MEZZANINE FINANCING
This work was Authored by Onduma Sabit LLB 3 Uganda Christian University
[1] The lack of financing options has particularly been problematic for SME’s in the
so-called missing middle,1 and has often times led to their demise. 2 The hybrid or the
involvement of both debt financing and equity financing forms what is termed as
mezzanine financing which ever since has been relied upon by such companies..
[2] This script in detail explains mezzanine financing, the features of mezzanine
financing, the key players in mezzanine financing and the impact of this form of
raising funds on companies.
[3] Its genesis can be traced after World War II, as industrial and corporate activity
rapidly increased, businesses began to seek more sophisticated forms of capital
beyond traditional bank loans and equity investments. These transactions often
required funding structures that could bridge the gap between what banks were
willing to lend and what investors were willing to contribute as equity. Therefore the
combination between the two formed mezzanine financing
[4] The term mezzanine originates from an italian word mezzano meaning "middle"
developed, and then mezzanino, meaning "a small middle floor" or "intermediate
floor"To fill this “middle layer” in the capital structure, financiers began to develop
hybrid instruments, this led to the emergence of mezzanine financing. In finance, it
represents a similar concept: capital that sits between debt and equity.
[5] Mezzanine financing is therefore a hybrid of debt and equity financing that gives
lender the right to convert debt to an equity interest in a company in case of default. 3
In re Gen. Growth Props Inc,4 Courts recognized the rights of mezzanine lenders to
enforce remedies consistent with contractual and UCC terms.therefore if a contract
involves terms that give ownership rights to mezzanine lenders in case of default, then
it shall it be enforced by courts.
1
New Perspective for Financing of Small CAP SMEs by Eelco Benink and Rob Winters
2
Supra
3
Mezzanine Financing by Adam Hayes, updated june 13th 2024, at pg 1
4
409 B.R. 43 (Bankr. S.D.N.Y. 2009)
1
[6] Mezzanine financing has certain key features, the following are the features of
mezzanine financing;
[7] One of the main features of mezzanine financing is that it is subordinated to
senior debt. This means that in the event of a liquidation or bankruptcy, senior lenders
are repaid first, and mezzanine lenders are only repaid after them, but before any
equity holders.
[8] Not only that,mezzanine financing usually comes with higher interest rates 5 ,
often ranging from 12% to 20% or even more, depending on the contractual terms.
For instance in Stractured mezzanine Investment pty ltd v Basson and Others 6
where the interest went as far as 65% per year and court upheld it upon breach or
default by the respondent company.
[9] Besides, Another important feature is that mezzanine financing often includes an
equity component, such as warrants or options to convert debt into equity. This gives
the lender potential upside if the company grows or is sold at a high valuation. It's a
way for the lender to participate in the company’s future success beyond just
receiving interest payments.
[10] Mezzanine loans are also typically unsecured or only lightly secured. Instead of
being backed by physical assets, lenders rely on the cash flow and profitability of the
business. For this reason, mezzanine financing is often only available to companies
with strong and predictable earnings.
[11] The other notable feature of mezzanine financing is the longer maturity period
compared to typical bank loans. Mezzanine loans often have a term of five to seven
years, which gives the company breathing room to grow or stabilize its operations
before repaying the loan.this does not mean it cannot operate under short term
maturity period7
[12] The question would then be, how does mezzanine financing work or operate?
