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6 reasons why SMEs and mezzanine capital are a perfect fit

Privately held firms cannot achieve the same sort of fluid capital flows as publicly held firms. However, mezzanine financing offers a way to deal with the need for increased capital without going public or giving up control. 

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A mezzanine facility is a hybrid-financing instrument that allows a company to issue debt that can have a variety of structured terms such as periods of interest only, a blend of interest and equity or profit sharing added return options, and in some cases equity convertibility. These loan structures can involve collateral for firms with less robust cash flows or even little or no collateral for strong cash flowing companies.

Mezzanine can be an ideal fit for certain SMEs that can’t access venture capital or are not ready to give up equity and control in the firm. Outlined below are 6 reasons why mezzanine finance can be an extremely useful instrument for SMEs in need of capital.

Why SMEs and mezzanine are a perfect fit

  1. Ideal for firms that can’t go public: Many SMEs are not far enough along in their development for an initial public offering, operate in geographies without strong liquid public markets, or their owners don’t want to relinquish firm control. As long as the firm has a sound track record, stable cash-flows or liquid assets, and an experienced management team, mezzanine can provide the capital needed without giving up control or material ownership. 
  2. Increases the firm’s credit rating: Use of mezzanine finance in the capital structure of a firm can lead to eventual increased access to traditional bank debt financing. Debt incurred through mezzanine facilities is classified as “subordinated debt”, considered largely equivalent to an increase in equity by banks and other traditional borrowers. The more favorable ratio of equity to debt can lead to an improvement in the firm’s credit rating.
  3. Improves other loan terms and conditions: Banks often look more favorably on companies that are backed by institutional investors such as mezzanine lenders or private equity shops. This can lead them to extending more credit under more attractive terms as a result of their reputation and their expected increased involvement with the firm.
  4. Diversifies sources of financing: Mezzanine lenders can help entrepreneurs to diversify their banking relationships, thus acting as a source of reserve capital and reducing dependence on any one lender.
  5. Lowers financing costs: Returns on mezzanine finance are higher than those on senior debt but lower than those on equity. Mezzanine investors generally target a 15-25% internal rate of return compared to more than 25% for equity investors. Therefore, mezzanine financing can lower SME financing costs with respect to equity. 
  6. Allows for greater flexibility: While mezzanine debt is more expensive than bank debt, it is not as rigid. Generally, mezzanine finance share similar arrangements as bank loans, but terms can be more flexible. For instance, providing larger debt amounts, adapting amortization requirements to the SME’s needs, permitting a broader use of funds.
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