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Sunday, 19 October 2014

Is hybrid financing indeed “the new lubricant in the M&A market”? Or is it yet another symptom of the dangerous influence of “virtually free money” in the European economies?!

This week, Het Financieele Dagblad printed a very interesting article with respect to a ‘new’ form of company financing, called ‘mezzanine’ or hybrid financing. Here are the pertinent snips.

Subordinated loans work miracles at the Merger and Acquisitions market (M&A). Deals that scare away the traditional banks, are brought to a successful ending with it.

Take for instance the merger of two offshore companies, initiated by Amsterdam-based investment company Value Enhancement Partners (VEP). Traditional financing is virtually impossible to get, as there is too much risk involved in the multi million euro deal. No problemo: the London-based credit fund Beechbrook Capital, funded with capital from institutional investors, comes to the rescue.
The contribution of the British company was essential”,according to VEP-partner Bob de Lange. The role of the bank is now limited to the financing of working capital.  

In the business, hybrid loans are known as mezzanine financing. It is an ‘sub-level’ form of financing between equity and debt. The receiver of the funds gets subordinated debt in hands, which only has to be redeemed in the mid to long run.

And very important: in contrary to the offering of preferent and common stock at the exchanges, the executive control of the company does not change by it. The owners of the company remain in charge themselves.

The mezzanine loan is gaining importance. In the London City, billions of euro’s have been reserved for this form of financing. Private Equity houses of repute have established separate funds for mezzanine loans. With $4 bln in cash, Blackstone Group created in 2012 the largest debt fund in the world, closely followed by ICG, KKR and Greyrock Capital.

Mezzanine seems ideal for companies, which cannot (sufficiently) finance their growing ambitions at regular banks. Mezzanine is meant to fill up the void.

This whole article is a must-read, in my opinion, as it offers an excellent insight in this relatively new, but very risk way of financing.

I can imagine that mezzanine seems like the goose with the golden eggs for founders and CEO’s of innovative and fast-growing companies, which have enormous ambitions, but still suffer from financial growing pains.

Yet, a little voice in my head whispers:
When these companies are indeed so promising and seem to be a reduced risk; why don’t the renowned business and general banks want to finance these companies themselves?!

And a second voice whispers:
“When this kind of financing is too risky for business and general banks, why isn’t it for British and American private equity funds and the institutional investors that supply their funding?!

Does that have to do with the fact that banks have very strict capital ratios (solvability and liquidity), which are required and regularly assessed by the national banks and the European Central Bank, while institutional investors and private equity funds don’t have those ratios?

And is this perhaps a new kind of gambling with ‘other people’s money’?!

The skyhigh interest rates of 10% - 12%, plus additinal profit-based arrangements, definitely seem to point in that direction.”

And how many companies will eventually be successful enough and will indeed be able to earn sufficient cash flows, in order to pay back the substantial interest payments of 10% per year on their subordinated loans?

Losses and defaults of borrowing companies must be substantial; especially as a consequence of these skyhigh interest rates and the amount of risk involved. It is a very expensive kind of financing and also very risky; both for the money supplier and the debtor.”

I cannot help but think, that this new and extremely risky kind of financing – it looks, feels and smells a lot like the junkbond investments from the eighties, which went horribly wrong in the end – is only caused by the perversely low interest rates of this moment.

The institutional investors are desperately looking for ways to get more “bang for their buck”, than would be possible with sovereign and corporate bonds and shares.

On the other hand, the private equity funds are feasting on the ubiquitous availability of litterally shiploads of cheap money, which can be borrowed against only 2% or 3% interest. When the difference between the yields and the funding costs of loans is almost 10%, it rewards the risk of taking a gamble. Because that what it is, to these eyes. 

These kinds of investments will probably yield excellent results, until one day they won’t anymore. That will be the day that a lot of common people can wave a substantial share of their invested pension and insurance money goodbye!

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