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Why Mezzanine/Hybrid Debt is becoming the perfect form of funding for Small and Medium Enterprises

Businesses need funding to grow, and small and medium enterprises often find it difficult to obtain debt financing because banks and NBFCs are wary to lend to small businesses. The limited collateral, erratic cash flow, and below-average debt-to-income ratio become pain points when it comes to raising debt. The growing demand for alternative financing has therefore led to the growth of alternative asset management i.e., Venture Debt, and Private Credit/Debt firms.

These Alternative Investment firms can provide funds to small and mid-sized enterprises quickly and efficiently in different forms i.e., equity, debt, and mezzanine debt, etc. When it comes to equity and debt financing, enterprises may be apprehensive because either they may not want to dilute the ownership stake, or they may be unwilling to borrow debt due to a lack of collateral or reluctance to provide a personal guarantee.

Mezzanine/Hybrid financing fills the gap between equity and debt in terms of payout priority — superior to equity and subordinate to senior debt. While there can be multiple ways in which a Mezzanine debt can be structured, the most commonly used structure is the one that has an equity component in the form of warrants. Mezzanine debt also known as subordinated debt, offers flexible repayment terms such as monthly or quarterly Interest payments, with the principal to be repaid at final maturity. Further, there can be a convertible structure that allows the lender to convert all or a portion of the principal into equity. Mezzanine funding is also ideal for companies that don’t have the capital to self-finance big expansion moves or those with good positive cash flows.

Mezzanine/Hybrid Debt is an ideal option for borrowers as it offers the following benefits:

  1. Designed to allow the owners to retain complete control of the company.
  2. Lenders do not interfere with the working of the business and remain passive.
  3. Does not require a personal guarantee or collateral.
  4. Offers less restrictive covenants than senior debt.

Further, Mezzanine/Hybrid Debt also offers the following benefits to lenders as well:

  1. Yields attractive returns between 12 to 20% annually which is considerably higher than other forms of debt.
  2. Ranked ahead of equity investors when it comes to repayment which offers a safer avenue to investors in cyclical markets.
  3. Offers the lender an option to convert the debt into equity at a future date.

These are some reasons why a growing number of enterprises are opting for Mezzanine/Hybrid debt to manage expansion, acquisitions, etc. It is becoming a financing option of choice for small and medium enterprises resulting in a thriving Alternative Investment sector with a record number of deals being signed.

The ever-rising numbers of deals and investments have made the task of Investment managers very tough, given that most Alternative Investment firms still rely on traditional tools like Excel to manage their investments. Therefore, it is worthwhile to also discuss the benefits that technology offers in managing Mezzanine/Hybrid debt investments by addressing some of the major pain areas such as:

  1. Tracking investment pipeline
  2. Capturing cashflow transactions including interest repayments
  3. Managing different Mezzanine debt scenarios, for example, conversion of investment from debt to equity
  4. Tracking periodic valuations and performance metrics such as IRR/MoC (Multiple of Capital or Times money back)
  5. Monitoring Portfolio Financials/KPIs and ESG metrics
  6. Investor On-boarding, Communication, and Reporting
  7. Managing Capital Calls and Drawdown/Distribution
  8. Tracking Fund Cost and Fund Performance Metrics

There are many technology providers in the market today that offer independent solutions for specific processes such as Deal Flow Management, Investment Management, Portfolio Monitoring, Investor Management, and Fund Management. However, integrated technology solutions that offer end-to-end investment management capabilities have carved a niche for themselves in this industry. These solutions not only help in enhancing operational efficiencies but also add to the productivity of the investment team by offering mobile apps, email plugins, and built-in analytics. Such software solutions facilitate the process of alternative financing and make the experience safe, smooth, and seamless for all the stakeholders

If used strategically, both enterprises and Alternative Investment firms can benefit from Mezzanine funding. For enterprises, it is a good funding option that offers to reduce the cost of capital while ensuring that there is still an opportunity for borrowing funds from banks. On the other hand, for Alternative Investment firms, Mezzanine investments offer some of the highest return rates.

Authored By: Ankur Agarwal (Co-founder & CTO, PE Front Office)