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7.2 PROCEDURES FOR ESTABLISHING MEZZANINE FINANCE AND COST

In general, a mezzanine finance[1] contract is structured in such a way as to combine characteristics of both debt and equity, which means that the cost (or the expected return for the lender) is higher compared to a senior bank loan, whilst it is lower than the return expected by shareholders. The cost (or expected return) of mezzanine finance is therefore dependent upon its two constituent elements:

• subordinate debt, which comes in the form of a bank loan with an interest rate which under normal market conditions will be between 400 and 600 bps above the market rate for an equivalent maturity;

• an equity kicker, which makes it possible to benefit from any increase in the market value of the venture capital for the project financed, also providing for a form of profit share.

It is evident that the two components are inversely proportionate to each other: a higher rate of interest on subordinate debt will entail, assuming operational risk remains the same, lower return from the equity kicker, and vice versa.

For low levels of LTV, mezzanine financing is predominantly comprised of subordinate junior loans. However, as LTV increases it becomes increasingly necessary for the lender to secure higher returns in the face of increasing risk. On the other hand, the borrower needs to have access to a flexible form of capital, the cost of which will be aligned to the project's actual return. For this reason, once certain levels of LTV are exceeded, mezzanine financing also includes an equity kicker component which, in a manner which is more similar to equity, has a variable cost associated with the economic result of the project.

Mezzanine financing may therefore be more similar to debt or to equity, depending upon whether the emphasis for establishing returns is placed on:

• the former component (interest on the subordinate debt), in which case it is automatically regarded as equivalent to a form of debt with a higher cost;

• the equity kicker component (capital gain associated with expectations of successful completion of the project financed), in which case fixed interest payments are reduced and the mezzanine structure is more readily perceived as reduced-risk venture capital, or preferred equity.

Mezzanine financing may be implemented using subordinate loans (which attract higher financial charges compared to senior debts), preference shares with protective covenants in order to reduce risk, preferred loan stock, or again a combination of different financial instruments which, taken together, offer a risk/retum profile in between debt and equity. Whichever form is used, it must be structured in such a manner as to guarantee mezzanine lenders a higher return compared to senior lenders, but lower than that granted to shareholders.

  • [1] On mezzanine finance and private equity see also Willis and Clark (1989).
 
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