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Mezzanine financing offers a new opportunity for portfolio diversification.
The quest has led me to an innovative solution to the diversity dilemma: mezzanine financing, a category of asset-backed securities that up until now hasn’t been readily available to retail investors. But what is it and why do some companies use it?
One Flight UpMezzanine financing, by contrast, is used exclusively by private companies; often to fund some of the less traditional financing needs such as business expansion, raising cash to smooth a succession planning scheme, or for management buyouts. It’s sometimes known as private-placement or high-yield debt and it serves as an additional financing opportunity that sits between the bank funding and traditional equity investors. If you think of the ground floor of a building as representing a company’s basic bank financing, the first floor would represent senior debt. Mezzanine financing fits exactly where you’d think it would—on the mezzanine between the ground floor and the first floor. It’s a hybrid of debt and equity financing, and often gives lenders the right to convert to an ownership or equity interest in the company if the loan isn’t paid back on time and in full. In terms of structure, it’s usually subordinated to debt provided by a senior lender such as a bank. An obvious advantage to mezzanine financing is the interest is tax-deductible. It’s also treated like equity on a company’s balance sheet, and often makes it easier for the company to obtain standard bank financing. To attract mezzanine financing, a company usually must demonstrate a track record within its industry segment, have an established reputation and product, a history of profitability, and a viable expansion plan for the business (e.g. acquisitions, initial public offerings, etc.). At the higher-risk end of mezzanine financing, interest rates are often in the 20%-to-30% range; however, for more secure, lower-risk loans, rates can fall as low as 12%. Prudent UnderwritingAs far as I can determine, only one company, Toronto-based ROI Capital, provides the general retail investing public with access to this type of product. The firm is only five years old, although the principals of ROI have been involved in mezzanine financing on the institutional side for many years. Their first retail offering was a Labour Sponsored Investment Fund (LSIF) that invested strictly in mezzanine financing—instead of the venture capital and start-up equity typically favoured by the fund. Last year, the company launched two offerings modelled after pension funds that include private placements as a key asset class. In addition to the assets found in a traditional balanced fund, both ROI pension funds allocate between 15% and 20% to mezzanine debt. Since ROI is a highly specialized firm, it outsources management of the fixed income and equity portions of its Canadian Pension Fund to Sceptre Investment Counsel. The Global Pension Fund outsources to two other highly ranked global institutional money managers. The mezzanine component embedded in these funds acts as a steadying hand when measuring risk. In early 2007, the company also launched a private-placement fund, a pure play on mezzanine financing that’s managed completely by ROI. That product is only available to accredited investors through an offering memorandum. ROI operates at the more conservative end of the lending world and undertakes significant due diligence prior to making a loan. Once the money has been advanced, the firm conducts monthly on-site audits to ensure the loan’s proceeds are being used for their intended purpose, that the business being financed remains on track, and that none of the covenants in the loan agreement have been breached. Sample Criteria
• Asset coverage. Although mezzanine loans are typically secured solely by the cash flows of the business, ROI registers a general security agreement (GSA) on all assets of the company. In a liquidation scenario, any remaining debt to ROI would fall second in priority on all proceeds. • Skin in the game. Shareholders, especially those involved in operating the companies, must have a stake in the outcome and be directly subject to at least moderate personal financial risk.
• Diversified sales base. Ideally, business risk should be diversified so that no single customer would represent 10% or more of total company sales. Many companies are in need of this type of financing, but from a lender’s point of view it’s important to be selective about which deals are accepted. The terms and conditions set by the loan agreements must be strictly obeyed. ROI always employs a general security agreement against both tangible assets such as buildings (which are conservatively valued at close to fire-sale prices) and intangible assets such as the firm’s intellectual property. And it takes the cash flow for each loan into consideration. The lender further insists the business owners either have a significant equity interest or own the firm outright. In almost every case, lending agreements are structured to place ROI’s claim in the event of liquidation ahead of the interests of the owners.
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