Mezzanine investments

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Mezzanine investments

A mezzanine loan is one of the ways to invest. It is a hybrid of a bank loan and direct investment in a company. The investor gives a loan to the company and receives an income of 8-10% per annum.
In Europe and the United States, mezzanine loans are popular with investors. In Europe, mezzanines are mainly operated by banks and independent “investment boutiques”. Every fourth development project attracts mezzanine loans. In the United States, mezzanines are operated by insurance companies, pension funds, and special purpose funds.
In other countries (for example, in the post-Soviet countries) the overwhelming majority of investors do not know about mezzanines or do not use this financial instrument.
So, what does an investor get?
Profitability. The investor receives a yield of 8-10% per annum.
Algorithm. The investor gives a loan. He has no operational problems associated with owning an investee. The investor does not need to open companies abroad, does not need to notify the tax authorities at the place of implementation of the project about the Controlled Foreign Company.
A way to invest. Invest in mezzanines remotely from any bank account.
Investor protection. The investor is protected by a pledge of an object or a pledge of shares in a project company. So in a negative scenario, the investor gets the opportunity to control the initiator directly or receives shares of the company that owns the investment object.
Amount of investment. The investor gives a loan to the initiator of the project. Loan amount – from € 20 thousand to several million.
How does an investor receive mezzanine payments? The mezzanine combines the attributes of bank credit and equity. For an investor, this means that a mezzanine loan has a maturity, repayment and clear payments. In some cases, the investor may have corporate rights, in others – to participate in the company’s profits. The company takes a mezzanine loan from an investor and a bank loan. The company first pays off the bank loan, then the mezzanine loan. Only then does the company receive the rights to the remainder of the profit. That is, in order to get its profit from the project, the company first pays the investor for the mezzanine loan.

The investor receives profit in three ways:
  1. a fixed percentage that is paid regularly – for example, once a quarter;
  2. deferred interest (Pay in Kind – PIK), which is paid at the end of the period, but capitalized once a year;
  3. payments that allow you to participate in the growth of the company’s value (equity kicker). Such participation can be structured through options, warrants or penny warrants. This usually allows you to acquire 1–5% of a company share.

A mezzanine loan combines several financial instruments with different levels of risk and return. For example: subordinated debt, certificates of participation in the company’s profits, rights or warrants for shares of the company. The mezzanine loan is repaid according to two principles:
  • subordinated to bank financing. The loan is paid after the obligations of the issuer for a bank loan;
  • a mezzanine loan has precedence over equity. The issuer is first required to pay all mezzanine financing commitments in order to be entitled to the remaining earnings.

What kind of investors is a mezzanine loan suitable for? Mezzanines are suitable for an investor in two cases:
  • if he is not chasing super profitability;
  • if he is willing to bear a moderately higher risk compared to placing money on deposit with a bank or buying bonds.
Why do companies need mezzanines? Mezzanines help companies that generate positive cash flow to grow. Usually, mezzanines are needed in mergers and acquisitions of companies, in capital restructuring, for share buybacks, in project financing. Companies attract mezzanines in two cases: 1) when they do not have enough equity capital; 2) when it is expensive to use equity capital.

Mezzanine financing allows the company to reduce capital costs and improve return on equity. When a company organizes its capital structure by using more leverage, the cost of capital (WACC) decreases and the return on equity (ROE) increases.

What are the mezzanines? Mezzanine loans involve different financial structures:
  1. the investor provides a mezzanine equity loan with a secondary pledge of assets and guarantees from operating companies;
  2. project bridge, for which the initiator buys out tangible assets, improves them, develops permits;
  3. the investor buys shares in the capital of a company with a separate class of shares, call options, various warrants – the right to buy the company’s shares.
How to choose a mezzanine project? To select an effective mezzanine project, you need to analyze it and assess the risks:
  • estimate the cost and selling price of the project. Often, initiators underestimate project costs and optimistically overstate the sale price. For an investor, this means that the risk is higher than the initiator says. Therefore, first of all, it is necessary to evaluate the financial models of projects, the cost of construction / production and the sales price;
  • evaluate the tenant or operator. The tenant must deal with their obligations. To evaluate the tenant, you need to analyze the economics of the project and the contract. Everything is in order in the project if the economy of the project allows the tenant to pay interest on the mezzanine, and the contract is not less than the term of the mezzanine loan;
  • evaluate the capital structure. The amount of the share capital in the project must not be less than the mezzanine loan. Ideal distribution of funds in a mezzanine loan: 60% – bank loan, 20% – company shares, 20% – mezzanine.
The key point with a mezzanine loan is the equal ratio of the company’s share capital to the mezzanine. In some cases, the ratio is unequal. If the project is of high quality and has been tested, then this is permissible. In such projects, the investor’s risk is higher, so the investor can demand a higher percentage of profitability.

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