at the end of the period but will not pay any cash interest).
- Ownership — Along with the typical interest payment associated with debt, mezzanine capital will often include an equity stake in the form of attached warrants or a conversion feature, similar to that of a convertible bond. The ownership component in mezzanine securities is almost always accompanied by either cash interest or PIK interest and in many cases by both.
- Participation payout (“equity kicker”) — Instead of equity, the lender may take an equity-like return in the form of a percentage of the company’s performance, as measured by total sales, or EBITDA as a measure of cash flow, or profits.
- Voting rights / veto rights – mezzanine deals often include voting and / or veto rights granted to the lender by acquiring borrower’s equity or a “golden share”. This way a lender is entitled to approving some of the borrower’s decisions that could potentially hamper the lender’s interests, e.g. CEO replacement, large commitments to third party projects or altering the corporate structure.
From haute couture to prêt-à-porter
The wide array of elements and an even wider range of their combinations fully explain why mezzanine deals are one of the most complicated fields in the financial sector. Most of them are organised by specialised funds. Many of them perform just a handful of such deals per year, often assisting the M&A activity. It is challenging to compose such a deal in the first place, as it requires thorough due diligence and creating a deal structure that matches the unique circumstances of the borrower and of the project involved. FInally, the complicated composition of mezzanine loans can make it challenging to reflect such assets in a correct manner on the fund’s balance sheets. Even here automation can be of great help and reduce the workload in collecting information about potential borrowers, analysing the structure of previous deals and matching it with new clients’ input, automated reporting and back office routine.
But imagine a mezzanine financing business scaled up from several to tens or even hundreds of deals per year. Many prerequisites for such an outcome have already been met. Mezzanine funds recently boasted a stellar performance in terms of committed capital. According to PitchBook’s H1 2023 Global Private Debt Report, private debt attracted $94.9 bln in the first six months of 2023 (surpassing the same period of 2022) and was on the way to exceed $200 bln in 2023 (no complete data for last year was available at the time when this article was written). Mezzanine debt ranked second after direct lending strategies, accounting for a stunning 27.9% of all fundraising, more than twice as much compared to 12.3%, an average scored over the last five years.
More fundraising means more deals. But there is another significant factor that might indicate an even bigger number of expected deals, although arguably of smaller individual sizes. The point of making mezzanine wizardry available to the wider public, especially small and medium enterprises (SMEs) came to the mind of Organisation for Economic Co-operation and Development (OECD) as early as 2012-13. Dictated by the slow recovery tempo after the 2008-09 financial turmoil, despite record-low interest rates, the idea was to broaden the financing tool inventory available to SMEs to help them pass through strained times. A more recent report by OECD confirmed that policymakers took steps to make mezzanine financing more popular, which even involved launching publicly-funded mezzanine funds in Canada and Austria.
However, it is not the public funds that are going to be the main engine of mezzanine business growth in the near future. Paul Wilson, Chief Investment Officer at Channel Capital Advisors, sees that the new mezzanine era is going to be driven by fintech startups and other ‘alternative lenders’. “As well as a reluctance to lend due to their high-risk perception, the financing processes at traditional banks are often slow and impersonal, as many of these institutions have been slow to fully adopt technology-based digital lending”, he said in an article for the International Banker. “As such, more SME lending is required. But if SME lenders cannot secure attractive funding terms to on-lend to their clients, a vicious cycle is created. This is where innovative fintech plays a vital role, with alternative lenders stepping in to fill the funding gap. And mezzanine finance is key in facilitating this”.
Tech is the key
So, the automation that looked helpful but maybe still optional for scarce large deals in old mezzanine tradition, now seems inevitable and even vital if we think about hundreds of smaller deals involving SME borrowers. Scaling means standardising, industrialising and ultimately automating as many processes as possible, no matter what sector we are talking about. Mezzanine deals incorporate a myriad of instruments such as loans, stocks, options, and corporate rights. Managing and accounting for these deals places a substantial burden on business units, significantly heightening operational risks and constraining the pace of business growth. Also, doing this without a systematic approach would inevitably lead to operational errors and accounting mistakes.
Building an accounting system for such complex deals is akin to constructing a structure from a Lego set. Each financial instrument (tranche, loan, stock, option, etc.) breaks down into numerous parameters that need meticulous attention, from filling in payment dates for a decade to verifying the correctness of commissions and option dates. These individual product instruments then come together to form financial instruments; for instance, combining stock purchase with a sale option transforms it into a Repo deal, which is accounted for in a specialised manner in financial reporting.
Ultimately, creating such a reporting system allows for the construction of the entire financial company’s / fund’s cash flow. It enables easy modifications to transactions by altering only the deal’s input parameters, conducting stress testing based on various parameters, tracking different risks, and monitoring option expiry dates.
The result? Building an accounting system not only aids in financial reporting but significantly reduces operational risks, creating a portfolio management tool and risk assessment element. Also, it would enable scaling the mezzanine business to a scale previously unseen in this sector, but supported by the demand and the changing economic situation.
