Mezzanine

Mezzanine capital is a broad financial term that refers to unsecured, high-yield, subordinate debt or preferred stock. Mezzanine capital represents an intermediary between equity and debt in a company's balance sheet.

Due to increased credit risk, mezzanine capital is a relatively expensive source of company financing. For this reason, it is most appropriate for financing growing companies with high profitability.

One reason a company might prefer mezzanine capital is to maintain its equity-ratio, as even loan-oriented mezzanine instruments are often valued as commercial equity.

Mezzanine capital is mainly offered by banks, especially when it comes to debt-related products. In return, private equity firms focus on equity-related instruments.

Different forms of mezzanine capital are classified as equity or debt according to three factors:

1. Duration of the Capital Commitment

The duration of the capital commitment should be unrestricted or at least long-term for consideration as equity. Generally the spread of the maturity for the mezzanine capital is between five to ten years.

2. Liability and Loss-Sharing

the loss-sharing is one of the major factors for the assessment of equity. In case of insolvency equity-oriented mezzanine investors usually participate on losses, whereas debt mezzanine is only subordinated.

3. Conditions of Compensation

Compensation for mezzanine investment comprises a fix current interest payment and participation on the generated profit and growth. A mezzanine instrument is rather equity than debt if the compensation is flexible, dependant on profit and takes part on the performance of the company.

The following chart illustrates several forms of mezzanine capital and their respective categorization as either debt or equity. Variations may occur due to the different accounting rules such as International Financial Reporting Standards (IFRS) and German Accounting Rules (Handelsgesetzbuch - HGB).

In Germany, one of the classical forms of mezzanine financing is the silent partnership. The silent partner contributes a share of the capital and obtains a share of the profit in return. The participation in losses is typically limited to the capital contribution.

There are two main types of silent partnership:
the typical silent partnership and the atypical silent partnership:

• The typical silent partner does not influence the management of the company and expects a minimum rate of return on a regular basis (usually yearly).
• By comparison, participation in management and risk is an inherent part of the atypical silent partnership, and for this reason, the atypical silent partner demands an extraordinary return.

The typical silent partnership is widely used in public funding. In Germany, public venture capital companies (Innovations- und Technologiebeteiligungsgesellschaften) or public-private equity enterprises (Mittelständische Beteiligungsgesellschaften) take minority shares in technological ventures or growing small or medium-sized enterprises (SMEs).

The subordinate loan, also known as a junior tranche, is a debt instrument that takes a lower repayment priority than the normal debt provided by lenders. In the event of payment default, the repayment is subordinated and all other lenders are repaid in the first instance.

Subordination also refers to the payment of amortization and the provision of securities. With regards to securities, subordination means that banks do not require collateral for these loans. However, the advantages over normal debt for the creditor are combined with a higher risk for the bank. These risk factors must be covered with a higher margin, which means higher interest rates for the borrower.