Mezzanine or selling shares. Why capital that sounds like usury can be cheaper for the owner than a new partner

The most expensive financial decision we saw at Capital One Advisers last year was made by an owner who turned down mezzanine. He heard that it costs between 10 and 20 percent a year, called it usury and chose a solution that looked cheaper. He let a minority fund into the company. He gave it a third of the shares and a say in the most important matters, and he did so at a valuation from before the growth that was still to come. Mezzanine would have cost him a fraction of what he gave up in shares, and he would have remained the sole owner of the company.

I have changed the details so that neither the company nor the parties can be identified.

The owner knew the market. He got it wrong because he used the wrong point of reference. He heard an interest rate and instinctively compared mezzanine with a bank loan. When mezzanine is on the table at all, no further bank loan is available. The bank has already said “enough.” Mezzanine therefore has to be compared with selling shares.

In the previous article I described four routes to capital and how a company closes some of them off long before any conversation about money. This article is about the route that owners most often misunderstand. Most of them regard mezzanine as expensive debt. Compared with selling shares, it can be the cheapest capital for growth. There is one condition: the company’s value must grow faster than the mezzanine provider’s annual rate of return.

What mezzanine is

Mezzanine is financing that is repaid after the bank loan, but before any payout to the owner. Formally it is debt. The mezzanine provider gets its money back only after the bank, so it takes more risk and expects a higher return. The company’s assets are usually already pledged as security for the bank loan. The mezzanine provider therefore gets second-ranking security behind the bank, and often also a pledge over the shares. It uses them only if the company fails to repay the debt. Its entry requires an agreement with the bank that already finances the company. The bank has to be sure that its loan has priority of repayment, and if trouble arises it can stop payments to the mezzanine provider.

Why mezzanine sounds more expensive than it is

The rate that scares owners off describes the mezzanine provider’s entire target return on an annual basis. Out of current cash, the company pays only part of this rate each quarter. It settles the rest only after several years, when the financing is repaid. For a company that is investing in growth, this is a clear relief. The cash stays in the company and works for growth, instead of flowing out every quarter as interest.

Three components of the price

The first component is the cash coupon, that is, interest paid on an ongoing basis from the company’s cash flows. Most often it is roughly half of the provider’s target return. Only this part weighs on cash from the first quarter.

The second component is capitalized interest. It accrues and increases the debt, and the company repays it in one payment at the end, once the investment has had time to produce results.

The third component is a share in the growth of the company’s value, called a warrant. Formally it can be a right to take up shares, but in practice it is usually settled in cash, as a premium calculated on the increase in the company’s valuation. A large part of the provider’s profit comes from this component. The provider accepts lower current interest because it is counting on a share in the value the company has yet to build. The better the company does, the more the provider earns, so its interest here is aligned with the owner’s.

What the warrant changes

A loan without a warrant is ordinary subordinated debt, repaid after the bank. The agreement then obliges the company to pay all the interest and principal on time, regardless of whether the year was good or weak. The mezzanine provider shifts part of its return from interest to the warrant, whose value depends on the company’s future growth. As a result, the company’s fixed cash burden is lower than with ordinary debt of the same amount. In a weaker year the company has an easier time, and the risk of breaching the terms of the agreement falls.

The total cost depends on the result. If the company grows strongly, the warrant will be worth a lot and the provider will earn more than on ordinary debt. The warrant therefore turns part of a fixed cost into a contingent cost that grows together with the company’s success. For an owner who is investing in growth and believes in it, this is a favorable exchange. He pays more when he can afford to.

Mezzanine or selling shares

When the bank has said “enough,” the owner in practice has two routes: mezzanine or selling part of the shares to an investor. Selling shares looks cheaper, because there is no interest rate attached. Shares, however, are sold once and for all, at today’s valuation, usually before it reflects the growth still to come. An investor who takes a third of the company today will take a third of its future value, even if the company grows many times over. He will also get a veto over the most important matters. After a few years the fund will have to exit the investment. If the owner cannot buy back its shares at that point, the shareholders’ agreement often allows the fund to force a sale of the whole company.

