What Is a Mezzanine Fund?

Mezzanine Fund is a source of financing in leveraged buyouts, especially management buyouts (MBOs). It provides funds between equity and debt, and its role is to fill an acquisition that takes equity into consideration. Funds, ordinary debt funds still insufficient after the acquisition funding gap. The term MBO fund currently used in China actually refers to a mezzanine fund. However, because the financing channels in MBO transactions are diversified and the financing structure is hierarchical, different funding sources, entry methods, return requirements, and repayment methods are different, so collectively referred to as MBO funds are not accurate.

Mezzanine fund

Mezzanine fund is also called silent internal fund. Between equity investment and debt investment, not only benefit from equity income brought by the growth of the company's finances, but also take into account the benefits of subordinated bonds. Its investment instruments are mainly: a combination of financial instruments such as subordinated bonds, convertible bonds, convertible preferred stocks.

Payments for management buyouts are all-cash purchases, not share purchases, so acquisition financing is critical. In a typical MBO financing structure, funding sources include three components:

1. 10% of the purchase price is provided by the management team. This part of the funds forms the equity capital of the reorganized enterprise after the acquisition and completion.

2. 50-60% of the purchase price is provided by bank loans. This part of the funds forms senior claims, with corporate assets as collateral, and is generally a syndicated loan composed of multiple banks.

3. 30-40% of the purchase funds are provided by mezzanine funds.

The essence of a mezzanine fund is a kind of borrowing funds. The method of providing and recovering funds is the same as that of ordinary loans, but it is behind the bank loans in the order of corporate debt repayment. Therefore, in M & A financing, collateralized financing methods such as bank loans are senior claims, while mezzanine funds are subordinated claims. The junk bond, which is very famous in leveraged buyout financing, is also a way to provide subordinated debt funds. It has the same role as a mezzanine fund. However, due to the credit crisis in the junk bond market since the 1990s, the western leveraged buyout The funds of middle and subordinate debt mainly come from mezzanine funds.

The role of the fund

The mezzanine fund involved in an MBO transaction, reducing the demand for senior debt funds and equity funds for transaction financing, and improving the security of senior debt funds such as bank loans because the corporate asset mortgage factor (value of mortgage assets such as corporate fixed assets / bank Loans have increased, making it easier for MBO transactions to obtain bank loans. In addition, the involvement of mezzanine funds has also increased the attractiveness of MBO transactions to equity capital providers because mezzanine funds have their own inherent return requirements for investment projects. Compared to mezzanine funds, equity capital can achieve higher investment returns.

Fund Lending Rate

Mezzanine funds generally provide unsecured loans. Therefore, the repayment of loans mainly depends on the cash flow generated by the business (but sometimes the cash flow brought by the sale of corporate assets is also considered.) The loan interest rate of the fund is higher than the bank loan interest rate. . The interest rate of a mezzanine fund loan is the standard money market fund rate (such as LIBOR) plus 3-5%. In addition, if the business runs smoothly after three to five years, the fund generally requires a final payment. This final payment is generally issued by the enterprise to the mezzanine fund to purchase warrants for common shares (WARRANTS).

Return on investment of the fund

Generally, 5 years after the completion of an MBO, if the target company was originally a listed company, the company has gone through the process of delisting, reorganization, and re-listing; if the target company is an unlisted company, the company has undergone reorganization and completed listing . At this time, each of the fund providers realized their withdrawal: the management sold the stock, the mezzanine fund and the bank all recovered the loan principal and interest. Because different funds in different levels of MBO's financing structure bear different risks, the requirements for different funds' returns are also different, and there are large differences. The intrinsic rate of return required by general equity capital providers exceeds 40%, the intrinsic rate of return required by mezzanine funds is between 20-30%, and the intrinsic rate of return required by banks is 2 percentage points higher than the benchmark interest rate (such as LIBOR).

