Mezzanine Finance In the UK and Europe

The term mezzanine finance as used within the UK is a description given to a combination of debt and/or preferred equity financing. Whether you are an investor seeking to place an investment, or a borrower seeking to maximise investment into a business, mezzanine finance is a popular and attractive solution.

Mezzanine lending is a sum lent or invested into a business on a junior basis that ranks in priority behind senior debt, but ahead of standard equity. By virtue of being subordinated to senior debt, which in itself often secures the main banking facility, the returns reflecting the risk are likely to be higher, proving the old adage: ‘a greater return for greater risk.’

What the funds raised are used for are largely immaterial, but dedicated mezzanine finance providers would typically expect to see it used for capital expansion and growth. They are often used in leveraged finance transactions, in conjunction with other sources of capital, to fund the purchase price for the target company being acquired. In those circumstances, mezzanine finance will typically be used to fill a funding gap between what the senior lenders can lend and what the private equity sponsor will itself invest.

In the UK, mezzanine finance can be made available through several different structures based on the specific objectives of the transaction. Mezzanine lenders look for a certain rate of return. This can come from cash or ‘payment in kind’ (PIK) interest, but also from an equity stake in the borrower.

Mezzanine finance is an appealing investment to lenders for a number of reasons. To compensate the lender for assuming greater risks, mezzanine lenders can expect to require interest rates in the region of 12 -20 per cent. While mezzanine finance can take the form of pure debt, it can also be taken as preference shares (preferred equity) or often a combination of both. Considerations by a provider are based upon its own model, market forces or the position a borrower can actually offer. It may also be attractive to the provider, who is looking to maximise returns on investment, but it can have the impact of locking away an investment, so careful consideration should be given when looking at the rules surrounding it. A debt/equity solution can be attractive when considering a senior funders’ financial covenant requirements. Rules surrounding equity would be set out in the constitution of a company and the articles of association and rules on interest payment and/or conversion to full equity would be governed by the mezzanine facility.

Mezzanine finance by nature is a complex arrangement and decisions as to what can be repaid and when, and what security is taken, needs to be considered. The senior lenders are likely to want to ensure that the mezzanine (and any other) debt is fully subordinated to theirs. The level of subordination is typically negotiated but it is usual for the mezzanine debt to be repaid only after all the senior debt has been repaid in full. However, payments, and/or interest payments during the term, can be negotiated.

Rules governing the ranking of debt and security will be governed by an intercreditor agreement. The inter-creditor agreement will typically act to protect the senior lender, agree on any co-operation terms and restrict the circumstances in which mezzanine lenders can take enforcement action in respect of mezzanine debt.

In the UK, most mezzanine lenders are likely to take security. In international mezzanine finance arrangements, the type of security that can be taken and is enforceable would be subject to the laws of the jurisdiction governing the mezzanine facility and the jurisdiction in which the secured assets are located. In the UK there are four types of security interest under English law, mortgage, charge, pledge and lien. Most commonly in the UK, you would see mezzanine lenders taking security over the assets of the borrower in the form of a debenture. If the borrower is a small company or is incorporated as a special-purpose vehicle entity, mezzanine lenders should also consider obtaining additional security from any group company or parent company – this can be achieved by obtaining a corporate guarantee. If the mezzanine lender is looking for the investment to take the form of preferred equity they should also consider requiring additional security over shares in a group or parent company of the borrower.

Mezzanine lenders may also include covenants into the mezzanine facility. Covenants are conditions that the borrower undertakes to comply with under the terms of the facility. Restrictive covenants can prohibit the borrower from securing further debt and some covenants might require the borrower to meet certain financial ratios.

Mezzanine lending may be a high-risk investment for lenders, but if careful consideration is taken, lenders can develop a strategy to maximise the long term value of their investment. Many of the risks associated with mezzanine lending can be mitigated through the appropriate use of security and the inclusion of the correct warrants and restrictive covenants.