by Josef A

Created on: May 25, 2009

The term mezzanine capital might need some explanatory words to begin with. Mezzanine describes a type of financing that can take different forms, but is always somewhat in between equity and debt. It usually combines elements of debt and equity; some tending more towards equity others being closer to a regular bond. Two typical examples of mezzanine financing are preferred shares and subordinate notes.

A holder of a subordinate note is usually the last creditor getting money, if a company files for bankruptcy and has to be liquidated. Bank loans and regular bonds are serviced first from a sell-off of assets. Only in case something is left, investors holding a subordinate note get money. This procedure implies that investing in subordinate notes can lead to a significant loss if a company goes out of business. Naturally, investors demand higher interest to take on such risk.

Preferred shares can for example guarantee a certain added bonus on the dividend in return for losing certain ownership rights. Often preferred shares have no vote at the annual shareholders' meeting. As many private investors, who have only a small amount of money in the market, have no interest in influencing corporate decisions, they willingly forgo those rights for a higher return on their investment. Those are just two examples and many other forms of hybrids between equity and debt exist.

So why will the mezzanine market rebound? In general, such financing can be quite attractive for investors, but is complicated to manage for the issuing firm. When credit was easily available there was not much need to rely on such rather exotic ways of financing. Bank loans, simple equity sales, and regular bond issues are more straightforward ways of financing companies. However, getting access to credit has become much more difficult and attracting investors is not as easy as it used to be. On the one hand, to grant a bond like paper certain rights to participate on a company's earnings in addition to regular interest payments might be a successful channel to convince investors. On the other hand, investors might rather purchase equity that includes some kind of guaranteed fixed payment that has to be paid out even if regular shareholder miss out on a dividend. In order to secure financing smaller and less financially strong companies will have to be more inventive to attract investors. That will certainly revive the mezzanine market.

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