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18 Int'l Bus. Law. 445 (1990)
Theory and Practice of Mezzanine Financing

handle is hein.journals/ibl18 and id is 447 raw text is: BANKING LAW

Theory and Practice of
Mezzanine Financing
Rory H Brooks
Mezzanine Management Ltd (Advisor to First Britannia Mezzanine), London

ezzanine financing is the term
adopted in the UK and now
increasingly widely in Europe
for that layer of financing that lies both
in risk and return after senior debt but
before equity. The fundamental
characteristic of mezzanine is that of a
debt instrument with a contractual
entitlement to the repayment of
principal. It is created as a separate
instrument from the senior debt and is
not therefore afi expansion of existing
senior debt terms. The mezzanine
instrument will almost certainly be
subordinated in rank to the senior debt
but because of its debt characteristics it
will have priority over any underlying
equity instruments. The presence of
mezzanine generally denotes a more
leveraged situation than would be the
case if only senior debt had been
borrowed.
In terms of capital structure, the
mezzanine layer does not dominate the
balance sheet but frequently takes
approximately 20 per cent of total
funding taking the position immediately
after the full amount of senior debt that
can be obtained. As a result, it tends to
diminish the amount of equity that is
required on the balance sheet. Although
proportions will vary from company to
company, industry to industry, and
country to country, a rough guide is that
60 per cent of total funding may be
derived from senior debt, 20 per cent
from mezzanine debt and then the
bottom 20 per cent from one or more
equity instruments. These ratios vary
depending upon the characteristics of
the deal and general market conditions.
The effectiveness of mezzanine is
simple but compelling. Its existence
implies the capacity and utilisation for
leverage. This in turn means that
mezzanine is an instrument that permits
considerable flexibility over the structure
of corporate funding and the overall
balance sheet. In the absence of
mezzanine debt, the total capital

structure is constrained largely by the
amount of senior debt that is available.
In this environment the equity portion
has to reach up from the total purchase
price through all the amount that is left
unfunded by the senior debt.
Mezzanine permits a freedom of choice
as to the level, greater or lesser, of
leverage that is utilised. The true power
of this, of course, is expressed in return
on equity. The presence of mezzanine
allows the possibility of a much higher
equity return than could be
contemplated under previous
conventional structures. In short, the
presence of mezzanine or a deeper
element of debt permits the true financial
management of an enterprise. The
ability to explore in a more full and
complete way the possibilities
represented by a body of assets and a
cash flow stream opens up a new series
of opportunities. For dynamic and
entrepreneurial management this is a
highly potent tool.
In Europe we have seen mezzanine
emerge only in the last two years. It has
perhaps been more widely utilised in the
UK than elsewhere and in Britain there
is now a steady stream of transactions
that have a mezzanine element
structured into them. Until recently, the
only tranactions involving mezzanine
were those where a management team
has, with a little equity, attempted to
buy a company. These management buy-
outs or buy-ins have grown dramatically
in number in Britain in the last three or
four years. Many deal makers have been
willing to incorporate a mezzanine
component in the capital structure for
This article is a revised version of a
presentation given by Mr Brooks at the
IBA's Section on Business Law 7th
Annual International Financial and
Banking Law Seminar, Zurich, May
1990.

the beneficial reasons which I have
mentioned. Furthermore the absence of
subordinated debt or mezzanine has been
a clear impediment to any larger
transactions because of the resultant
concentration of equity by investors in
any one investment. However, mezzanine
has only recently been employed because
of the earlier uncertainty felt among
deal makers of their capacity to be able
to find buyers for this instrument.
Mezzanine can, however, be deployed
in a far wider set of circumstances than
just management buy-outs. Any form of
acquisition, subject of course to its credit
risk characteristics, may be a candidate
for a mezzanine layer of financing. For
example, many US based acquirers of
companies in Europe treat a
subordinated or mezzanine debt layer as
a routine component of their financing
structure and are disappointed not to
find it so freely available. We have also
seen takeovers of public companies being
made by cash bids (or paper substitution)
involving senior and mezzanine debt.
Equally, there are, subject to prevailing
economic circumstances, many growth
industries where traditional bank
lending may not provide the level of
finance that the company needs to
maximise its potential. This is
particularly true in industries where
traditional asset values may be limited
but the overall value and cash
generation of the enterprises may be
substantial. In Britain at least we have
seen a dramatic change in the
recognition of values that are formally
classified as intangible. Brand names are
a case in point, they are now no longer
seen as valueless but rather as a possible
key to a predictable cash flow. Mezzanine
finance may also be appropriate for the
refinancing of existing and successful
development capital transactions. After
the company has survived its first year or
two of activity in a development capital
environment the risk may be sufficiently
reduced that some of the earlier equity

INTERNATIONAL BUSINESS LAWYER November 1990

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