Access to International Liquidity for Greece’s Corporates: Mezzanine Debt?

by Sophie Papasavva, Partner at EMFC Loan Syndications
June 2013

 

Introduction

Mezzanine capital is a long-term finance instrument, that is typically non-amortising. Mezzanine ranks second secured in the capital structure of a company and is thus subordinated to bank debt. As a hybrid instrument that is positioned between senior loans and equity, mezzanine typically contains characteristics of both debt and equity.

Originally developed in the North American market, mezzanine is also an established finance instrument used actively in the European capital markets. In more emerging parts of the continent, such as Central and Eastern Europe, mezzanine has evolved from a niche instrument used in a limited number of financings to a mainstream, widely understood form of leveraged finance and provider of growth capital. Indeed, following the peak of the economic crisis a few years ago in Europe, the demand and use of mezzanine has increased significantly. Given its advantages as a financing tool including smaller size, lower structuring costs and higher flexibility, mezzanine has become a favourite subordinated debt instrument in emerging Europe. Whilst this is not yet the case in Greece, perhaps the current economic environment might give rise to more cases of mezzanine being used by corporates, investors and bankers and perhaps mezzanine offers an option to finance that may otherwise not be obviously present.

Key Characteristics

As a loan instrument, mezzanine capital is ranked behind senior debt in terms of security and cash payments (both interest and principal), however, it requires a higher return than senior debt to compensate for the higher risk associated with its subordination. Mezzanine loans are typically secured on the assets of the borrower albeit in a junior position to senior secured lenders (banks).

Key Characteristics

A mezzanine loan is also typically structured to offer the mezzanine provider some form of equity upside, providing the opportunity to share in any upside associated with the growth in the borrower’s equity value through warrants or options. Thus the mezzanine providers’ interests are aligned with equity investors for growing the value of the businesses they invest in. In this respect, mezzanine providers are content to receive income through a combination of cash-pay coupon, Payment-In-Kind interest (“PIK”) and equity warrants. Mezzanine generally gives its provider the legal right to convert the subordinated loan to an ownership or equity interest in the company if the mezzanine is not fully repaid on time. Typical characteristics of mezzanine loans include:

  • Fixed interest rate
  • Aggressively priced / higher interest rate (in consideration for subordination)
  • Long-term
  • Deeply subordinated (with limited enforcement rights compared to senior lenders)
  • Secured (on second rank basis) or unsecured.

Some key benefits of using mezzanine to finance a company are shown below:

Stakeholder

Benefits

Borrower

long-term, flexible financing instrument
represents a source of finance when bank debt is unavailable or unsuitable
puts less strain on the borrower’s cash flow than bank debt, without inhibiting further growth
compared to bank debt, mezzanine is less restrictive
a mezzanine provider with equity upside is incentivised to support the company´s growth

Investor

represents a proven concept for enhancing equity returns
is cheaper than investing additional equity and proven to increase equity returns
reduces the equity requirement
its interest is often tax-deductible
use of mezzanine allows for larger transactions and/or a higher level of competitiveness in tenders for leveraged buy-out auctions
compared to senior (bank) debt, mezzanine is less restrictive

Senior Lenders

is contractually subordinated to senior debt; senior lenders maintain priority on all contractual fund flows
provides an additional, quasi-equity layer in the finance structure
typically has less restrictive financial covenants.

The main drawback from a borrower’s point of view, is that in consideration for making a loan which is subordinated to senior lenders, mezzanine capital is expensive, often priced at a double-digit margin. Moreover, it is important to note that there is scope for conflicts of interest between senior loan and mezzanine loan providers, with the inter-creditor agreement being a very important way to ensure clarity as to the relative rights and obligations of the different classes of  lender arrangements.

Common Uses

Senior lenders will determine the amount that they are prepared to lend based on the debt capacity of the borrower (or a project), using a debt to EBITDA leverage ratio amongst other metrics. Similarly, debt to equity financial covenants determine the minimum level of equity that must be available and / or newly injected by the shareholders in order for a borrower to be ‘bankable.’ Mezzanine is typically used to fill the gap between available financing by senior banks and the investment by equity sponsors.

