Mezzanine finance may suit SMEs when the risks and opportunities of the business are increasing, but have insufficient equity backing, and for this reason, face difficulties in accessing debt capital. However, it is not intended to be a permanent feature of the capital structure. Rather, it is applied at defined points in the business life cycle, in order to assist the company through certain transitions in its development.
The stages of firms ideally suited for mezzanine financing
- Young high-growth companies: A young high growth company that has used venture capital in earlier phases of growth may decide that it is more advantageous to use mezzanine finance for expansion capital. Since mezzanine finance is cheaper than equity finance, it results in lower financing costs and also diminishes the ownership dilution and loss control concerns for founding entrepreneurs that typically accompanies venture capital financing.
- Established companies with emerging growth opportunities: A large share of high growth SMEs are not fast growing recent “start-ups” but rather established companies that discover new markets segments. Some of these firms may not have the right profile to attract venture capital finance or the projected rate of return, though comparatively high, may not be sufficiently high to attract venture capital.
- Companies undergoing transitions and restructuring: Mezzanine finance can help to effect the transformation from a closely held family run business into a transparent company with professional management. The plan may ultimately lead to a sale to existing managers or to an outside management group. It can also anticipate an increase in equity and “cash-out” for the entrepreneur. Mezzanine finance is ideally suited to support spinoffs of parts of the business.
- Firms in need of strengthening of capital structure: Mezzanine finance can address financing constraints facing SMEs that are excessively leveraged, particularly those that are family companies, and can enable them to reduce their risk exposure. In the past, thinly capitalized firms have maintained access to debt financing based upon good relationships with banks. Following the recent financial crisis, however, many firms were forced to increase reliance on loans and/or official guarantees, and therefore are in need of pathways that help improve their capital structures.
- Leveraged Buy-Outs (LBOs): Mezzanine finance is often used in conjunction with leveraged buy-outs (LBOs). An LBO is a transaction that involves a company or asset that is purchased with a combination of equity and significant amounts of borrowed money, structured in such a way that the target's cash flows are used as the collateral to secure and repay the borrowed money. In most countries, the bulk of mezzanine transactions occur in the buy-out market.