Mezzanine Financing Revisited
EMPEA’s recently released Private Credit Solutions: Mezzanine Financing in Emerging Markets offers an in-depth look at the role that private credit plays in supporting the development of small- and medium-size companies across the emerging markets and in offering institutional investors a means of accessing this growth. The following is an introduction to the mezzanine sub-asset class and a summary of the report’s findings.
Access to finance is one of the most prevalent challenges facing entrepreneurs and business owners across the emerging markets. For entrepreneurs that cannot borrow from local or international banks and are reluctant to give up equity in their companies, mezzanine financing is a viable option to bridge the financing gap.
Mezzanine financing sits above equity and below senior debt in the capital structure and encompasses a wide range of debt and equity positions. The various structures that mezzanine investors employ include secured subordinated debt, convertible subordinated debt and preferred shares. Through combinations of these and other instruments, such as payable-in-kind loans and equity warrants, mezzanine providers are able to move up and down the capital structure to achieve a desired risk/return profile. This flexibility in structuring deals enables mezzanine investors to create a blend of downside protection and upside participation, tailor-made to each investment opportunity and the cash flow profile of the targeted firm. While mezzanine is a complex strategy where few transactions look the same, this flexibility is the sub-asset class’s defining feature and key strength.
In emerging markets, mezzanine financing is typically growth capital provided to small- and medium-size companies that are cash-flow positive and looking for financing to fuel growth, fund acquisitions or recapitalize. Mezzanine deals in emerging markets typically fall into two buckets: sponsored deals, where the mezzanine lender is part of a consortium including equity investors, and non-sponsored deals, where the mezzanine investor lends directly to the portfolio company. Unlike in the West, where the mezzanine market is more developed and commoditized, typical mezzanine transactions in emerging markets involve active relations between the lender and the borrower or equity sponsor.
Because mezzanine investors in emerging markets provide financing to fast growing, but capital-starved companies, they are often able to secure both equity-like returns and debt-like downside protection. A common refrain is that mezzanine strategies provide 80% of the returns of private equity with 50% of the risk. Risk mitigation is achieved formally through the structuring of contractual security and debt covenants and informally through the position of influence within the portfolio company that mezzanine investors enjoy. Another, often overlooked, source of risk mitigation is the self-liquidating nature of mezzanine instruments, which reduces capital at risk throughout the investment period.
In compiling the Mezzanine Financing in Emerging Markets report, EMPEA collected fund and investment level performance data from a number of mezzanine fund managers. Exhibit 1 provides a break-down of the data set’s demographics, while exhibit 2 outlines the performance of emerging markets mezzanine transactions by gross multiples.
The median emerging market mezzanine investment returned a 1.5x gross multiple, with the middle 50% of deals delivering multiples between 1.1x and 1.9x money. Indicative of mezzanine’s risk/return profile, the minimum return achieved a 0.1x return on capital, while deals incorporating substantial equity kickers achieved gross returns upwards of 6.4x.
Overall, EMPEA’s findings suggest that the development of mezzanine financing in emerging markets has followed a distinct trajectory, evolving to take advantage of the opportunities present in markets characterized by both high growth and capital scarcity. In these environments, savvy investors are able to structure deals to secure both upside participation and downside protection, and ultimately provide institutional investors with an attractive risk/return profile.