Organizational structure of the fund

The organizational structure of mezzanine funds generally adopts a limited partnership system. There is an unlimited partner who acts as the fund manager (or fund manager) and provides 1% of the fund, but must bear unlimited liability. The remaining fund providers are limited partners, providing 99% of the funds, but only need to assume limited liability within the share of funds provided. About 20% of the fund's income is allocated to the fund manager, and the rest is allocated to the limited partners. The fund managers of mezzanine funds, also known as leveraged buyout experts, act as consultants to management and are responsible for organizing the entire MBO transaction structure, especially the financing structure, and providing mezzanine fund financing, which is the soul of an MBO transaction. The most famous mezzanine fund managers in the West include KKR and ONEX.

Comparison of mezzanine funds and venture capital funds

From the perspective of organizational structure, mezzanine funds and venture capital funds are very similar, but mezzanine funds are not equity investments and do not require access to corporate equity. Venture capital is necessarily equity investment, and the target companies for the two investments are different. In addition, the amount of funds of mezzanine funds is generally smaller than that of risk funds.

Domestic management buyouts are very different from Western MBOs. Western MBO is a tender offer, while domestic management buyout is an equity agreement transfer. Western MBO will change the legal body of the company. For listed companies, MBO means that the company goes public (because the company is no longer owned by the public, it does not have the legal characteristics of a listed company, and non-listed companies must Make changes to the legal entity of the company. In short, after the completion of the Western MBO, the original company was dissolved and the business merged into the newly formed company. The company is the main body of MBO financing. The management has 100% equity and a very high debt ratio. After several years of operation, the company reissued its shares to the public and went public. At present, domestic management buyouts do not have the above characteristics.

Compared with Western MBOs, the differences between domestic management buyouts are:

1. The domestic management's acquisition does not change the legal status of the target company. After the acquisition, the acquisition company (or "shell" company) does not merge with the target company.

2. Non-negotiable shares are acquired, and relative ownership is held. The controlling shares of a listed company are non-tradable shares. The management team transfers and holds the non-tradable shares through the agreement. After the completion of the acquisition, it becomes a relatively substantial corporate shareholder.

3. Different exit channels after acquisition. The shares held by the management are generally difficult to be listed and circulated. Only in the future, the value of the company will increase, and the value added will be realized by re-negotiating the transfer. Therefore, the repayment of various financing funds involved in the management acquisition still comes from the dividends and appreciation of the shares held by the acquiring company (financing entity).

4. There may be corporate governance issues such as double taxation and related party transactions. In Western MBOs, the target company to be acquired disintegrated and merged into the acquiring company. A large amount of financing debts for the acquisition made the acquiring company enjoy significant tax avoidance benefits. The domestic management buyout does not involve changes in the main body of the target company, and the acquiring company and the target company coexist, so that the financial statements of the target company are not affected, and not only can the tax avoidance benefits of the acquisition liabilities not be obtained, but also the target company level and the acquiring company The possibility of double taxation exists at the level. Even when a listed company is acquired, there may be related party transactions and other corporate governance issues that harm other small and medium shareholders between the management-controlled acquisition company and the public listed company controlled by the acquisition company.

From the perspective of financing for management acquisitions, the Domestic Commercial Bank Law and the General Rules on Loans promulgated by the Central Bank clearly stipulate that commercial bank loans cannot be used for equity investment. (However, in the specific operation cases of some provinces and cities, there are still financial institutions such as banks and credit unions that provide equity pledge loans directly or in disguise for equity acquisition.) Therefore, it is legally impossible for bank loans to directly intervene in management. During the acquisition, this has greatly restricted the scale of acquisition financing. This has highlighted the problem that domestic management must find other financing channels for acquisitions. This is the objective reason for the recent calls for the establishment of so-called MBO funds in China. But despite the high voices, there are still many confusions and problems in actual operation. The domestic financing funds involved in management buyouts lack legal regulations. In the specific transaction process, because bank credit funds cannot be involved, various private equity funds have become the main source of financing for a management buyout transaction. The amount of financing is high and the risk is high. Financing parties often require management to give equity or arrange other "Under-the-table appointments". In these concealed under-the-table appointments, the financing parties and management of both parties to the transaction often intentionally leave a "fuzzy pen", which is likely to be an ambush for future risk outbreaks, which objectively increases Potential risks of domestic management buyouts.

Currently,

Mezzanine financing is a financing method between lower risk senior debt and higher risk equity investment. It is therefore in the middle of the company's capital structure. Mezzanine financing generally takes the form of subprime loans, but it can also take the form of convertible notes or preferred shares (especially if certain equity structures can benefit from regulatory requirements or balance sheets).

