The variety of German subordinated financial instruments shows there is a long established awareness and understanding of the need and use of hybrid instruments in the German market. Historically, however, there have been occasions of wrongly deployed senior debt or even equity investments by local German banks.
In the case of senior debt there has been a clear disregard of risks involved, and political interests have often dictated equity investments. Lending has been cheap, readily available and has generally limited the open-mindedness for risk-encompassing financial solutions among Mittelstand management. Fortunately, the increasing demand for expansion finance addresses these issues and involves more restrictive bank lending than seen in the past. The perceived aloofness’ of German domestic banks recently seems to be not only a result of historically experienced default rates, but also an anticipation of Basel II requirements, which will lead to a much more differentiated lending and pricing policy.
One of the main areas of development for flexible financing instruments has been mezzanine capital. It is a form of credit that sits between senior debt and equity on the balance sheet. As a hybrid’ financing tool it combines equity as well as debt characteristics in a highly flexible and often unique way, offering added value to all participants in a deal. Served mainly by traditional mezzanine lenders such as RBS Mezzanine, the niche market for mezzanine financing has flourished in the last three to four years, resulting in the recent establishment of E1bn+ in-house funds by a handful of US investment banks. These latest developments
are mainly the result of the emergence of the mid market mezzanine product which has become a common feature of LBO transactions like the management buyout of Takko and the merger of Pinewood and Shepperton Studios. As well as the use in LBO situations, there
is an increasing trend to use mezzanine in sponsorless/non-LBO situations. Currently, while precise pan-European figures for mezzanine investments are notoriously hard to obtain, US data show more than 40 per cent of all funds are applied to these type of opportunities.
Mezzanine in sponsorless transactions The most important source for sponsorless mezzanine solutions is expansion finance whether internal or external. Internal growth could
be volume-, product- or geographical-expansion, particularly for smaller, privately-owned businesses or neglected public listed companies, and also early stage opportunities. In terms of external growth, expansion finance can be used for financing acquisitions.
An increasing risk awareness will mean that in a growing number of cases alongside conventional bank funding the need for an additional higher risk/higher return financing instrument will become visible. Often the Hausbank of the Mittelstand company will approach a mezzanine provider. This way the Hausbank benefits because it can retain the customer relationship instead of losing it to a one-stop-shop provider. Also, for the existing senior bank, mezzanine represents quasi-equity/subordinated debt and stands for an even
stronger entrepreneurial commitment for the planned business initiative as well as a reduction of risk, combined with unchanged margins. The use of (subordinated) mezzanine for strategic issues also allows companies to free their balance sheet for the financing
of “ordinary” investments with senior debt.
Mezzanine is not only more suited to risk than senior debt, it also offers shareholders the comfort of less dilution than equity. Because many Mittelstand majority owners would not want to put their shares on sale, there is an obvious market entry barrier for private equity. Similarly, for publicly listed companies at SMAX or Neuer Markt, private equity represents only
a limited alternative, because in Germany there are significant legal impediments to public-to-private deals. In most cases shareholdings are widely spread and concept
of a squeeze-out mechanism’ remains some way off. In cases where shareholders accept dilution, they often have to realise that there is not always an availability of equity from the stock exchange.
The second most important source for sponsorless mezzanine solutions is reorganisation. This covers a much broader field and can be summarised as changes in the company’s shareholder structure or its balance sheet. Succession issues are also covered as are clean-ups’ of shareholder structures in family-owned businesses. To bring management
in full ownership mezzanine may also be the appropriate instrument in small and medium secondary buyouts. Mezzanine as a sole financing tool or in combination with senior debt is a perfect instrument to flatten the road to a new shareholder structure.
Further opportunities can also occur in cases of a planned trade sale or an IPO, and occasionally the refinancing of shareholder loans. Because of its treatment as debt
by tax authorities, mezzanine interests are fully, respectively 50 per cent tax deductible (KStG, respectively GewStG), and there is no conflict with German thin capitalisation rules (8a KStG), which limit the amount of (tax deductible interest bearing) shareholder loans to a maximum of 1.5 times equity. Also from the perspective of the company owners, mezzanine represents an alternative to their equity/shareholder loan injection, because it helps them to diversify their personal investment portfolio.
A different challenge Sponsorless mezzanine transactions show some peculiarities, which distinguish them from mezzanine provided alongside LBO transactions. The most important difference is
the absence of private equity’s emphasis on exits. Different (or non-existing) exit incentives for shareholders/owners compared to mezzanine providers make the alignment of interests a very challenging task. This means the structure of the exit, especially the definition of trigger mechanisms and respective valuations, becomes key.
In this regard, trigger events like IPO and trade sale are comparable to the LBO situation. However, the likelihood of a virtual exit increases requiring tailor-made structures in terms of the value and the trigger of a cash kicker.
In most cases, sponsorless transactions are not driven by M&A advisors and a set time table as well as a standardised procedure are not in place, which in LBO deals often helps to structure and speed up the process.
As a further distinction, documentation becomes more time consuming, because the parties involved are often not familiar with the respective documentation, like undertakings, financial covenants, intercreditor agreements, and second ranking securitisation agreements. Furthermore, company owners have to get familiar with monitoring and reporting requirements, which are more elaborate than for ordinary corporate loans. Also the due diligence process has to be looked at closely as the budget for this should reflect the respective deal size.
Comparing these challenges with the outlined bundle of advantages mezzanine offers as a debt instrument, it will in most cases definitely remain an opportunity worth considering. In particular, shareholders who do not want to sell their companies and have exhausted the traditional ways of raising credit will be interested in such new forms of financing.