Private Credit Solutions: Mezzanine Financing in Emerging Markets

What is Emerging Markets Mezzanine Financing?

Access to finance is one of the most prevalent challenges facing countless entrepreneurs and business owners across the emerging markets. Local banks have traditionally focused their lending on only a handful of large companies—in part, because they view smaller firms as having insufficient assets or collateral— while the global financial crisis and subsequent introduction of new capital adequacy requirements have resulted in many of the international banks scaling back their emerging market activities in recent years. Even when bank debt is available, it is often short term in nature and does not provide the type of patient capital small- and medium-size companies need to grow. While private equity is one viable option to bridge this gap, entrepreneurs are sometimes hesitant to go this route due to a reluctance to give up equity in their companies. In such cases, another alternative exists: mezzanine financing.

The Space In-Between

Encompassing a wide range of debt and equity positions that can be structured in a variety of ways, mezzanine is a complex sub-asset class. As one veteran of the industry explains, “The only absolutes we know are that we’re not senior debt and we’re not pure equity.” Mezzanine refers to the level of financing that sits above equity and below senior debt in the capital structure— in other words, in the event of a default, mezzanine investors stand in line behind all senior obligations but in front of equity holders—and is priced according to its position.

The various structures that mezzanine investors employ include secured subordinated debt, convertible subordinated debt and preferred shares, and through combinations of various instruments (see sidebar on Constructing the Mezzanine Return in report), these providers are able to move up and down the capital structure (from what some industry participants refer to as “debt plus” to “equity minus”) 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, for instance by matching the structure to the cash flow profile of the firm.

Mezzanine in Emerging Markets

Since its genesis in the United States in the 1980s and expansion into Western Europe the following decade, mezzanine in developed markets has matured into a US$100 billion dollar industry. Initially driven by interest from insurance companies but now supported by a range of institutional investors, mezzanine financing in the West is used by companies for a multitude of reasons, including as growth capital, for restructurings or recapitalizations, and as part of leveraged buyout packages.