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CHAPTER 7. Hybrid Forms of Financing

Hybrid forms of financing, also defined as mezzanine debt financing and preferred equity, cover a range of flexible financial instruments with different technical characteristics, and may be combined to offer tailor-made solutions for specific financing requirements. These are not forms of capital financing which may be classified under traditional pre-existing forms, such as for example loan agreements, but rather forms of capital financing that are situated half-way between senior debt and equity, and which draw characteristics from both types of capital. This typically refers to mezzanine debt financing, which is fundamentally a subordinate debt, when the debt component is predominant, whilst the term preferred equity is used when the equity capital component prevails, and where there is hence a sharing of risk. For the sake of simplicity, the discussion of hybrid financing will refer to the more general term mezzanine,[1] unless it is specified in each individual case whether the debt or equity component prevails, depending upon the actual structure of the contract. Preferred equity solutions involve structured joint venture agreements in which there are two different classes of shares or fund units, under which the income and cash earned from the initiative may be distributed differently.

7.1 DESCRIPTION

The term mezzanine financing came into common use at the start of the '70s in the United States, and subsequently also in Europe in the wake of the merger and acquisition deals implemented with considerable reliance on borrowed capital. The name originates from a credit position which is paid out after the senior debt in different ways and to differing extents during the repayment of capital and interest, both during ordinary operations and following liquidation if the borrower becomes bankrupt. Nevertheless, in all cases it occupies a privileged position compared to traditional equity.

Thanks to its twofold nature, mezzanine financing is a highly flexible instrument which may make provision for different arrangements as regards the structure of projected cash flows, in such a manner as to adapt itself as far as possible in line with the requirements of the project financed. Depending upon the way in which the financing is structured (e.g. whether the debt or the equity characteristics prevail) it may come in the form of junior debt or preferred equity.

The use of mezzanine financing enables the debt ratio to be increased in order to obtain a higher equity expected return[2] or to meet financial needs in cases involving capital rationing.

Mezzanine financing is often applied within the real estate sector to trading and development deals, since it enables projects to be completed whilst retaining control over the initiative and participating in the profits, but with a lower equity stake. Mezzanine solutions are used in order to increase leveraging, which may be achieved without changing the level of financial risk for senior lenders, whose financial position will remain unchanged both in terms of their protection in the event of liquidation as well as the assets provided as collateral for the financing.

In particular, it is used in situations in which shareholders intend to maximize the financial leverage effect without being forced to issue additional senior debt.

EXAMPLE 7.1

The simple example set out below represents an investment project with a value of €5 million financed according to three different forms of structured financing shown in Figure 7.1:

1. Unlevered: only equity with 15% unlevered expected return (only operational risk).

2. Traditional financing: senior debt (cost 6% per annum) and equity with an expected return of 24% (operational risk and moderate financial risk).

3. Mezzanine financing: senior debt (6% per annum), mezzanine in the form of junior debt (for the sake of simplicity, at an average overall cost of 10% per annum), and equity with a levered expected return of 40% (operational risk and high financial risk).

Within the three scenarios considered, both the equity needs of the project and the WACC[3] are progressively reduced; if the property is sold for €6 million, the profit for each Euro invested in equity (equity multiple[4]) will increase exponentially as shown in Figure 7.2.

Structured financing, which also includes mezzanine financing, enables the (expected) return to be increased, albeit in return for a greater risk for shareholders, whilst lowering the equity necessary in order to complete the project.

Examples of different financial structures

FIGURE 7.1 Examples of different financial structures

Effects of different financial structures

FIGURE 7.2 Effects of different financial structures

EXAMPLE 7.2

A second simple example is proposed in which an income producing property is purchased, though with the possibility of a requalification project. The purchase value is €10 million, which generates cash flows (for the sake of simplicity, after all operating costs) of €700,000. A restructuring project costing €3 million (capital expenditure) would enable annual cash flows to be increased to €1.1 million. As in the previous example, there are three different scenarios.

(continued overleaf)

1. Unlevered, equity only:

• initial equity: €10 million;

• post capex equity: €13 million;

2. Traditional financing with senior debt (6% per annum) for an amount equal to 70% (LTC) on the initial investment and without capex financing:

• initial equity: €3 million;

• post capex equity: €6 million;

3. Mezzanine financing: alongside senior debt, mezzanine financing in the form of junior debt is used (for the sake of simplicity, at an average overall cost of 10% per annum) for an amount equal to 20% of the initial investment (which increases the overall LTV from 70% to 90%), thus financing 90% of capital expenditure:

• initial equity: €1 million;

• post capex equity: €1.3 million.

It is clear that, also in this different example, the current profitability of the operation will increase whilst the sponsor's parallel need for equity will fall, albeit in return for a higher financial risk. Results are shown in Figure 7.3.

Effects of different financial structures

FIGURE 7.3 Effects of different financial structures

  • [1] For further references please see also Watkins et al. (2003).
  • [2] Regarding the effects of financial leverage on the return on an investment, see Chapter 5.
  • [3] Weighted Average Cost of Capital of a single investment or a company.
  • [4] Equity multiple means the total profits of a deal plus the equity divided by the equity. If profits are €50 and equity is €100, the equity multiple will be 1.5 (i.e. (€50+€100)/€100).
 
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