Mezzanine is temporary. The company repays the principal, and the provider’s share in growth is set by a formula in the agreement. At the end of the financing, the company most often settles the warrant in cash, and the provider does not become a shareholder. The owner remains the owner and keeps control of the company.

A numerical example

The figures in this example are illustrative and do not relate to the company described above. Before the investment the company is worth PLN 78 million and needs PLN 39 million for growth. Once a fund pays this money into the company, it will be worth PLN 117 million. For its PLN 39 million, the fund will therefore take up one third of the shares. A mezzanine provider will lend the same amount. Let us assume for simplicity that its total return, including the warrant, will be 15 percent a year. After five years it will then collect, in simplified terms, PLN 78.4 million.

The fund will take one third of the value of the whole company. With mezzanine, the owner will keep the entire value of the company less what he pays the provider. If the company is worth PLN 290 million, the fund’s share will be PLN 96.7 million, PLN 18.2 million more than the mezzanine would have cost. If it is worth PLN 170 million, the fund’s share will be PLN 56.7 million, and selling shares will turn out to be cheaper by PLN 21.8 million. The two solutions cost the same at a value of around PLN 235 million. In five years the company therefore has to double its value, growing by 15 percent a year, that is, at a pace equal to the mezzanine provider’s rate of return. In reality, at PLN 290 million the warrant would be worth more. The provider, however, usually gets a small part of the increase in value, while the fund gets a third of the whole company.

With healthy growth, faster than the provider’s rate of return, mezzanine therefore costs less than selling shares at today’s valuation. With slow growth, the reverse is true. This calculation does not include control of the company, which the owner gives up when selling shares regardless of the result.

Two conditions

Two conditions decide whether mezzanine is a good choice for a company. Both follow from how the instrument is built.

The first concerns the cash part of the coupon. The company has to pay it from current cash flows year after year, alongside the installments on its existing bank loan. The bar is lower than business owners think, because only about half of the provider’s target return is paid on an ongoing basis. The company must, however, have cash flows stable enough to carry this expense even while the investment is not yet producing results.

The second condition concerns the pace of growth. Over the provider’s horizon, usually four to six years, the company’s value must grow faster than the provider’s total annual rate of return. With an unchanged valuation multiple, this also applies to EBITDA, which the owner tracks every month. Mezzanine works best where the capital finances a specific growth project, for example the acquisition of another company or an expansion of production capacity. The clearer the growth path, the more willing the provider is to lower the cash cost in favor of the warrant.

I repeat a simple rule to business owners. When both conditions are met, mezzanine beats selling shares. It provides capital where the bank has already said “enough.” It also costs less than a new partner, whom many owners turn to only because a partner does not sound like debt.

When mezzanine does harm

Mezzanine can also be the wrong choice. If the growth does not come, the capitalized part keeps accruing and the debt to be repaid grows faster than the company. A fund that has bought shares brings people and contacts to the company, and if things go wrong it shares the loss with the owner. A mezzanine provider usually does not help run the company and expects full repayment regardless of results. A breach of the terms of the agreement in a difficult year gives it the right to make demands on the company long before the repayment date.

The principal and accrued interest are usually repaid in one payment at the end, together with the settlement of the warrant, so at that point much more is due than the amount borrowed. If the company’s profit has grown according to plan, its borrowing capacity is much higher than at the start. The company then repays the provider from the cash it has generated and from a new, cheaper bank loan. If the growth did not materialize, the bank will not grant such a loan, and the owner negotiates with the provider from the weaker position.

The heart of the matter

At Capital One Advisers we like well-structured mezzanine deals. They provide capital for growth beyond the bank’s limit and leave control in the owner’s hands. With healthy growth they also cost less than giving up shares. We begin every such conversation by checking both conditions, before the question of the rate even comes up. This is another article in the series on ways of financing mid-sized companies.

The owner from the start of this article compared mezzanine with a loan he would not have got anyway. Had he set it against selling shares, the choice would have come down to one question, which remains open: who judges the company’s future pace of growth more accurately. The owner, who believes in his plan, assumes growth faster than the provider’s rate of return. The investor who is to buy the shares usually assumes slower growth and values the company according to his own plan. Which route was cheaper is known only after five years, and the decision has to be made today.

Service: Debt and mezzanine financing