Alongside private equity firms, mezzanine providers lend capital to assist proven management teams in buying their businesses from existing owners (management buy-outs) or in acquiring new business to add to their portfolio (leveraged buy-outs). Mezzanine fills the gap where some but not all of the financing requirement is fulfilled by banks, and where the equity sponsors seek an alternative to injecting more cash equity. Mezzanine providers invest longer-term capital in companies that seek additional finance to fund further growth, either through add-on acquisitions or organic expansion. As mezzanine is a non-amortizing, long-term loan, it is particularly suitable for high-growth companies as more of the cash flow is retained in the company to fund expansion, rather than being used to amortise bank debt.

Mezzanine capital is also used to enable companies to streamline their existing debt structure, for example in reducing the proportion of short-term amortising loans. Mezzanine can also be used to buy-out minority shareholders or, in certain circumstances, it may be used by existing shareholders to achieve liquidity without ceding control.

Mezzanine in Western Europe

In Western Europe, mezzanine is most actively used in leverage buy-outs and has formed an important source of liquidity, that remained partly available in the aftermath of the economic crisis in Europe, where banks’ lending appetite diminished. In leverage buy-outs, it is the private equity investor / sponsor that decides whether there is a funding ‘gap’ and thus whether a mezzanine tranche will be included in the financing structure, often guided by the terms they are offered by the banks.

As mentioned previously, mezzanine may be an expensive option, especially where general liquidity is tight, therefore it is not surprising to see that those private equity sponsors that had relied on mezzanine during 2009-2010, are now tapping into the market to try and re-finance their mezzanine with cheaper bank debt.

In April 2013 Dutch information provider Bureau Van Dijk Electronic Publishing signed a €140m-equivalent add-on term loan. The new loan matures in 2018 and its use of proceeds is intended to repay an existing €140m mezzanine loan carrying interest of 7% cash and 3.25% PIK. British payment processing company WorldPay’s £343m mezzanine loan was put in place in support of Advent and Bain’s £2bn buyout of WorldPay in 2010; the mezzanine formed part of a wider £970m financing and paid 12% interest.

Another innovation of the Western European market has been the unitranche, which is a blend of senior and mezzanine financing. Unitranches are an alternative to syndicated leveraged loans, mainly to small- and medium-sized borrowers seeking debt that has no amortisation payments and is provided by a single institution. It is not uncommon for unitranches to pay double-digit margins. Providers of unitranches include institutional investors such as Axa’s private debt unit, which has invested more than €700m in the debt class since 2011. Despite their uncommon structure, unitranches are also popular with some borrowers as a result of banks, particularly in the medium-sized market, having pulled back from lending to riskier companies that are backed by smaller private-equity firms.

Mezzanine has also been used in western European project financings. Here, mezzanine is usually made available at the project company level which entitles the mezzanine providers to distributions in the form of excess cashflow after senior debt service, but ahead of the shareholders. In project finance, mezzanine can often fill a critical shortfall between banks’ senior debt capacity and equity funding, offering a financing alternative for a project that has reached the limit on borrowing capacity and where shareholders prefer not to issue new equity. The form of mezzanine finance may include:

  • Subordinated / junior tranche
  • Preference shares
  • Convertible notes (convert from debt to equity at a certain date)
  • Hybrid securities, hybrid loans.

Indeed, across several mature financing markets, there have been several instances of institutional investors providing mezzanine in project finance.

Whilst the above instances describe a more mature financing market than what Greece may be experiencing at the moment, it is encouraging to see that innovative structures, albeit expensive ones, are becoming available for smaller corporate borrowers. At the same time, mezzanine is finding itself in longer-established non-recourse structures such as project finance. As has been the case time and time again, such structures, liquidity and general market appetite eventually trickle through from western Europe to less mature markets and it is encouraging to know that such structures have been tried and tested elsewhere, before potentially being made available to Greece’s corporates.

