Mezzanine capital is a hybrid financing concept which by definition combines characteristics of equity financing and debt financing. Companies as well as banks use this type of financing as ist closes the financing gap between available equity and loan promised by a financing bank. For private investors this can be an opportunity for increased returns in start ups and the real estate industry. Mezzanine capital is very relevant in the divestment of company departments, new product developments, growth capital financing as well as the funding of real estate projects.
PARTICULAR FEATURES OF MEZZANINE FINANCING
Mezzanine Capital is characterized by similarities common in both external capital as well as proprietary capital. In case of insolvency it will be paramount to proprietary capital, but claimed after external capital. Should a company go bankrupt the claims of external capital providers will first be satisfied. If assets are still available, mezzanine capital providers will be paid. Similar to proprietary capital, mezzanine capital is unsecured. While returns of proprietary capital depend on the economic success of the company, credits have a fixed or variable interest rate. Mezzanine capital can also have a combination of fixed and variable interest rates: A small fixed interest rate as well as a profit-related factor.
The external capital provider is not affected by the successes or the losses of a company. He will receive interest as a compensation for providing the funds. The actual amount of the proprietary capital, on the other hand, may vary depending on the economic activity of a business, so that any financial losses will decrease the company’s proprietary capital.
Generally speaking, mezzanine capital providers will profit from a company’s financial success and will not be harmed by any losses made. Mezzanine funds just like external capital are typically available medium to long term.
TYPES OF MEZZANINE CAPITAL
- Dormant equity
- Atypical dormant equity
- Profit participation rights
- Shareholder loans
- Subordinated loans
Mezzanine capital counts as proprietary capital when it is being invested long term and the credit provider signed a subordination statement in case of the company’s capital loss. The first three types of mezzanine capital are similar to proprietary capital while the others are more comparable to external capital.
EXAMPLE: CAPITAL STRUCTURE OF A REAL ESTATE INVESTMENT
PROS AND CONS OF MEZZANINE CAPITAL
The provision of mezzanine capital bears a lot of advantages for businesses. The ownership of the company remains without any dependency on investors. The capital will guarantee the funding of important investments and facilitate an ideal financial structure by allowing more leeway for an improved credit rating. In addition to that, the company rating will also be favourable to trade, business and cooperation partners.
Another advantage lies in investors not having ordinary termination rights and only few extraordinary termination rights for provided funds. The creditors of mezzanine capital are not entitled to act like proprietary capital providers and only have limited legal control. Corporations do not need to follow a guarantee of underwriting and claims cooperation. The funding via mezzanine capital is ideal for medium sized businesses. Due to the lack of regulations in regards to mezzanine capital, contracts can be individualized.
However, there are also some disadvantages of mezzanine capital. One of the disadvantages is higher capital costs as well as decreased profit margins due to the participation of investors in the profits. While the costs of raising capital are higher than the costs of external capital, they are lower than raising proprietary capital. When the duration of the provision of capital expires, the company will find new sources of funding. Furthermore, the business activity must have a positive cash flow in order to accomplish the promised revenue targets.
PRIVATE MEZZANINE INVESTMENTS
The classification as mezzanine capital does not depend on the terminology but rather on the binding agreements between the capital provider and the capital seeker as outlined in the legal contract. The acquisition of mezzanine capital is also publicly carried out with private investors. Capital providers are banks, mezzanine fonds and private equity corporations as well as individuals who wish to invest in promising real estate projects with small funds. In German law only the bonus share - which is created as a participation right - requires a sales authorisation according to § 32 of the The German Banking Act (Kreditwesengesetz - KWG). Dormant equity, unsecuritised participation rights, participating and qualified subordinated loans do not qualify as financial instruments according to The German Banking Act (Kreditwesengesetz - KWG) and can be offered by brokers that are registered at the national trade office (Gewerbeamt). Profit sharing rights, participating and qualified subordinated loans are asset investments and follow the regulations of the Capital Investment Act (Vermögensanlagengesetz - VermAnlG) and the Retail Investment Act (Kleinanlegerschutzgesetz - KASG).
Due to the financial regulations Basel I, II and III and the limitation of external capital, there is a noticeable increase in additional non-proprietary financing in the real estate industry. Projects that require larger starting capital with later revenues are preferred investment options.Property developers make use of mezzanine capital in order to limit the amount of proprietary capital used and to start upcoming projects sooner rather than later.
Building properties can result in much higher returns than the acquisition of completed properties. The investor invests in a property development company which will then build and sell the object. Crowdfunding for real estate is reducing the risks of real estate investments as it distributes them through a variety of small individual investments. The loan agreement are concluded between the property development company and the investors, making it impossible to use the funds on other projects. Investors should still read and fully understand the loan agreements prior to investing.
WHAT DOES IT MEAN FOR CROWDFUNDING?
Mezzanine capital is quite significant in crowdfunding. Providers of real estate projects and start-ups for corporate financing have the opportunity to obtain more favourable loans by crowdfunded investments. Banks regard it more valuable than proprietary capital. Due to this, it is be easier to obtain loans because of a higher equity to assets ratio. In addition to that, a new investment opportunity is created for investors.
WHAT TO PAY ATTENTION TO: SUBORDINATED LOAN
A subordinated loan is the type of mezzanine capital that comes closest to a classical loan. The disadvantage of mezzanine financing is that it is more risky than external financing. By using a subordinated loan private and institutional investors are able to provide the required liquidity. If the debtor files for insolvency, the claims of the secured creditors such as banks and suppliers will be met first. Mezzanine financing however uses a qualified postponement of priority clause. This clause ensures that the repayment does not apply if it leads to insolvency. The investor is liable to the same extent as the equity investor. Private investors should be aware of these risks and assess the interest rate of the subordinated loan according to the compensation for any risks taken. Their investment is similar to an entrepreneurial cooperation. However, a subordinated loan will not require an obligation to make an additional contribution or share in the losses.
For real estate crowdfundings subordinated loans are generally used with Mezzanine financing. The investors will provide funds short to medium term to the project developers and will receive an attractive interest rate for the subordinated loan. Once the project is sold, the interest payments and repayments of the loans will be made. Furthermore, it is also possible for investors to profit from the increase in value of the project.
Real Estate Crowdfunding has a lot of advantages for both investors and debtors due to the lack of sales and bank commissions that apply with other types of financial investments. Investors profit from high interest rates and property developers do not need to rely on expensive financing from financial institutions. Small investors must be aware though that a failure of the project can result in the loss of the capital investment.
- Mezzanine capital is a hybrid of external capital and proprietary capital. It has many benefits. It is being used when the use of proprietary capital is too costly or financing through external capital is impossible. Mezzanine capital will improve an investor’s balance sheet.
- A company’s credit score will improve due to a reduced debt ratio and can lower financing conditions. Companies that have higher financial requirements - such as real estate companies - have the opportunity to complete lucrative projects.
- It is crucial for companies to include contractual terms and conditions in regards to mezzanine financing in order to ensure an improvement in credit ratings.
- Private investors should be aware of the higher risks associated with subordinated loans and spread their assets over multiple projects.