5
Ekonomska istraživanja, Vol. 23 (2010) No. 3(57-67)
6
S.A decision on 24th April 2013
7
As it was in the case of Structured Mezzanine Investment Property ltd v Basson and Others
2
[13] Mezzanine financing is a hybrid form of capital that combines elements of debt
and equity. It is typically used when companies require more capital than banks are
willing to lend, but wish to avoid the significant ownership dilution that comes with
issuing new equity.8
[14] Positioned below senior debt but above equity in the capital structure, mezzanine
financing carries higher risk for the lender. As a result, it typically commands higher
interest rates—often between 12% and 20% ) 9. Despite its cost, it is often viewed as
less expensive than equity in terms of long-term capital cost, especially because it
allows the company to retain more ownership control.10
[15] In essence, mezzanine financing provides growth capital while helping
companies improve their return on equity, making it particularly attractive for
expansion-stage businesses11
[16] Whereas mezzanine financing can have positive impacts such as access to
growth capital, flexible terms of borrowing, enhancement of borrowing capacity and
strategic partnership and guidance, it nevertheless has drastic negative impacts on
both SME’s and bigger companies. The following are the negative impacts of
mezzanine financing on the above companies;
[17] High Cost of Capital due to high interest rates. According to the OECD (2015)12
One of the biggest drawbacks is the high interest rates, often between 12% and 20%,
which can strain the finances of a small business if cash flows are inconsistent reports
that while mezzanine funding increases capital availability, the cost is significantly
8
Berk, J., & DeMarzo, P. (2020). Corporate finance (5th ed.). Pearson
9
Brigham, E. F., & Ehrhardt, M. C. (2016). Financial management: Theory & practice (15th ed.).
Cengage.
10
PwC. (2019). Raising capital for growth: Options for SMEs. PricewaterhouseCoopers LLP
11
· OECD. (2015). New approaches to SME and entrepreneurship financing. OECD Publishing.
12
OECD. (2015). New Approaches to SME and Entrepreneurship Financing: Broadening the Range of
Instruments
3
higher than senior debt, making it unsuitable for low-margin or early-stage
companies.13
[18] There is high Risk of Equity Dilution If the company fails to meet its repayment
obligations, the lender can convert debt into equity, leading to dilution of ownership
and potential loss of control.14
[19] According to KPMG. (2020). Leveraging the Middle Layer, Mezzanine and
Alternative Capital, Using mezzanine capital in addition to existing debt can increase
leverage, raising the risk of financial distress, especially during downturns or
unexpected disruptions.
[20] Types of mezzanine financing
[21] In addition to the structural types of mezzanine financing—such as debt-based or
equity-linked, mezzanine funding can also be classified by its source that is either
private or public.
[22] Private Mezzanine Financing
[23] Private mezzanine financing refers to capital provided by non-governmental
investors. These may include private equity firms, specialized mezzanine funds,
hedge funds, institutional investors like insurance companies, or even wealthy
individuals. What makes private mezzanine financing attractive is its flexibility deals
are often tailored to the needs of the business, though they come with relatively high
costs.
[24] In most cases, private investors expect higher returns due to the subordinated risk
they are taking. These investors may also ask for some form of equity participation,
such as conversion options, to benefit from the company’s growth in the long term.
13
Supra[8]
14
Smith, A. (2017). Private Equity and Mezzanine Debt in SME Financing. Journal of Financial
Strategy.
4
[25] For example, a firm like iungo Capital, which operates in Uganda and other parts
of East Africa, provides mezzanine funding to growth-stage businesses that fall
between traditional bank loans and venture capital. Their approach is flexible and
aimed at helping small companies scale without giving up too much ownership too
early.
Public Mezzanine Financing
[26] On the other hand, public mezzanine financing comes from government agencies
or development finance institutions (DFIs). 15 These sources are more focused on
promoting economic development than generating high returns. Public mezzanine
funding is often offered to businesses in strategic sectors such as renewable energy,
agriculture, or manufacturingespecially in emerging economies where access to
capital is limited.16
[27] In Uganda, for instance, institutions like the Uganda Development Bank or
UECCC (Uganda Energy Credit Capitalisation Company) provide blended
finance options, which can include mezzanine-style funding. These funds are usually
offered on more favorable terms compared to private investors and may come with
technical assistance or capacity-building support.
[28] What would then be some of the key players in mezzanine financing?
[29] Its important to note that there are no many mezzanine players in uganda yet as
the mezzanine financing landscape in Uganda is evolving, with a mix of local banks,
international investors, and development institutions contributing to the growth of
SMEs. These players offer a range of financial products tailored to the unique needs
of businesses seeking capital beyond traditional debt or equity financing. Their
collective efforts are instrumental in fostering economic development and
entrepreneurship in Uganda.
15 Supra
16 https://doi.org/10.1787/9789264240957-en
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