Mezzanine in Emerging Europe

The use of mezzanine in Europe’s emerging economies has to-date been effected by only a small group of providers. A combination of limited appetite for risk, plus providers concentrating on the larger corporates, has resulted in only a few strong candidate borrowers for the instrument. The telecoms sector has been the single exception, where US and UK institutional investors with a good understanding of the sector have been willing to take on the risk, however, such transactions are generally well-banked.

Emerging Europe’s corporates or private equity investors seeking to ‘fill the gap’ in their financing efforts, have only a handful of mezzanine providers to turn to. Darby Private Equity, Mezzanine Management, SEAF and Syntaxis Capital, are all active mezzanine providers in Central and Eastern Europe, with years of experience in this field. For such mature mezzanine providers, even the services industry (with limited or no fixed assets) can be attractive and several mezzanine loans have been closed by them in recent years, across several East European countries and in a variety of industry sectors.

Of particular interest are some of the investments closed by Emerging Europe’s mezzanine providers in southern Europe, where mezzanine has been a rarity. Examples of mezzanine borrowers have included Serbian Broadband and DDSG-Cargo (water transportation) in Serbia, EuroHold (conglomerate), Teletek Electronics and Ceres (industrial farms) in Bulgaria, TotalSoft (software), Lipomin (mineral water bottling), Imcorp Group (construction) and Labormed (pharmaceuticals) in Romania, Krug (publishing) and On.net (internet service provider) in FYROM.

Final Thoughts

Whilst the use of mezzanine in Southern European buy-out transactions has sometimes been in the absence of banks offering leveraged finance, Greece has yet to see evidence of such. In Western Europe mezzanine typically accompanies senior leveraged finance structures, however, in Southern Europe, where banks have not actively used the leveraged loan to facilitate private equity investments, mezzanine sometimes appears as the only option. Sometimes accompanied by a working capital line and sometimes by a capital investments line, but not necessarily in a leveraged finance form. This innovation by Europe’s private equity investors active in the mezzanine space is very encouraging for bank markets that are either not mature or that have suffered in the way that the Greek bank market has suffered.

There remains no publicly-announced evidence today that mezzanine providers are actively seeking opportunities in Greece. Unfortunately for Greece’s corporates, the state of affairs in the country implies that very few financing structures are likely to attract international liquidity and whilst mezzanine may be one, it is certainly unlikely to be used on its own. Still, we note that the mezzanine instrument has been tried and tested in countries very close to home and that is indeed a positive. But for Greece today, private equity first, then short-term trade finance, then tightly secured off-shore project finance and then maybe, just maybe, some form of quasi-equity instrument such as mezzanine. The sentiment against Greece remains such, that once again the most likely successful borrower will be one that seeks innovative structures that have an ‘international’ element to them and perhaps mezzanine may have a role to play there. It is a well-liked loan instrument that brings significant flexibility to a finance structure and we look forward to seeing it used more actively in Greece and the region in the coming years.

Sophie Papasavva

Sophie Papasavva

Sophie Papasavva is the Founding Partner of EMFC Loan Syndications (“EMFC”), a boutique firm assisting companies seeking to raise bank debt. EMFC offers Loan Execution Support, acting as an additional ‘in-house’ resource to time-constrained finance teams. Prior to establishing EMFC, Sophie was a loans banker for 12 years, first as telecoms, media & technology relationship manager and later in loan syndications and sales, where she gained experience in multiple sectors such as oil & gas, mining, infrastructure, agribusiness and others. Sophie has originated, structured, executed, sold, restructured and syndicated loan financings ranging from simple bespoke bilaterals to complex multi-billion dollar, multi-currency syndicated transactions. Her expertise lies in arranging structured, bespoke financings for corporate borrowers operating in the emerging markets. To contact Sophie, please e-mail her directly at sophie@emfc-loans.com or follow her on Twitter at @Sophie_EMFC.