The return on mezzanine financing is usually obtained from one or more of the following sources: 1. Cash coupon, usually a floating interest rate that is higher than the relevant interbank interest rate; 2. Repayment premium; 3. Stock incentives, which are like This kind of warrants can be exercised by the holder when the stock is sold or issued. Not all mezzanine financings have the same characteristics. For example, the return on an investment may be entirely a cumulative option or redemption premium without cash coupons.

Mezzanine financing is a very flexible financing method, and the structure of mezzanine investment can be adjusted according to the needs of different companies.

Benefits for borrowers and their shareholders

Mezzanine financing is a very flexible financing method, which can be adjusted according to the special requirements of the raised funds. For borrowers and their shareholders, mezzanine financing has the following appeal:

Long-term financing. Many medium-sized companies in Asia find it difficult to obtain loans from banks for more than three years. And mezzanine financing usually provides funds with a repayment period of 5 to 7 years.

Adjustable structure. The provider of mezzanine financing can adjust the repayment method to meet the borrower's cash flow requirements and other characteristics. Compared with financing through the public stock market and bond market, mezzanine financing can be carried out on a relatively small scale and relatively quickly. The equity characteristics of mezzanine financing also allow companies to benefit from lower cash coupons, and in some cases, companies can also enjoy deferred interest, in-kind payments, or exempt coupon options.

Less restrictive. Compared with bank loans, mezzanine financing has fewer restrictions on corporate control and financial contracts. Although mezzanine financing providers require the rights of observers, they rarely participate in the day-to-day operations of the borrower and do not have voting rights on the board of directors.

Lower cost than equity financing. It is generally believed that the cost of mezzanine financing is lower than equity financing, because providers of capital usually do not require access to a large amount of the company's equity. In some cases, the nature of physical payments can reduce the dilution of equity.

The following are the main characteristics that distinguish mezzanine investment from typical private equity investment:

An investment method with less risk than equity. The level of mezzanine investment is usually higher than equity investment, and the risk is relatively low. In some cases, mezzanine financing providers may gain a favorable position in areas such as cross-default clauses caused by defaulting on borrowers of preferred debt, and first or second priority in retaining company assets and / or shares. The return on equity from "equity incentives" can also be very substantial and can increase returns to a level comparable to equity investment.

Exit is more certain. The debt composition of mezzanine investments usually includes a predetermined repayment schedule, which can be repaid in installments over a period of time or can be repaid in one installment. The repayment model will depend on the cash flow position of the target company of the mezzanine investment. As a result, mezzanine investment provides a clearer exit path than private equity investment (the latter generally relies on liquidation methods with greater uncertainty).

Current yield. Compared to most private equity funds, a large portion of mezzanine investment returns come from front-end fees and regular coupon or interest income. This feature makes mezzanine investments more liquid than traditional private equity investments.

Priority lenders still do not welcome the existence of secondary lenders, even if secondary lenders have only subordinated debt. The main objections of the priority lenders are that they share the same guarantee with the mezzanine financing provider, so they require the mezzanine financing provider to accept the structural secondary position (that is, the mezzanine financing provider invests in the holding company level, and the priority loan People provide loans to operating companies).

It is also important to carefully evaluate the mortgage arrangements that the mezzanine financing provider has obtained and their ability to execute the agreement (priority lenders usually limit the ability of mezzanine finance lenders to execute mortgages through agreements between creditors).

Priority lenders typically restrict cash flows to mezzanine providers through strict agreements, and borrowers usually prepay most of the excess cash to reserve lenders as a reserve. They also need to make a detailed assessment of the borrower's ability to repay (such as how interest is paid, the distribution of dividends or asset disposal).

Mezzanine investments in Asia are often transnational transactions, so a careful assessment of borrowers is needed to determine their remittance capabilities (especially China). Investors must also have an in-depth understanding of withholding taxes and regional tax agreements.

In some regions (such as India's implementation of the European Central Bank's standards), international financing providers are restricted in their use of high-yield financial instruments, and financing providers must also carefully evaluate some restrictions.